Hedge Fund Strategies - Merger Arbitrage 1 | Hedge funds

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Hedge Fund Strategies - Merger Arbitrage 1

Hedge Fund Strategies - Merger Arbitrage 1 Simple case of merger arbitrage when there is an all cash acquisition

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Hedge Fund Strategies - Merger Arbitrage 1

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Let's say there's some company A here
and let's think about what it's stock might be doing
let's say this is just over the course of the day let's say that it's stock is just trading right over here
so as we go through the day it's price naturally changes but then right over here
let's say this within the day. Maybe this is happening at 10 AM eastern time.
An announcement comes out, that B intends to acquire A at I don't know,
let's say that A right now is trading at 5 dollars a share, but a press release comes out that B
intends to acquire A at 10 dollars a share.
Let me right this down.
At 10 dollars per share.
So you can imagine, and they say they're going to do it with cash.
And we'll talk in future videos about how it becomes a little more involved if they were doing it with their own shares.
But they intend to do it with cash. So they're able to acquire A,
everyone who owns a share of company A will get 10 dollars for it
Those shares will go to company B. Company B will own company A all of a sudden.
So what do you think would happen to the stock of company A?
We know that B intends to buy it for 10 dollars a share.
Well you can imagine if everyone thought that this is definitely going to happen.
That anyone who holds the stock is going to get 10 dollars you can imagine that the stock
would just gap up immediately to something close to 10 dollars a share.
Something close to 10 dollars a share and not even trade much around it
because they know what they're going to get for it.
So this is if you knew that this merger or this acquisition was going to happen.
The reality is you don't now always just from this press release that B definetly will acquire A.
Maybe they have to get approval from government bodies to make sure that they aren't getting
a monopoly here. Maybe they still have to get the funding from some bank, they still have to get a loan
in order to be able to do this deal, so there's somewhat, maybe something else happens,
Maybe there's another bidder that wants to acquiere A and they're willing to pay more. So you don't now exactly
what's going to happen in this situation so you don't know for sure this is going to happen.
So what does normally happen is that instead of going all the way up it goes some place in between.
So in reality instead of jumping from 5 to 10 dollars it might jump from, I don't know,
5 to 8 dollars. And maybe it trades around here. And you might say why does it trade at 8 dollars?
And it would trade at 8 dollars so notice that there's a 100 percent chance it would trade all the way to 10 dollars.
Right? Because that's what stock A would be worth now because B is going to pay that. But if it trades at 8 dollars
essentially the market is saying that we're going to give you three fifths right? From 5 to 8 is 3 dollars
So it's going to be three fifths of the total jump that it could have if there's a hundred percent chance.
Or another way to say it is that the market is saying there is a 60 percent chance that this merger will go through.
Any one who thinks that there's more than a 60 percent chance, it they do this over a bunch of security so that all the
probabilities are kinda worked out eventually, they should buy this security
because they could buy 8 and they think that it should really be worth 10. Any one who thinks that
No way that this acquisition is going to happen that they, B isn't going to get the financing or that the regulatory
authorities aren't going to allow B to do this then they should short the stock when it goes up here because if the
acquisition falls through then the stock is going to go back down here. It's gonna go
back down to the 5 dollar range before the announcement.
And so people, and specially hedge funds,
who act in this way based on they are thinking that the merger is more likely to ocur or less likely to ocur based on
their reasearch or maybe they have some quantitative models or may they have some information other people don't have
that might be legal or might be otherwise they would place these bets; the people who think that the merger will happen
will buy expecting it to go to 10 dollars the people who think it won't they would short it expecting it to go
to 5 dollars. And this strategy of playing the probabilities of a merger happening this is called merger arbitrage.
Merger arb some times called for short. Merger arbitrage.
And it's arbitrage because someone who feels they know the merger is going to happen they can
buy some thing for 8 and then sell or they could buy some thing for 8 but it's going to be worth 10 dollars
they could sell it for 10 at some future date when B acquires the company.
Or if they know the merger isn't going to happen
they could short it for 8 and then buy it back for 5 dollars. Once again kind of doing an arbitrage on a prize differential.
They think some thing that is worth 5 is trading at 8 on the downside, and on the upside they think that something that is trading at 8 is worth 10.

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