Risk Arbitrage

What Is Risk Arbitrage?

Risk arbitrage, also known as merger arbitrage, is an investment strategy to profit from the narrowing of a gap of the trading price of a target's stock and the acquirer's valuation of that stock in an intended takeover deal. In a stock-for-stock merger, risk arbitrage involves buying the shares of the target and selling short the shares of the acquirer. This investment strategy will be profitable if the deal is consummated. If it is not, the investor will lose money.

Understanding Risk Arbitrage

When a merger and acquisition (M&A) deal is announced, the target firm's stock price jumps toward the valuation set by the acquirer. The acquirer will propose to finance the transaction in one of three ways: all cash, all stock, or a combination of cash and stock.

In the case of all cash, the target's stock price will trade near or at the acquirer's valuation price. In some instances, the target's stock price will surpass the offer price because the market may believe that the target will be put in play to a higher bidder, or the market may believe that the cash offer price is too low for the shareholders and board of directors of the target company to accept.

Risk Arbitrage and All-Stock Offers

In an all-stock offer, whereby a fixed ratio of the acquirer's shares is offered in exchange for outstanding shares of the target, there is no doubt that risk arbitrage would be at work. When a company announces its intent to acquire another company, the acquirer's stock price typically declines, while the target company's stock price generally rises.

However, the target company's stock price often remains below the announced acquisition valuation. In an all-stock offer, a "risk arb" (as such an investor is known colloquially) buys shares of the target company and simultaneously short sells shares of the acquirer. If the deal is completed, and the target company's stock is converted into the acquiring company's stock, the risk arb can use the converted stock to cover his short position. The risk arb's play becomes slightly more complicated for a deal that involves cash and stock, but the mechanics are largely the same.

Risk arbitrage can also be accomplished with options. The investor would purchase shares of the target company's stock and put options on the acquiring company's stock.

Criticism of Risk Arbitrage

The investor in risk arbitrage is exposed to the major risk that the deal is called off or rejected by regulators. The deal may be called off for other reasons, such as financial instability of either company or a tax situation that the acquiring company deems unfavorable. If the deal does not happen for whatever reason, the usual result would be a drop — potentially sharp — in the stock price of the target and a rise in the stock price of the would-be acquirer. An investor who is long the target's shares and short the acquirer's shares will suffer losses.