Mergers & Acquisitions (M&A) Arbitrage Stock Trading

Mergers and Acquisition (M & A) arbitrage involves trading stocks of those companies that are targeted for either Merger or Acquisition. The whole idea is that an M & A deal normally involves a price premium for the target company and this price gap creates a potential for arbitrage. But it's important to understand the underlying risks before attempting to profit from an M & A arbitrage strategy.

What is an M & A Arbitrage Opportunity?

There are three types of M & A arbitrage opportunities, namely:

1. Cash buyouts
2. Stock-for-stock deals
3. Combination cash-and-stock deals

An acquirer offers to pay the target company’s shareholders a pre-decided fixed amount of cash for the shares they hold. Post-announcement, the target company’s stock rises sharply, but lingers at a level slightly below the offer price. This difference in offer price and the current trading price is what creates an opportunity for trading profit.

For example, in Dec 2006, Ericsson (ERIC) announced that it had signed a definitive agreement to acquire Redback (RBAK) for $25.00, representing a 60% premium over RBAK’s pre-announcement trading price of $15.60. Post-announcement, RBAK’s stock rose sharply to $24.70. The price stayed between $24.70 and $24.85, lingering at a level slightly below the offer price of $25.00.

Acquirer	Target Company	Type of Deal	Offer Price	Spread / Potential profit
Ericsson (Nasdaq: ERIC)	Redback (Nasdaq: RBAK) $15.60	Cash only	$25.00/ share	$0.15 to $0.30/ share                         (Offer price less Price of target company after the announcement)

The acquirer offers to trade shares of its company for those of the target company at a pre-decided conversion ratio / exchange ratio.

For example, in Jan. 2005, Proctor & Gamble (PG) announced that it would acquire Gillette (G) and it would pay 0.975 share of its common stock for each share of Gillette’s common stock. So, if you owned 100 shares of Gillette, you would receive 97 shares of PG at the close of deal.

Lastly, combination cash-and-stock deals involve exchanges of both cash and stock. Similar to a pure Stock Deal, the potential profit for a cash-and-stock deal is difficult to determine.

Since a cash deal involves a fixed amount of cash exchange, it is the simplest of the three M & A arbitrage opportunities and involves the lowest risk of all. For now, we will focus on the cash buyout arbitrage strategy only. As explained in the above cash buyout example, to seize a price-gap opportunity, you would need to purchase RBAK shares at $24.75 and eventually sell them for the agreed offer price of $25.00 per share once the deal is closed. Thus, you would make a $0.25/share or 1% gain. ERIC and RBAK’s deal was closed within a one month period from the date of announcement, thus translating a 1% gain into roughly a 12% annualized return. Not bad, ehh?

Before a deal is finalized, it must clear several hurdles. Possible reasons for deals not going through could be regulatory objections, financing problems, synergy issues, etc. Another risk factor to watch out for is the duration of a deal. As a general rule, the longer a deal takes to close, the higher the likelihood of things going wrong. If a deal does not go through successfully, the target company stock may drop to the price before the time of announcement.

1. Regulatory Objections
Regulatory agencies may not approve the deals involving companies in certain industries. For example, in 1999 Exxon (XOM) and Mobil planned to merge to form one of the largest mergers in US history. However, the U.S. Department of Justice declined the deal due to possible anti-trust concerns.

2. Synergy Issues
A second hurdle could be that market conditions may have changed, and either or both companies may agree to terminate the deal.
For example, in Dec 2006, Intuit Inc. (Nasdaq: INTU) agreed to acquire Electronic Clearing House, Inc. (Nasdaq: ECHO) for $18.75 in a cash deal.  Post-announcement, ECHO jumped from $15.00 to $18.70. But, in Mar 2007, INTU and ECHO mutually agreed to terminate the deal. After the news, INTU shares plummeted 35% to $12.23 per share.

3. Failure to Get Shareholder Approval
In deals where public companies are involved, execution risk may rise if shareholders fail to approve the deal. This leads to either a bidding war, or ultimately dumping the deal altogether. For example, in 2007, shareholder resistance to M & A deals became a huge issue.  In Jan 2007, Formation Capital announced a cash-deal to acquire Genesis HealthCare Corporation (Nasdaq: GHCI) at $63.00 (representing a 31% premium over GHCI’s Dec 2006 stock price). After resistance from GHCI’s shareholders, in April 2007, Formation Capital raised its bid price to $64.25. However, the deal still faced shareholder resistance at that price. Finally, Formation Capital successfully closed the deal at $ 69.35 (representing a 10% premium over the initially offered target price).

Another Deal which turned into a bidding war was that of Biomet Inc. (Nasdaq:BMET) which was to be acquired by a private company, TPG Capital, for $44/share. The deal was initially announced in Dec 2006, and after much resistance from BMET’s shareholders, BMET’s stock price kept hovering between $42 to $46 for several months. Finally, in September 2007, BMET’s shareholders approved the deal at a $46/share buyout price.

Only after all hurdles have been cleared and a deal has been fully approved, would a closing date be announced. As long as risks are carefully examined, returns from M & A arbitrage strategy could far exceed the returns you would get from other investments on an annualized basis.

An investor is less interested in historical prices and focuses her attention on the fundamentals of the company or asset.  The purpose of an investment is to find a security that is undervalued by the market and will provide a return of capital gains and income that compensates the investor for the risk taken.   Some of the factors considered for an investment are the financial condition of the company, the quality of the management, the competitive advantage the company holds in the market, and the potential growth of the security’s price and dividends.

Let’s review the steps to implement an M & A arbitrage strategy:

Step One: When you learn of a Merger or Acquisition, note the following details:

• Acquirer’s name and ticker, price before announcement
• Target company’s name and ticker, price before announcement
• Date of announcement for deal
• Offer Price / Buyout Price,  Premium Offered
• Deal closing date (this information may not be available until all approvals have been granted)
• Notes: (To track any key news dates)
  • Regular news related to acquirer and target company which indicate health of the companies
  • Date of regulatory approval
  • Date when target company’s shareholders would vote for the deal or in case of merger, date when both company’s shareholders would vote for the deal

Step Two: Make sure the target company’s market price is less than the Offer Price (In some cases, post-announcement target company may be trading at a higher price, which means the market is betting that a higher bidder may emerge).

Step Three: Buy the target company's shares and hold them until the deal is closed or until your price target is reached.

To seize the spread between Offer Price and the price of a Target Company, buy the target company shares and hold on to the shares. Monitor risk factors and watch out for news related to the deal on a daily basis. If everything goes well, eventually sell the shares for the agreed Offer Price once the deal is closed or sell the shares once your price target (somewhere between the current price of the target company and the offer price) has been achieved.