April 5, 2007

You can be a stock market genius arbitrage and merger securities

The next topic in the book is on arbitrage and merger securities. Risk arbitrage is the purchase of stock in a business that is subject to an announced merger or takeover.

Risk arbitrage involves two kinds of risk. The first risk is event risk. The deal or merger may not go through due to various problems such regulatory issues, financial problems, unforseen events.

The second nature of risk is the timing risk. For ex: A company A announces the buyout of another company B. Company B trades at 200. The buyout offer is at a premium of 20%. As a result of the announcement, the stock rises to 230. This is still below the deal price of 240 and give rise to an arbitrage of 10 per share (4.3%). Now the time take for the deal to play out will have a big impact on the eventual returns. If the deal takes 2 months, the returns are 25%+. However if the deal takes a year, then the return falls to around 4% which is below the risk free rate.

Finally the area of risk arbitrage is now fairly competitive and the typical returns have come down over the years. As a result the risk/ reward equation is not compelling in several situations and hence the author advises that non-professional investors should stay away from this area of arbitrage

The next sub-topic is on merger securities. These are securities such as warrants, bonds, shares etc which are issued by the acquirer to pay for an acquisition. These securities, issued during the merger, may not really be desired by the large investors for various reasons (similar to the spin-offs). The reason could be the restrictions on the institutional investor such as a stock fund may not be allowed to hold bond securities issued during a merger. In addition some securities such as warrants may not be large enough for the large investors to get interested. Finally due to the various reasons, these securities are sold off without regard to the investment merits. As a result these securities can be purchased below their intrinsic value

Thus merger securities are similar to spin-offs and an investor who is able to do a certain amount of analysis and due-diligence may be able to profit from both the special events.

My thoughts. I have seen a few merger and acquisition announcements in the past. However these coporate events are not as frequent in the Indian market as compared to other foreign markets. Also the pricing in quite a few of these merger announcements is fairly efficient and these is little opportunity for a small investor to earn a good return (without leverage). However it is still a good area to investigate if one is interested in extra returns. A word of caution though aribitrage of any kind requires continous effort and may not be too truly appropriate for a part time investor.