Merger arbitrage was first perfected by Benjamin Graham, one of the world's first and most successful “value” investors. Although Ben Graham used merger arbitrage in the early 20th century, there is still room to make money on this strategy today.
Merger arbitrage is a way to generate an income on low-risk mergers. When a company agrees to buy another company on the public markets, the acquiring company and the acquired company continue to trade until the merger is complete. The acquired company tends to trade at a discount to the acquisition price, reflecting the risk that the deal does not go through, and the time value of money between the announcement of the acquisition and the completion.
Merger Arbitrage With Dell
I previously wrote on Micheal Dell's bid for Dell Inc. (DELL), one of the most controversial take-private offers in recent memory.
Micheal Dell and a number of Dell insiders offered to purchase all of the shares in Dell they do not own at a price of $13.65 per share. Dell currently trades for $13.43, or a $.22 discount to the take-private price.
Investors who purchase Dell shares today and hold for a $13.65 take-private price would stand to earn 1.6% on their investment over six months, or about 3.2% annualized, which is very good in a low interest rate environment. US Treasuries would provide for a .045% return (.09% per year) in the same 6-month period.
Bigger Upside And Downside
Investors have essentially priced Dell as if the take-private deal goes through. If it does go through at $13.65 per share, the maximum upside is 1.6%.
However, there are two other potential outcomes:
- Dell is not taken private – In this case, Dell stock could drop significantly from the current $13.65 per share price.
- Dell gets a better bid – Carl Icahn has proposed a better bid than the bid from Micheal Dell in which shareholders would get a $12 special dividend as well as stock in the “new Dell,” which Icahn estimates will trade for $2 to $5 per share.
A better bid is the kicker that makes for home run winners in merger arbitrage. Suppose that Micheal Dell's bid is thrown out for Icahn's offer. Investors receive $12 in dividends and hold onto shares that trade for $3.50 per share. This merger arbitrage would be significantly more profitable – investors receive $15.50 for their $13.43 investment. The net gain is 15.4% in less than one year!
Making Money In Merger Arbitrage
Merger arbitrage becomes more profitable the smaller the company, because small companies are not watched by bigger institutions because of a lack of liquidity. I watched one merger between Continucare Corp (CNU) and Metropolitan Health Networks (MDF) – two sub-$300 million companies at the time – in which there was a consistent 5% spread between the current stock price and acquisition price for several trading days. Investors who played the merger arbitrage in that trade earned as much as 20% annualized on the transaction!
Arbitraging larger companies can be just as profitable when a better bid comes through. Right now, arbitragers are happy to take a potential 1.6% from Dell should Micheal Dell steal the company at a price which many have declared to be too low. If Micheal Dell gets rejected for Icahn, the returns could be monstrous – more than 15% in less than one year on a relatively low risk play.
That's merger arbitrage in a nutshell.
Have you ever participated in arbitrage?