Merger arbitrage or sometimes called risk arbitrage involves investing in announced merger deals.
Typically when a takeover/merger is announced, the price of the target company would rise to levels close to the takeover price. Sometimes the price would be over the levels of the takeover price due to speculations that the acquirer will bid up or there are other potential bidders. However in most cases, they would be at a slight discount to the takeover price.
Merger arbitrage traders would come in to evaluate the takeover/merger deal and take a position. The usual course for the trader would be to look up the regulatory filings, evaluate the risk involved ie due diligence risk, financing risk, regulatory risk and etc, and evaluate if they will have a position in the target company. In normal cash deals, the traders would normally just long the target company. In stock deals, they will go long the target and short the acquirer to lock in their potential profits.
The risk involved in this strategy is if the announced takeover does not happen for some reason ie regulators blocking the deal, insufficient shareholder support or some conditions/terms of the deal not being fulfilled. Then the price of the target company will fall back to where it was before the takeover/merger announcement. Usually the fall is a big number ( 25-40% ). However there is as likely a chance for potential lucrative upsides in the case of a bidding war. Sometimes another potential bidder will enter the bidding competition to acquire the target. In these cases, prices can go up by significant amounts as the potential acquirers outbid each other.
This blog serves as a discussion on merger arbitrage deals in Asia Pacific.
