Risk Arbitrage

What is risk arbitrage?

Risk arbitrage, also known as merger arbitrage, is an investing strategy that profits from the closing of a gap between a target’s stock trading price and the acquirer’s valuation of that stock in an expected takeover agreement. In a stock-for-stock merger, risk arbitrage is purchasing the target’s stock and selling short the acquirer’s stock. If the transaction is completed, this investment plan will be beneficial. Otherwise, the investor will lose money.

Understanding Risk Arbitrage

When a merger and acquisition (M&A) transaction is revealed, the target firm’s stock price rises to the acquirer’s value. The acquirer will propose one of three financing options for the transaction: all cash, all stock, or a combination of cash and shares.

Risk Arbitrage in stock mergers

In the case of an all-cash transaction, the target’s stock price will be close to or equal to the acquirer’s valuation price. In certain cases, the target’s stock price will exceed the offer price since the market believes the target will be put up for sale to a higher bidder, or the market believes the cash offer price is too low for the target’s shareholders and board of directors to accept.

In most circumstances, though, there is a disparity between the target’s trading price immediately after the sale is announced and the buyer’s offer price. This spread will form if the market believes that the transaction will not close at the offer price or will not conclude at all. Purists disagree since the investor is just going long the target stock in the expectation or belief that it would increase toward or meet the all-cash offer price. Those who use a broader definition of “arbitrage” would note that the investor is aiming to profit from a short-term price difference.

Risk Arbitrage in Cash Mergers

Cash mergers are transactions in which the acquirer agrees to pay a certain sum of cash (at a premium) for the target company’s shares. In such cases, the acquirer would often disclose the price at which it will buy the target’s shares if the merger is accomplished. The investor/arbitrageur is betting on the merger’s success and stands to profit from the difference between the price at which he or she purchased the share and the acquisition price.

Passive Arbitrage vs. Active Arbitrage

Active arbitrage occurs when the arbitrageur owns enough shares in the target business to affect the merger’s result.

Passive arbitrage occurs when arbitrageurs are unable to influence the merger — they make bets based on the likelihood of success (and the degree of hostility) and raise their investments as this likelihood grows.

Criticism of Risk Arbitrage

The investor in risk arbitrage faces the significant risk that the transaction may be cancelled or disapproved by authorities. The transaction may be called off for other reasons, such as financial insecurity at either firm or an adverse tax condition at the acquiring company. If the deal falls through for any reason, the stock price of the target will typically fall — potentially sharply — while the stock price of the would-be acquirer would climb. An investor who is long the target stock and shorts the acquirer stock will lose money.