What it means
When one company announces a takeover of another, the target's share price usually jumps but stays below the offer price. The gap exists because the deal is not certain: regulators may object, shareholders may vote no, or financing may fall through.
A risk arbitrageur buys the target's shares and collects the gap if the deal closes. The gap is called the spread.
It is the difference between the offer price and the market price. A wide spread suggests that the market sees more risk or a longer wait, while a narrow spread suggests confidence that the deal will complete soon.
If the offer is paid partly or wholly in the buyer's shares, the arbitrageur often sells the buyer's shares short (borrows and sells them, hoping to buy them back cheaper) in the right ratio. This hedges the risk that the buyer's share price falls and lowers the value of the offer.
The arbitrageur is then exposed mainly to the deal risk, not to the market. The strategy can produce steady returns, but it has a serious downside.
If the deal collapses, the target's price often falls sharply to its previous level, and the losses can be much larger than the gains from successful deals. For this reason, arbitrageurs study regulatory approvals, financing, shareholder votes and the strategic logic of each deal.
Returns are usually quoted on an annualised basis, because deals complete over months. A modest spread of 5% for a six-month deal is about 10% a year, which looks attractive compared with cash.
The figure is only a rough guide, since it ignores the chance of failure and costs such as trading fees and borrowing charges. Hedge funds are the main practitioners, and their buying can help the target's shares trade close to the offer.
For ordinary investors, the strategy is a reminder that the price after a takeover announcement is not free money; it is the market's estimate of the chance the deal succeeds.
In practice
Real-world examples.
Example
A hedge fund buys 100,000 shares of a takeover target at $47.50 when the cash offer is $50. If the deal closes, the fund earns $2.50 a share, or $250,000. If it fails, the fund could lose far more, so the position is sized with care.
Example
A fund buys a target in a share-for-share merger and sells short the acquirer's shares in the agreed ratio. This protects it from a drop in the buyer's share price. The fund adjusts the hedge as the two share prices move.
Example
A regulator announces an in-depth investigation into a large merger. The target's share price falls, the spread widens, and an arbitrageur decides the risk is too high and sells. He accepts a small loss rather than risk a larger one if the deal is blocked.
Formula
Calculation
Spread = Offer price - Market price
Simple return = Spread / Market price
Annualised return = Simple return x (365 / Days to completion)
Suppose a company has agreed to be acquired for $50 per share in cash. The shares trade at $47.50, and the deal is expected to complete in 6 months (about 182 days).
Spread: $50.00 - $47.50 = $2.50
Simple return: $2.50 / $47.50 = 5.26%
Annualised return, approximating 6 months as half a year: 5.26% x 2 = 10.53%
If the deal fails and the shares fall back to $38, the loss would be $47.50 - $38.00 = $9.50 per share, almost four times the potential gain.Case study
Seen in the real world.
Northstar Opportunity Fund is a fictional hedge fund used in an illustrative scenario. A medical device maker agrees to be bought for $50 a share in cash, and the shares trade at $47.50.
Northstar buys 200,000 shares for $9,500,000, expecting completion in six months. Its analysts review the deal terms and decide that the regulatory risk is low because the companies sell different products. The deal closes on schedule, and Northstar receives $10,000,000, a gain of $500,000.
In another deal that year, Northstar buys a target at $30 against a $32 offer, and the regulator blocks the merger. The shares fall to $22, and the fund loses $8 per share. The two outcomes show why careful deal selection, and diversification across many deals, are central to the strategy.
Watch out
Common mistakes.
- Treating the spread as a guaranteed profit. It compensates the investor for the chance that the deal fails.
- Ignoring the downside. Losses on failed deals can outweigh several successful ones.
- Quoting annualised returns without noting the risks and costs. The headline figure ignores failure rates, fees and borrowing costs.
Questions
People also ask.
Why is the target's price below the offer?
Because investors allow for time, the cost of capital and the risk that the deal may not close. The wider the gap, the more doubt the market has.
Is risk arbitrage the same as pure arbitrage?
No, pure arbitrage is risk free, while risk arbitrage carries the risk of deal failure.
Who uses this strategy?
Mainly hedge funds and specialist investment firms with research teams. They study the legal documents, the regulators involved and the financing.
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