Thursday, June 26

ARBITRAGE in a MERGER TRANSACTION

ARBITRAGE in a MERGER TRANSACTION
When a merger or takeover is announced, arbitrageurs sell short the stock of the acquiring company, and take a long position (buy) in the stock of the target company. Because of the risk that the transaction may not be completed, the price of the target stock may not immediately rise to the full offer price. So arbitrageurs may gain as the price of the target stock rises toward the offer price.
Indeed, the target may resist, driving its price even above the initial offer price. Another possibility is that another firm may make a competing bid at a richer price.

An example will illustrate the arbitrage operation. When a tender is announced, the price will rise toward the offer price. For example, bidder B selling at Rs. 100 may offer Rs.60 for target T, now selling at Rs.40 (a 50 percent premium). After the offer is announced, the arbitrage firm (A) may short B and go long in T. The position of the hedge depends on price levels after the announcement. Suppose B goes to Rs.90 and T to Rs.55. If the arbitrage firm (A) shorts B and goes long on T, the outcome depends on a number of alter-natives. If the tender succeeds at Rs.60, the value of B may not change or may fall further, but the value of T will rise to Rs.60, resulting in a profit of at least Rs.5 per share of T for A. If the tender fails, T may fall in price but not much if other bids are made for T; the price of B may fall because it has “wasted” its search and bid-ding costs to acquire T. Thus, A may gain whether or not the bid succeeds. If the competition of other bidders causes B to raise its offer further, A will gain even more, because T will rise more and B will fall. (Remember that A is short on B and long on T.)


Arbitrageurs perform another role in the merger process. Since they go long in the stock of the target and short the stock of the bidder, they are in a hedged position. A change in the price relationship between bidder and target is not a risk because they can cover their short position with their stock ownership in the target. The big risk to the arbitrageur is that the deal does not go through and the price relationship has shifted. When arbitrageurs have accumulated large positions in a target stock, they become a force pushing the deal to its completion.

Source: Mergers & Acquisitions by J. FRED WESTON and SAMUEL C. WEAVER; THE McGRAW-HILL EXECUTIVE MBA SERIES

No comments:

Post a Comment