What is Merger Arbitrage? How It Works and Why Warren Buffett Uses It!

Wall St. Nerd

A.Kelm

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January 14, 2023

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What is merger arbitrage? How does it work, and why would Warren Buffett use it in his investment portfolio? In this article, we will answer all of those questions and more! We will start by explaining what a merger is and how the M&A process works. Then, we will discuss merger arbitrage and how you can take advantage of it in your investment portfolio. Finally, we will examine why Warren Buffett uses merger arbitrage and his top five deals using this strategy.

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What is a Merger?

A merger is a business combination where two companies form a single entity. This occurs when the stockholders of both companies vote in favor of the merger, which is approved by regulatory authorities. There are various types of mergers, such as horizontal, vertical, conglomerate, and reverse.

  • A horizontal merger is the merger of two companies in the same industry. This helps reduce costs, expand the customer base, and capture a larger market share.
  • A vertical merger is a merger between two firms at different stages of production or distribution of a product or service.
  • A conglomerate merger is when two unrelated businesses merge to form one entity. And lastly, a reverse merger is when a private company merges with an already established public company.

Merger arbitrage, or risk arbitrage, takes advantage of merger deals by buying into one side of the merger and selling short on the other. This allows investors to make profits from mergers. It requires careful analysis of merger targets and a close watch on merger announcements.

Companies often use mergers to expand, diversify, or increase efficiency. Mergers can also benefit shareholders, leading to higher stock prices and improved profits. However, merger deals may fail due to regulatory or antitrust issues. Investors need to do their due diligence when considering merger deals.

The M&A Process

The M&A Process (mergers and acquisitions) can be divided into several key steps, starting with merger arbitrage. Merger arbitrage is a form of investing where investors look to benefit from the merger or acquisition of two companies by attempting to buy stock in the target company (the company being acquired) at a price less than the eventual merger consideration. This can lead to potential profits for investors if the merger is successful.

The next step in the M&A process is due diligence, which involves researching both companies involved in the merger/acquisition to ensure they are suitable for combining. This step includes the analysis of financial statements and other data related to the merger. It also typically involves obtaining legal advice on potential regulatory and legal issues that may arise from the merger.

Once due diligence is complete and both parties have agreed to move forward, the shareholders must approve the merger or acquisition of each company. This typically involves a shareholder vote at an annual meeting, after which all merger documents can be finalized and executed.

The final step in the M&A process is closure. This involves completing the merger or acquisition and integrating the two companies, combining operations, personnel, and resources. If the company is public, the merger/acquisition will be announced to the public and the stock of both companies will likely change in price.

Mergers and acquisitions can be complex processes requiring significant time and resources. Understanding these steps ahead of time can help ensure the merger/acquisition process runs smoothly and efficiently.

What is Arbitrage?

Arbitrage is a trading strategy that takes advantage of short-term price discrepancies in the same or related financial instruments. It involves simultaneously buying and selling an asset on different markets or using various arbitrage methods to exploit price differences. This allows traders to profit from small changes in the asset price when sold on different markets or in different forms.

The most common type of arbitrage is merger arbitrage, which refers to taking advantage of the price difference between the announcement and when the merger becomes official. This strategy involves buying one company's stock before the merger and selling it after the merger at a higher price when market sentiment has changed. Traders can also take advantage of merger arbitrage by shorting the target company's stock and buying the acquiring company's stock.

Arbitrage can also involve taking advantage of differences in currency exchange rates or prices on different exchanges. This is a popular strategy for traders who want to profit from minor market discrepancies. By taking advantage of these small changes in the prices of financial instruments, traders can profit without taking on too much risk.

Arbitrage is a popular trading strategy that many traders take advantage of as it is relatively low-risk and offers potential rewards. However, it is essential to note that risks are involved in any trading, and arbitrage trading should be done with caution.

For example, merger arbitrage can be risky if the merger fails to go through or if market sentiment shifts quickly. It is, therefore, essential to monitor the markets closely and understand the risks associated with any trading before engaging in it.

Types of Mergers

Mergers are a vital part of corporate finance, involving the merger and acquisition of one company by another. There are five commonly-referred to types of business combinations known as mergers: conglomerate merger, horizontal merger, market extension merger, vertical merger, and product extension merger.

  • Conglomerate Merger occurs when two unrelated companies merge their assets, often from different industries. This merger typically occurs when the two companies want to diversify and reduce risk by investing in various businesses.
  • A Horizontal Merger occurs between companies directly competing in the same industry and offering similar products or services. By merging these two companies, they can produce more efficiently, reduce costs and increase their market share.
  • Market Extension Merger occurs when two companies from different industries merge to create a new product or service that can be sold to a new market. The merger of Amazon and Whole Foods in 2017 is an example of this merger type, as the merger enabled Amazon to expand its reach into the grocery industry.
  • A Vertical Merger involves two companies from different levels of the same industry who merge. This merger typically occurs when a company wants to increase its control over the supply chain, such as when Apple purchased Beats Electronics for $3 billion in 2014. The merger allowed Apple to gain control of the headphones and speaker market.
  • Product Extension Mergers involve two companies from different industries who merge to create a product or service related to their products or services. This merger benefits companies looking to expand their product portfolios and reach new markets.

