Risk arbitrage is an investment strategy that speculates on the successful completion of mergers and acquisitions. An investor that employs this strategy is known as an arbitrageur. Risk arbitrage is a type of event-driven investing in that it attempts to exploit pricing inefficiencies caused by a corporate event.
During my 13 years on Wall Street, I covered hedge funds that deployed the risk arbitrage strategy. Their bread and butter trade would be to go long a stock they thought would be a potential acquisition target, and then go short either the company they thought would over pay, competitors that would be hurt from the acquisition, or a combination of both.
But besides merger arbitrage trading, there are several other types of arbitrage styles as well.
Risk Arbitrage Fundamentals
In a merger one company, the acquirer, makes an offer to purchase the shares of another company, the target. As compensation, the target will receive cash at a specified price, the acquirer's stock at specified ratio, or a combination of the two.
In a cash merger, the acquirer offers to purchase the shares of the target for a certain price in cash. The target's stock price will most likely increase when the acquirer makes the offer, but the stock price will remain below the offer value. The reason being is that not all mergers go through. There is always a risk that a deal breaks a part, resulting in the collapse of the company that was to be acquired.
In some cases, the target's stock price will increase to a level above the offer price. This would indicate that investors expect that a higher bid could be coming for the target, either from the acquirer or from a third party. If you believe that no higher bid will appear, then you could short the stock.
To initiate a position, the arbitrageur will buy the target's stock. The arbitrageur makes a profit when the target's stock price approaches the offer price, which will occur when the likelihood of deal consummation increases. The target's stock price will be equal to the offer price upon deal completion.
In a stock merger, the acquirer offers to purchase the target by exchanging its own stock for the target's stock at a specified ratio.
To initiate a position, the arbitrageur will buy the target's stock and short sell the acquirer's stock. This process is called “setting a spread”. The size of the spread positively correlates to the perceived risk that the deal will not be consummated at its original terms.
The arbitrageur makes a profit when the spread narrows, which occurs when deal consummation appears more likely. Upon deal completion, the target's stock will be converted into stock of the acquirer based on the exchange ratio determined by the merger agreement. At this point in time, the spread will close. The arbitrageur delivers the converted stock into his short position to close his position.
How Likely Will A Merger Be Successful?
A study by Baker and Savasoglu show that the best single predictor of merger success is hostility. The more hostile the potential takeover, the LESS successful the potential merger.
Only 38% of hostile deals were successfully consummated, while so called friendly deals boasted a success rate of 82%. Lesson learned: if you want something, be nice.
Professors Cornelli and Li contend that arbitrageurs are actually the most important element in determining the success of a merger. Since arbitrageurs have made significant financial bets that the merger will go through, it is expected that they will push for consummation. For this very reason, the probability that the merger will consummate increases as arbitrageur control increases.
In their study, Cornelli and Li found that the arbitrage industry would hold as much as 30%-40% of a target's stock during the merger process. This represents a significant portion of the shares required to vote yes to deal consummation in most mergers.
Thus, takeovers in which arbitrageurs bought shares had an actual success rate higher than the average probability of success implied by market prices. As a result, they can generate substantial positive returns on their portfolio positions.
Activist Investing Can Make A Difference
People like Carl Icahn and firms like Value Act Capital are activist investors. They regularly take on large positions in order to gain a board seat to try and make something positive happen for shareholders.
These activist investors initiate sales processes or hold back support from ongoing mergers in attempts to solicit a higher bid.
On the other end of the spectrum, passive arbitrageurs do not influence the outcome of the merger. As we just learned, being a passive arbitrageurs is more difficult to earn excess returns.
Passive arbitrageurs have more freedom in very liquid stocks: the more liquid the target stock, the better risk arbitrageurs can hide their trade. After all, you don't want to the world to know what you're doing out of fear they will “front-run” your trade and eliminate the spread.
Risks With Risk Arbitrage
The risk-return profile in risk arbitrage is relatively asymmetric. There is typically a far greater downside if the deal breaks than there is upside if the deal is completed. Therefore, many arbitrageurs tend to short comparable securities to protect their downside.
Risk arises from the possibility of deals failing to go through or not being consummated within the timeframe originally indicated. The risk arbitrageur must be aware of the risks that threaten both the original terms and the ultimate consummation of the deal.
These risks include price cuts, deal extension risk and deal termination. A price cut would lower the offer value of the target's shares, and the arbitrageur could end up with a net loss even if the merger is consummated.
An unexpected extension to the deal completion timeframe lowers the expected annualized return which in turn causes a decline in the stock to compensate assuming the probability of the deal completing remains constant.
