Trading the securities of companies involved in announced but as-yet incomplete mergers is known as “Merger Arbitrage.”

When a company decides to assume control of a public company, the per-share price that the acquiring company must agree to pay for the target company is typically greater than the prevailing per-share stock price on the public exchange. This price difference is known as the “takeover premium.”

After the takeover terms are announced, the share price of the target company rises, but typically continues to hover somewhat below the price specified in the takeover terms.

Example: Company A agrees to purchase Company B. Prior to the takeover announcement, Company B’s shares trade on the NYSE for $20.00 per share. The deal terms specify that Company A will pay $25.00 in cash per share of company B. Shortly after the deal is announced, it would not be unusual to see Company B’s stock trading at $24.90 – higher than it had been trading, but still a 40 basis point discount versus the agreed upon deal price.

There are two primary reasons for this discount:

1. While the takeover has been announced, it may never be completed, because of, e.g., regulatory, business, or financing difficulties; and,
2. The interest cost of holding the target company’s shares.

If the acquiring company is a public company, the takeover deal may also be structured as a “Fixed Ratio” deal, where the acquiring company pays for the target company in a fixed ratio of its shares. Once a fixed-ratio acquisition deal is announced, the stock price of the target company’s shares will become a function of the acquiring company’s stock price.

Example: Company C, whose stock price is $10.00, agrees to acquire Company D, whose stock price is $15.00. The deal terms specify that two shares of Company C will be paid per share of Company D. Shortly after the deal is announced, it would not be unusual to see Company D’s stock trade at $19.90 on the stock exchange, even though two shares of Company C are currently worth $20.00 in cash.

As with a cash deal, the trading price of the target company will typically be at a discount to that implied by the deal ratio because of potential deal roadblocks and interest costs. This spread can also be influenced by differences in dividends received versus dividends owed over the expected life of the deal, and also by difficulties in borrowing the acquirer’s shares. (Sometimes takeovers are structured using floating ratios of stock, or with collars around a floating stock-for-stock ratio. There are also mergers that use combinations of stock and cash that require an election by holders of the target company. Such deals will make the relationship between the acquiring company and target company stock prices much more complicated than for standard, plain vanilla “cash” and “fixed ratio” takeover deals), and require very specific, intricate trading strategies.

For both Cash and Fixed Ratio takeover deals, the discount on the open market price of the target company tends to shrink as the closing date of the deal approaches and the deal progresses through various milestones such as the successful receipt of financing and shareholder and regulatory approval. Typically any discount largely disappears by the day that the takeover is completed.

Standard merger arbitrage trading strategies attempt to capture the spread between the current trading price of an acquired company and the eventual deal price. In the case of a Cash takeover, the standard Merger Arbitrage trade is to buy shares of the target company when the open-market price of the target company’s shares is lower than the deal price, hoping that the deal will successfully close and the target company’s shares will rise to the deal price. In the case of a Fixed Ratio takeover, the standard Merger Arbitrage trade is to buy shares of the target company and simultaneously short shares of the acquiring company when the shares of the target company are trading at a discount to the price specified in the takeover terms, as calculated by the companies’ current stock prices and the deal’s specified ratio. In both cases, the trader hopes that the deal will close, making money as the discount to the deal price decays.

Of course, if a trader believes that the market is too sanguine about a deal’s prospects, he could execute the opposite of the trades described above – shorting shares of the target and potentially buying shares of the acquirer.

As with all trading strategies, Merger Arbitrage strategies contain inherent risk.

The long merger arbitrage strategies described above are designed to profit if a takeover successfully closes; but, if the takeover is delayed or cancelled – or even rumored to be delayed or cancelled – these strategies risk losing money, in some cases more money than the original investment. The short merger arbitrage strategies risk losing money if the deal is completed, with significant loss potential if there is a sweetened offer for the target company.

This communication is provided for information purposes only and is not intended as a recommendation or a solicitation to buy or sell securities. Trading in shares of companies involved in announced mergers is inherently risky. You should make yourself aware of the terms and risks of the proposed transaction before making any trading decision. Customers are solely responsible for their own trading decisions.