Question

What is merger arbitrage and what kind of investors choose it?

Answer 1

What is merger arbitrage?

Merger arbitrage is a strategy deployed by investors to earn profits due to a merger. This is achieved by:

• Shorting the shares of the acquiring company
• Buying the shares of the target company

This strategy works on the assumption that:

• As soon as a merger is announced, the acquirer's share price declines and it takes some time to revert back to normal
• As soon as merger is announced, the target's share price increases, but it still trades below the acquisition price.

A merger arbitrageur buys the shares of the target and short sells the shares of the acquirer. Once merger is through, the shares of the target is swapped (in case of share swap) by the shares of the acquirer. Thus the investor now gets the share of the acquirer which it then uses to close out its open short sold position in the acquirer making profits.

What kind of investors choose it?

Investors that choose merger arbitrage are:

• large institutional investors
• Hedge funds
• Private equity firms and
• Investment banks