Reducing Market Risk with Merger Arbitrage

by Dion Friedland, Chairman, Magnum Funds

In early 1997, when SBC Communications sought to acquire Pacific Telecom, fund manager David Liptak did some simple math. If he bought Pacific Telecom’s stock, he could be poised to profit from the expected rise in Pacific Telecom’s stock when converted into SBC shares. At the same time, to lock in this price difference and protect himself in case SBC stock fell, Liptak could sell SBC stock short. So long as the merger was completed (which it was), Liptak could effectively assure his fund a profit.

Liptak, managing director of West Broadway Partners in New York, used a hedging strategy known as merger arbitrage. Designed to ensure profits regardless of the direction of equity markets, this strategy takes advantage of expected price movements — arbitrage opportunities — that occur after a merger or acquisition offer is announced.

Here’s how it works:

After a company announces an intent to acquire another, the price of the target company’s stock predictably goes up, although usually not to the full offering price. Instead, because of the risk of the deal not closing on time or at all, the target company’s stock will sell at a discount to its value at the merger’s closing, this discount increasing with the expected length of time until closing and the perceived risk of the deal. (In the SBC-Pacific Telecom merger, West Broadway got in at an approximately 5 percent discount, or spread, two months before closing.) The merger arbitrageur seeks to lock in this spread. When the offer is a cash offer, the arbitrageur merely has to buy the stock of the target in order to do this. However, when the offer is a trade of securities, like in the SBC-Pacific Telecom merger, the investor must also hedge against the possibility of the acquirer’s stock falling. He does this by selling the acquirer’s stock short.

Consider a hypothetical stock-for-stock transaction in which Company A, with stock trading at $105, offers one share of its stock for each share of Company B stock, currently trading at $80. An investor looking to create an arbitrage profit would buy Company B stock at, say, $100, the price to which it climbed immediately after the merger announcement, and sell short Company A stock at $105 in an amount equal to the exchange ratio — in this case 1-to-1. (Actually, in some instances, particularly in megamergers, the acquirer’s stock price usually drops somewhat immediately after the announcement, as shorting pressure pulls down the price; but for this example we’ll keep it at $105.) As the merger date draws nearer, this $5 spread will narrow as the prices of Company B and Company A stocks converge. When the spread narrows, the investor’s returns grow — for example, if Company B stock rises to $101 and Company A falls to $104, the investor earns $1 on the long investment and $1 on the short.

Once the merger is consummated and Company B stock is converted to Company A shares, the investor locks in the $5 gain regardless of the current price of Company A stock. (His Company B shares are converted into Company A shares, which he delivers to cover his short sale of Company A shares at $105.) If during the interim the market has tumbled, sending Company A stock down to $80, the investor makes $25 on the short sale of Company A stock at $105 minus the loss of $20 on the Company B shares for which he paid $100. (Though if a market downturn causes Company A stock to fall significantly before the merger closes, Company B might back out of the deal; as a cover against a market downturn, some fund managers supplement their merger arbitrage investments with put options on the S&P Index, which enable the manager to lock in a sell price in the event the index craters.) In this way, the investment is buffered from violent market swings.

The following table illustrates this scenario:

Merger Arbitrage Strategy: