Merger arbitrage: trading around a deal in the works

When a company is being taken over, its share price often trades below the offer price, creating a gap. Merger arbitrage tries to profit from this. This guide explains it and its risks.

Quick answer

Merger arbitrage is an approach that tries to profit from the gap between a target company's market price and the price offered in a takeover or merger. The gap exists because a deal is not certain to complete. Merger arbitrage carries real risk, since if the deal fails, the price can fall sharply.

Key takeaways

• Merger arbitrage trades the gap in a takeover or merger.
• The target trades below the offer price before completion.
• The gap reflects the risk the deal may fail.
• Profit depends on the deal completing.
• If the deal fails, the price can fall sharply.

What is merger arbitrage?

Merger arbitrage is an approach that tries to profit from the price gap that appears when a company is being taken over or merged. After a deal is announced, the target's shares often trade a little below the offer price.

The idea is to buy the target's shares at the market price and, if the deal completes at the higher offer price, profit from the difference. It is a bet on the deal going through.

Why does the price gap exist?

The gap exists because a deal is not certain to complete. Deals can fall through due to regulatory objections, financing problems, shareholder rejection or other hurdles.

So the target's shares trade below the offer price to reflect this risk. The bigger the doubt about completion, the wider the gap tends to be.

How is it meant to work?

A merger arbitrageur buys the target's shares hoping the deal completes at the offer price, closing the gap in their favour. The expected profit is the difference between the market and offer prices.

So the approach depends heavily on judging whether a deal will actually go through, which is far from certain.

What are the risks?

The risks are real. If the deal fails, the target's price can drop sharply back down, causing a loss that can be much larger than the small gap that was being chased.

So merger arbitrage is not low risk. It trades a small potential gain against the chance of a large loss if the deal collapses, and predicting deals is difficult.

What should investors know?

For investors, merger arbitrage is a specialised, risky approach that depends on deal outcomes. Understanding it mainly helps you see why a target trades below the offer price.

Understanding merger arbitrage helps you read takeover situations. Any investment decision should be your own after proper research and reading all related documents.

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