Patiently inching your way towards the Costco cashier, you overhear a conversation about a merger. The guy in front of you holding the 20 lb can of cat food keeps talking about his portfolio’s new event driven strategy. Interested, you wonder, is merger arbitrage an event driven strategy? You have got to read this.
Is Merger Arbitrage an Event Driven Strategy?
Yes, merger arbitrage is an event driven strategy. This special situations investment is considered event driven because it relies on corporate action to generate capital gains.
An event driven investor capitalizes on the price differential between the acquiring company’s offered share price and the current share price of the company being acquired.
Arbitrage investors use either the soft-catalyst or hard-catalyst driven approach. The soft-catalyst investment strategy predicts or anticipates an upcoming event and capitalizes by making a pre-emptive investment. This financial fortune-telling strategy’s success rate is 50%, at best.
The hard-catalyst driven approach requires less clairvoyance as the investor bases her investment participation on an event driven public announcement.
Corporate events have a defined timeline and produce specific outcomes. The following are attributes that affirm our answer to: Is merger arbitrage an event driven strategy?
Corporate Event Dependent – Merger arbitrage is a byproduct of a catalytic corporate event that creates price discrepancies. These corporate actions range from merger arbitrage, and distressed debt investing to liquidations and divestitures. Mispricing begets capital gains.
Specific Event Analysis – Investors not only assess the fiscal worthiness of the firms involved but they analyze the specific corporate event itself. Merger terms and conditions, regulatory hurdles, and competition ramifications are scrutinized to determine the likelihood of a transaction’s completion.
Time Sensitive Event – Merger arbitrage is inherently an event driven strategy because it is time sensitive. The acquiring firm and the target company are involved in time-finite negotiations, which investors monitor for positive progress.
Risk and Return Assessment – An event driven investing characteristic is the pending merger’s systematic and idiosyncratic risks weighted against the probability of the transaction’s successful completion.
This paradigm is precipitated by the defined risk and reward profile offered in a merger’s public announcement and detailed in its filed Securities and Exchange Commission (SEC) prospectus.
Event and Market Volatility – Market events surrounding mergers and acquisitions can cause volatility and increase uncertainty. These market ripples can negatively or positively affect share prices in general and merger opportunities, specifically.
Let’s check out merger arbitrage’s event driven sensitivity as we refine our answer to: Is merger arbitrage an event driven strategy?
Announcement Price Reaction – Upon announcement, typically, the acquirer’s share price declines reflecting a potential increase in acquisition debt and uncertain synergies. The acquired or target firm’s shares will initially rise in the hopes of a strengthening capital structure and access to increased capital resources.
Regulatory Approval – Share price fluctuations of the acquirer and target firms can be regulatory and IRS dependent. When governing bodies have antitrust concerns or require divestitures, shares will fall. Announced regulatory approvals will send shares higher, closing the spread between the offer price and the current price.
Shareholder Vote - Mergers experience the time sensitivity of a shareholder vote. Shareholder approval is necessary for the merger to be completed. Any dissatisfaction with the offer price or terms and conditions will adversely impact both firms' stock prices.
Counteroffers – Another company, known as a “white knight”, may emerge as an additional suitor for the target firm. Counteroffers are time sensitive, and negotiation disruptive. They can trigger a bidding war changing the term of the initial offer and increase heightened consummation uncertainty.
Deal Consummation – With regulatory and shareholder approval secured, the merger can close. Share prices of the acquirer and target company converge closing the spread to resemble the final terms of the agreement. Bear in mind, that the unexpected seems to occur as the transaction nears completion.
Is merger arbitrage an event driven strategy? Absolutely. The reliance on specific corporate actions, its event-focused analysis, its sensitivity to negotiation timelines, coupled with a managed risk-reward dynamic defines merger arbitrage as an event driven strategy capable of generating substantial, short-term capital gains.
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