What are Risk Arbitrage Strategies (or Merger Arbitrage Strategies)?
Investment strategies that aim to make money off of companies merging or acquiring one another. Risk arbitrage usually refers to one of three flavors of arbitrage that contain an element of risk:
- Merger and acquisition arbitrage - The simultaneous buying long stock in a company being acquired and selling short the stock in the acquiring company. Until the acquisition is completed, the stock of the target typically trades below the purchase price. An arbitrageur buys the stock of the target and makes a gain if the acquirer ultimately buys the stock.
- Liquidation arbitrage - The exploitation of a difference between a company's current value and its estimated liquidation value.
- Pairs trading - The exploitation of a difference between two very similar companies in the same industry that have historically been highly correlated. When the two company's values diverge to a historically high level you can take an offsetting position in each (e.g. go long in one and short the other) because, as history has shown, they will inevitable come to be similarly valued.
Why You Care
A good strategy to be aware of, even if you do not plan on learning and using it. Public companies merge and acquire other public companies all the time. At some point, your portfolio will have a stock of a company merging with another company or acquiring one.
This strategy is not risk free. Risk arises from the possibility of deals failing to go through. Obstacles may include either party's inability to satisfy conditions of the merger, a failure to obtain the requisite shareholder approval, failure to receive antitrust and other regulatory clearances, or some other event which may change the target's or the acquirer's willingness to consummate the transaction. Such possibilities put the risk in the term risk arbitrage.
Risk Arbitrage Simplified
Imagine you are a gambler who plays the odds. That in a nutshell sums up the essence of risk arbitrage. In a game of roulette, one option is to bet on red numbers or black numbers, which would amount to a fifty percent chance of an even payout; however, since there are two green numbers, their existence offsets the even percentage. A player who would be betting against the red or black would be playing the substantial odds of hitting green.
Translated to investment: Hypothetically, if Joe's taco shop were publicly traded at $50.00 per share, and Sam's taco shop moved to take over Joe's taco shop at a proposed $65.00 per share, this means Joe's taco shop's shares are instantly worth $65.00 per share. The game comes into play because those same shares are currently trading at only $50.00 per share, should the buyout occur. If the early trades (restricted or non-retail trades) elevate the value up to $60.00 per share, there exists the $5.00 difference. This is the entrance of risk arbitrage. The risk inheres in the chance that the acquisition may not be completed, in which case the price per share will reduce to the original $50.00 per share.