What is merger arbitrage? How does a merger impact share values, and how can you use those changes to your advantage?
Merger arbitrage is a strategy where investors take advantage of changing share values when one company acquires or merges with a second company. When shareholders receive new shares in a merger, they often sell those shares at a bargain price, creating an opportunity for special-situation investing.
Learn more about what merger arbitrage is with these concepts from Joel Greenblatt’s You Can Be a Stock Market Genius.
What Merger Arbitrage Is and How To Do It
In You Can Be a Stock Market Genius, Joel Greenblatt discusses how pre-existing companies undergoing significant changes can yield lucrative investments. In this article, we’ll discuss what merger arbitrage is and how you can use this strategy to find bargain investments.
How to Profit From Companies Undergoing an Acquisition
Acquisitions occur whenever one company purchases a majority of another company’s stock from its shareholders, thus giving the acquiring company controlling interest in the acquired company. Greenblatt argues that acquisitions can create promising investment opportunities because so-called merger securities are often sold at bargain prices. Merger arbitrage is an investment strategy based on finding and purchasing these merger securities.
Merger securities, Greenblatt explains, are securities given to shareholders of the acquired company in addition to cash. For example, if Apple decided to purchase Microsoft at the start of 2023, then Apple might pay Microsoft shareholders (say) $275 per share, in addition to $10 per share of five-year Apple bonds that return 6% annually.
(Shortform note: The term “merger securities” is somewhat of a misnomer, since there’s a distinction between mergers and acquisitions. While mergers refer to the creation of an entirely new company from two existing companies, acquisitions refer to a parent company purchasing another company and subsuming it into the parent company. However, merger securities can arise following a merger or an acquisition.)
Greenblatt points out that merger securities trade at bargain prices for two reasons. First, similar to spinoffs and orphan equities, individual investors receive merger securities that they didn’t want. Merger arbitrage is a way to reallocate those shares to investors who do want them. In the previous example, Microsoft shareholders were interested in owning Microsoft stock, not five-year Apple bonds. Consequently, these shareholders will often seek to pawn off merger securities, even if that means selling them for less than their true value.
(Shortform note: In addition to purchasing merger securities directly, other experts point out that investors can profit by investing in the stock of companies that are likely to issue merger securities later on—for instance, companies undergoing an acquisition. Profit opportunities arise, they argue, because the market sometimes fails to accurately value potential merger securities. In turn, investors can practice merger arbitrage by purchasing stock in companies likely to issue merger securities, then selling the stocks and merger securities separately to profit from this mispricing.)
Second, Greenblatt notes that institutional investors typically aren’t allowed to keep these securities, because their investment funds stipulate that they can only invest in stocks. Returning to the previous example, institutional investors in Microsoft would likely be prohibited from keeping the five-year Apple bonds. The upshot is that these institutional investors have no choice but to sell merger securities, even at bargain prices. Merger arbitrage is a way to take advantage of these sales.
(Shortform note: Investment funds aren’t the only institutional investors that can inadvertently acquire merger securities—for instance, pension funds and insurance companies that own stock in a company being acquired can also be given merger securities. In the case of pension funds, they may likewise have to sell these securities because they have a specific ratio of stocks to bonds that they must adhere to.)