Merger Arbitrage in Investment Banking

In the past few years, the number of mergers and acquisitions has increased drastically. This can partially be attributed to advances in the investment banking industry.

Investment bankers typically earn large amounts of money as fee and interest in mergers and acquisitions transactions. Hence, they use a lot of strategies to ensure that the merger does actually go through. One such strategy is the use of merger arbitrage.

In this article, we will discuss the merger arbitrage strategy as well as how it affects the outcome of the merger.

What is Merger Arbitrage?

Merger arbitrage is an aggressive investment strategy that is used by investment bankers. This strategy makes money for investors if the merger goes through. On the other hand, if the merger fails to go through, the investor ends up losing money. This strategy may be directly used by the investment bank. This means that they themselves might take a stake in the acquired company.

However, in most cases, the investment banks take an indirect route. This means that the role of arbitrageur is played by an organization, which is not the investment bank itself but instead is an ally of the bank.

How Merger Arbitrage Works?

There are two different types of merger arbitrage strategies that are commonly used depending upon the nature of the merger. The details have been explained below:

  1. Cash Merger Strategy: In the case of a cash merger, the stocks of the target company generally witness a price rise. This is because the acquiring company can only buy the shares if they offer a premium to the existing shareholders.

    Investment bankers typically ask their allies to start buying shares in the stock market before they make their intention to acquire the target known publicly. Hence, arbitrageurs are quietly accumulating the shares for months before the acquisition bid actually takes place. Now, once the acquiring company makes an acquisition offer, the price of the shares of the target company increases.

    Since the arbitrageurs have already acquired a large number of shares, a win-win dynamic emerges between the investment bank and the arbitrageurs. The arbitrageurs gain because they are able to sell the shares for a much higher price than they bought it.

    At the same time, the investment bankers gain because the arbitrageurs vote in favor of the merger, and this drastically increases the probability of the merger going through. It is estimated that in big mergers and acquisition transactions, almost 40% of the shares and, therefore, the votes are held by arbitrageurs.

  2. Stock Merger Strategy: In case the acquiring company offers its own stock in a merger transaction instead of cash, the arbitrageurs have to modify their strategy slightly. This is because here there a two-pronged approach is used. Hence, there is a possibility of making money on two different transactions.

    The first part of the strategy is the same as above. This means that the arbitrageurs go long on the shares of the target company. Going long means that they buy the shares in anticipation of a price rise. If a merger does take place, the price also rises. Hence, they stand to make a gain by selling the shares on the open market.

    The second part of the strategy means going short on the shares of the acquiring company. This is done because if the acquiring company is offering more shares, it will have to issue them. As a result, the value of the existing shares in the market will be diluted. Going short is the strategy wherein the investor makes money when the value of the shares goes down. Arbitrageurs profit from the fall in the value of the acquirers’ shares as well!

Types of Merger Arbitrage

Investment bankers often have relationships with firms who specialize in these arbitrage investments. They make two different types of arbitrage investments.

  • In the first type of investment, they acquire a stake in the target company, which is so large that they can unilaterally influence the outcome of the merger. This is called active arbitrage.

  • In the second type of investment, these investors are not able to acquire a large stake. Hence, they cannot unilaterally influence the outcome but instead, have to invest based on the probability of the actions of other participants.

Criticism of Merger Arbitrage

It is often said that the term merger arbitrage is misleading. This is because arbitrage typically means a risk-free profit. However, in this case, the transaction is anything but risk-free. The investor is exposed to a wide variety of risks. This is because the value of the shares of a potential target generally increase in value on the speculation that a merger will go through.

If the merger doesn’t go through for any reason whatsoever, the price drop is sudden and quite steep. This can cause serious losses to the arbitrageur. To make matters worse, the deal could fall off for many potential reasons such as regulatory or tax issues over which the arbitrageur has very little control. Investment banks often sweeten the deal for arbitrageurs by pitching in to make up for the losses if the deal does not go through for some unforeseen reason.

Also, merger arbitrage has been criticized as it borders on insider trading. The whole crux of the strategy is that the arbitrageurs have access to information that is not public.

To sum it up, merger arbitrage is a high-risk strategy that is used by investment banks all over the world in order to influence the outcome of mergers and acquisitions.

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Investment Banking