Merger Arbitrage Strategy - Investing in Deals

The next group of hedge fund investment strategies that we will take a brief look is corporate restructuring.  The most well known is merger arbitrage.  In this strategy, sharp-eyed managers identify mergers that are happening or that will happen to profit on a paired trade.  The stock of the target firm will be bought and the stock of the acquiring firm will be sold.  When a merger is announced, the buyout price is usually at a premium to the current price of the stock.  The normal market action is for the price to rise in reaction (or anticipation) to the announcement.  Meanwhile, the price of the buying firm declines as the market anticipates a short term correction because the firm will need to use resources, cash and time to integrate the target firm.

In a cash acquisition, the manager would buy the target firm at a price lower than the bid.  When the transaction is closed, the profit would be the spread between prices.  In a stock for stock merger, the manager takes the positions described above:  short the buying firm and long the target firm.  When the transaction is closed, the target firms' stock is converted and used to close out the short position.  The profit is the spread between both positions.  The hedge fund also receives the short interest rebate.

To identify the best trades, managers will use a variety of information sources such as the financial statements, SEC filings, company and sector knowledge.  They will be well informed in regulatory and anti-trust issues.  They will need to know when and at what price to trade into the positions.  Depending on their investment thesis, rumored deals may be included in the portfolio.  Obviously, this is much riskier as trading desk rumors are rampant.

There are several reasons the deal may not be completed.  The merger may not be approved by all of the regulatory agencies.  Another firm may try to buy the target or acquirer.  The target may try to acquire another firm as a takeover defense strategy.  The shareholders may not approve the deal.  This is the risk.

In bad markets, there may be very little merger activity.  In times like these, the fund will invest in low risk fixed income vehicles until activity increases or may shut down the fund and return money to the investors.