Risk arbitrage is the investment strategy that profits from the merger of two companies by buying the stock of one or both firms. Known as merger arbitrage, the best way to understand this event-driven concept is to look at a risk arbitrage example. Here are seven scenarios:
Cash Merger – Risk arbitrage is predicated on capitalizing on pricing discrepancy. Company B announces its intentions to purchase Company Z for $60 a share in cash. Company Z’s stock is currently trading for $45 a share. An arbitrageur (Arb) will purchase Company Z’s shares at $45 a share anticipating receiving $60 a share upon the merger’s completion. The arb’s profit is the $15 price discrepancy between shares times the number of shares owned by the arb.
All Stock Merger – Stock-for-stock mergers are more tax-friendly because they do not trigger an immediate tax liability. Upon the sale of the merger stock, then capital gains and losses have IRS reporting accountability. Company D announced a merger with Company Y and has offered 0.5 shares of Company D stock for every 1 share of Company Y stock. If Company Y’s shares are trading at $30 per share and Company D, the acquirer, shares are trading at $80, based on the offer the implied value of Company Y's shares is $40 per share. The acquirer is offering 0.5 or half a share, which is $40 for each Company Y share currently trading for $30. The arbs will purchase Company Y shares and profit from the $10 a share difference and simultaneously sell short (or short) the acquirer Company D shares to lock in the spread (pricing discrepancy).
If the merger closes, the arb makes a profit from owning Company Y stock. This is considered a long position because a profit was realized from the rise in stock price. If the price of the acquirer falls during the merger process and usually after its completion, the arb makes money on the price decline for her short position. This is a common risk arbitrage example.
Cash and Stock Merger – Company R offers to acquire Company K for $20 in cash and 0.3 shares of Company R for every 1 share of Company K stock. The shares of the target firm, Company K, are trading below the total value of Company R’s cash-plus-stock offer. The arbs will purchase Company K shares profiting from the pricing discrepancy in anticipation of the merger closing.
Hostile Takeover – Company G makes an unwanted (hostile) offer to purchase Company T for $70 a share. The Company T shares are trading at $50 and savvy investors will purchase the Company T shares and bank on a successful merger consummation or another interested bidder, White Knight (friendly) or hostile, entering the picture and making a higher offer, thus increasing the investor’s potential profit.
Regulatory Play – Company A is to acquire Company J, but the merger is subject to regulatory approval. If the market has any apprehensions that the merger will close, Company J’s shares will trade below Company A’s offer price. The arb’s risk increases due to the uncertainty of the merger’s closing and the market’s wait-and-see attitude is reflected in the lack of narrowing or even widening of the price spread.
This is a common risk arbitrage example with firms attempting mergers in highly regulated industries such as energy and utilities, telecommunication, pharmaceuticals, and environmental and waste management.
Distressed Asset Acquisitions – Company W is acquiring the financially distressed Company E for $15 a share. Company E is trading at $9 per share and the market has no confidence the merger will be done; hence the pricing spread is not narrowing. Investors may purchase the $9 Company E stock in anticipation that the merger may eventually close at a higher share price once a comprehensive accounting of Company E’s distressed assets has been marked to market.
Tender Offers – Company S makes a tender offer to buy 60% of the outstanding shares of Company Q for $30 a share. Arbs will purchase the lower Company Q shares and tender, sell the shares back to Company S, and pocket the price difference.
This tendering of shares may not be done immediately, the arbs may wait to see if Company S receives their requested 60% of Company Q’s outstanding shares. If the tendered percentage is short of the 60% threshold, Company S may raise the tender offer share price and patient arbs will realize a higher profit on their Company Q investment.
These risk arbitrage scenarios have unique advantages and inherent risks of macro and microeconomic climate, regulatory risks, and market timing challenges.
Read next: What is an Add On Acquisition?