However, the majority of mergers and acquisitions are not revised. Therefore, the arbitrageur need only concern himself with the question of whether the deal will be consummated according to its original terms or terminated.
Additional complications can arise on a deal-by-deal basis. An example includes collars. A collar occurs in a stock-for-stock merger, where the exchange ratio is not constant but changes with the price of the acquirer. Arbitrageurs use options-based models to value deals with collars.
The exchange ratio is commonly determined by taking the average of the acquirer's closing price over a period of time (typically 10 trading days prior to close), during which time the arbitrageur would actively hedge his position in order to ensure the correct hedge ratio.
A 2010 study of 2,182 mergers between 1990 and 2007 experienced a break rate of 8.0%. Another study conducted by Baker and Savasoglu, which replicated a diversified risk arbitrage portfolio containing 1,901 mergers between 1981 and 1996, experienced a break rate of 22.7%.
Risk Arbitrage Returns
In the long run, risk arbitrage appears to generate positive returns. Baker and Savasoglu replicated a diversified risk arbitrage portfolio containing 1,901 mergers between 1981 and 1996; the portfolio generated excess annualized returns of 9.6%.
Maheswaran and Yeoh examined the risk-adjusted profitability of merger arbitrage in Australia using a sample of 193 bids from January 1991 to April 2000; the portfolio returned 0.84% to 1.20% per month.
Mitchell and Pulvino used a sample of 4,750 offers between 1963 and 1998 to characterize the risk and return in risk arbitrage; the portfolio generated annualized returns of 6.2%.
The arbitrageur can face significant losses when a deal does not go through. Individual deal spreads can widen to more than fifty percent in broken deals. The HFRI Merger Arbitrage Index posted a maximum one-month loss of -6.5% but a maximum one-month gain of only 2.9% from 1990 to 2005.
Example Of A Risk Arbitrage Trade
Suppose Financial Samurai is trading at $40 a share. Then CNBC announces a plan to buy Financial Samurai, in which case holders of Financial Samurai stock get $80 in cash. Then Financial Samurai's stock jumps to $70. It does not go to $80 since there is some chance the deal will not go through.
The $10 spread is what an arbitrageur is playing for.
In this case, the arbitrageur can purchase shares of Financial Samurai's stock for $70. He will gain $10 if the deal is completed and lose $30 if the deal is terminated (assuming the stock returns to its original $40 in a break, which may not occur).
According to the market, the probability that the deal is consummated at its original terms is 75% and the probability that the deal will be terminated is 25%. The arbitrageur has three choices:
- Purchase Financial Samurai's stock at $70. He would do this if he believes the probability that the deal will close is higher than or in-line with the odds offered by the market.
- Short sell Financial Samurai's stock at $70. He would do this if he believes the probability that the deal will be terminated is higher than the odds offered by the market.
- Do not get involved in the deal at this point in time.
The arbitrageur can also consider going long other companies similar to Financial Samurai that he or she believes are even better acquisition targets. Once a merger announcement is made, the market rationally starts looking for other potential acquisitions.
Day-To-Day Arbitrage Opportunities
So far, we've discovered the traditional risk arbitrage investment opportunities when it comes to mergers and acquisitions. But did you know there are day-to-day arbitrage opportunities you can also conduct to improve your quality of life?
Here are some quick examples:
1) Apply to a top Canadian university where the acceptance rate is 35% – 50%. Then get a top job in the U.S. versus trying to get into a top U.S. university with a <10% acceptance rate. Then trying to get the same top job in the U.S.
2) Opening up a high interest rate online savings account that pays far higher than the 10-year bond yield when the yield curve is inverted. You can short a 10-year bond fund if you want to take on more risk.
3) Buy ocean view properties in San Francisco, which are trading at a 15% discount to the median price. Every other international city in the world has ocean view properties trading at 50% – 100% premiums. San Francisco is one of the cheapest international cities in the world because six-figure jobs are a dime a dozen, unlike in places like Vancouver.
4) Buy real estate in the heartland of America because valuations are way cheaper, cap rates are higher, and technology enables employees to no longer have to live in a high cost of living area.
The easiest way to do so is through Fundrise, the top real estate crowdfunding platform today along with CrowdStreet, that specializes in 18-hour city real estate. In the past, only ultra high net worth investors or institutional investors could buy commercial property, and no so easily across the country to earn higher real estate returns. Fundrise and others are arbitraging this opportunity for retail investors.
The great thing about these examples are that a lot of them are low-risk to risk-free. The more you can identify arbitrage opportunities before the general public, the wealthier and better your lifestyle will be.