Merger Arbitrage Strategy Explained

Merger Arbitrage, a type of event-driven strategy, is one of many Hedge Fund Strategies.  The most popular Merger Arbitrages hedge fund includes John Paulson’s “Paulson and Co.”.

Merger arbitrage is when a speculator aims to capture the difference or “spread” between the price an acquirer agrees to pay for a target and the price at which the target’s stock price trades at post news announcement. In a cash deal, the speculator would buy the target’s stock price at a discount to the cash offer per share and would hold until the deal closes and the speculator receives cash for each share owned. In a stock deal, the speculator would buy the target’s stock and short the acquirer’s stock in a dollar amount equal to the number of shares the speculator would receive in exchange for the target’s shares.

There are macro risks involved in merger arbitrage such as market and interest rate risks. Other micro risks include earnings, financing, legal, premium, merger agreement, taxes, consideration, fraud, regulatory, timing and due diligence risks (these mostly relate to the actual buyer’s and target’s business).

When screening for merger arbitrage opportunities, speculators typically try to avoid agreements in principle, deals subject to financing, deals subject to due diligence, targets with poor earnings trends, targets with poor earnings, deals in cyclical sectors and deals in highly regulated industries such as telecom. Speculators focus on the definitive agreements, strategic rationale of the acquisition, whether it is a large acquirer, no financing conditions, no due diligence conditions, a strong performing target, a fair valuation and an acquisition with little to no regulatory risk such as the banking industry. And as these speculators build a portfolio with a merger arbitrage strategy, they aim to reach non-correlated, low-volatility superior returns.