Risk arbitrage, also known as merger arbitrage, is an investment strategy that speculates on the successful completion of mergers and acquisitions. An investor that employs this strategy is known as an arbitrageur. Risk arbitrage is a type of event-driven investing in that it attempts to exploit pricing inefficiencies caused by a corporate event.
Basics
Mergers
In a merger, one company, the acquirer, makes an offer to purchase the shares of another company, the target. As compensation, the target will receive cash at a specified price, the acquirer's stock at specified ratio, or a combination of the two.
In a cash merger, the acquirer offers to purchase the shares of the target for a certain price in cash. The target's stock price will most likely increase when the acquirer makes the offer, but the stock price will remain below the offer value. To initiate a position, the arbitrageur will buy the target's stock. The arbitrageur makes a profit when the target's stock price approaches the offer price, which will occur when the likelihood of deal consummation increases. The target's stock price will be equal to the offer price upon deal completion.
In a stock merger, the acquirer offers to purchase the target by exchanging its own stock for the target's stock at a specified ratio. To initiate a position, the arbitrageur will buy the target's stock and short sell the acquirer's stock. In their study, Cornelli and Li found that the arbitrage industry would hold as much as 30%-40% of a target's stock during the merger process. This represents a significant portion of the shares required to vote yes to deal consummation in most mergers. Thus, takeovers in which arbitrageurs bought shares had an actual success rate higher than the average probability of success implied by market prices. One set of passive arbitrageurs invests in deals that the market expects to succeed and increases holdings if the probability of success improves. and deal termination. A price cut would lower the offer value of the target's shares, and the arbitrageur could end up with a net loss even if the merger is consummated. An unexpected extension to the deal completion timeframe lowers the expected annualized return which in turn causes a decline in the stock to compensate assuming the probability of the deal completing remains constant. However, the majority of mergers and acquisitions are not revised. Therefore, the arbitrageur need only concern himself with the question of whether the deal will be consummated according to its original terms or terminated. Such possibilities put the risk in the term risk arbitrage.
Additional complications can arise on a deal-by-deal basis. An example includes collars. A collar occurs in a stock-for-stock merger, where the exchange ratio is not constant but changes with the price of the acquirer. Arbitrageurs use options-based models to value deals with collars. The exchange ratio is commonly determined by taking the average of the acquirer's closing price over a period of time (typically 10 trading days prior to close), during which time the arbitrageur would actively hedge his position in order to ensure the correct hedge ratio.
A 2010 study of 2,182 mergers between 1990 and 2007 experienced a break rate of 8.0%. A study conducted by Baker and Savasoglu, which replicated a diversified risk arbitrage portfolio containing 1,901 mergers between 1981 and 1996, experienced a break rate of 22.7%. Mitchell and Pulvino used a sample of 4,750 offers between 1963 and 1998 to characterize the risk and return in risk arbitrage; the portfolio generated annualized returns of 6.2%.
The arbitrageur can face significant losses when a deal does not go through. Individual deal spreads can widen to more than fifty percent in broken deals. The HFRI Merger Arbitrage Index posted a maximum one-month loss of -6.5% but a maximum one-month gain of only 2.9% from 1990 to 2005.