Merger Arbitrage vs. Distressed Investing: What is the Difference?
Certain event-driven strategies such as merger arbitrage and distressed investing can perform well independent of economic conditions.
- Merger Arbitrage → Event-driven investing around M&A transactions has historically outperformed amid periods of economic strength, as the number of opportunities (i.e. deal volume and count) is the highest, as well as the chance of purchase premiums.
- Distressed Investing → Conversely, distressed investing performs best in recessionary periods, as more companies become prone to financial distress.
What is an Example of Merger Arbitrage Investing?
As an illustrative example, suppose that a company just announced its interest in acquiring another company, which we’ll refer to as the “target.”
Typically, the target’s share price will rise, although the amount will depend on how the market perceives the announcement at the end of the day.
The market attempts to price in various factors, such as the chance of closure, the anticipated synergies, and control premium, which creates a period of uncertainty in the market, i.e. the uncertainty among investors is reflected in the volatility of the share prices.
The market price tends to remain slightly discounted to the announced offer price, which reflects the remaining uncertainty on the close of the acquisition.
An event-driven investor could analyze the potential acquisition to determine how to maximize profits from the opportunity, with consideration towards factors such as the following:
- Acquisition Rationale
- Estimated Synergies
- Deal Closure Likelihood
- Potential Hurdles (e.g. Regulations, Counter-Offers)
- Shareholders’ Reaction
- Market Mispricing
If the transaction appears near-certain to close, the event-driven investor could purchase shares in the target to profit from the post-acquisition stock price appreciation and take a corresponding short position in the acquirer’s shares – which is the “traditional” merger arbitrage strategy.
But more efficient market pricing and increased competition among institutional investors have contributed to more complex strategies being employed.
For instance, hedge funds nowadays integrate options, utilize secular shorts, trade derivatives around the acquirer, and willfully target highly-complex scenarios with more contingencies (e.g. competing bids, hostile takeovers / anti-takeover).