Taking Advantage of Merger Arbitrage in Your Portfolio

Merger arbitrage is an effective strategy for investors who want to make money from merger deals. Let's discuss ways to take advantage of merger arbitrage in your portfolio.

The first way to take advantage of merger arbitrage is by researching. Investing in merger deals can be risky, and you must understand the risks before investing. You should also be familiar with merger regulations so that you can make sure that the merger deal is legitimate.

Additionally, it's essential to understand the merger process and how it affects the value of a particular stock. Research can help you make an informed decision before investing in merger deals.

Another way to take advantage of merger arbitrage is by monitoring merger news. Many merger deals involve a lot of back-and-forth negotiation, and keeping up with merger news can give you an edge in predicting the outcome of merger deals. You can also use merger news to gain insight into potential merger targets, which can help you identify stocks that may be undervalued or overvalued due to merger activity.

Finally, merger arbitrage can also be used as a way to diversify your portfolio. Since merger arbitrage involves investing in merger deals, it can be used as an alternative strategy for investing in stocks and other securities. This can help you spread your risk across different merger deals, which may provide a higher investment return if the merger deal is successful.

The Benjamin Graham Risk Arbitrage Equation

The Benjamin Graham Risk Arbitrage Equation is a mathematical formula developed by the father of value investing Benjamin Graham. This equation assists merger arbitrage investors in finding the potential return on their investments within merger and acquisition transactions. The formula was created to help merger arbitrageurs better understand the profitability of merger opportunities and how to calculate returns when two companies are merging or acquired by another company.

The formula is relatively straightforward and can calculate the potential arbitrage return that merger investors should expect. The formula uses three parameters to determine the return: the current stock price of the target company, the merger consideration, and the merger announcement date.

The merger consideration is calculated by taking into account any cash payments or stock swaps offered by the acquiring company. The merger announcement date accurately reflects the time frame in which merger arbitrage investors will receive their return on investment, as mergers and acquisitions can take up to a year or more to complete.

Using these three parameters, merger arbitrageurs can calculate an estimated investment return within merger and acquisition transactions. Although merger arbitrage can be risky, using the Benjamin Graham Risk Arbitrage Equation can help investors calculate expected returns and determine if merger opportunities are worth pursuing.

Why Warren Buffett uses it and his recent merger arbitrage investment

Warren Buffet, one of the world's most successful investors, relies heavily on merger arbitrage to help power his investments. He has used the Benjamin Graham Risk Arbitrage Equation for many years and sees it as an essential tool for evaluating merger opportunities. Some of Buffett's best-known merger deals have relied heavily on merger arbitrage.

Top 3 Merger Arbitrage Investments From Warren Buffett

Activision Blizzard: In 2022, Warren Buffett's top merger deal was Activision Blizzard / Microsoft. In January, Microsoft Corporation proposed to purchase the video game studio at $95 per share, amounting to $69 billion. Although Activision's stock prices went up upon hearing the news, it only rose to the $70-80 dollar range - 20% lower than what was initially paid for.

Buffett is investing in merger arbitrage, which means that investors buy an acquisition target for less than the proposed acquisition price in hopes that the deal will go through. The reason why this investment makes sense is that if the merger is approved, Buffett will make a 20% return on his investment - much higher than what he would have made through traditional stocks.

Merger Arbitrage - Activision-Blizzard - Microsoft offer

(Source: Google Finance)

With a strong signal from one of the largest tech companies indicating the share price (proposed value) could reach $95, merger arbitrage investors were able to take advantage of the situation and make a significant return. This shows that the market price of $70-$80 was undervalued compared to what Microsoft has proposed.

He has used the Benjamin Graham Risk Arbitrage Equation to calculate expected returns on each deal and determine if they are worth pursuing. Each merger is unique and offers different opportunities for merger arbitrageurs, but the equation can help investors determine potential returns on their investments in merger and acquisition transactions.

Texas National Petroleum Company: In 1964, Charlie Munger and Warren Buffett bet big on merger arbitrage when they acquired Texas National Petroleum Company with borrowed funds. In his own words, "On the bonds we invested $260,773 and had an average holding period of slightly under five months. We received 6 ½% interest on our money and realized a capital gain of $14,446. This works out to an overall rate of return of approximately 20% per annum."

With this investment, Buffett was guaranteed a set payout within a specific time frame—regardless of any negative changes in the market. This is called an absolute return. In general, Warren Buffet typically recommends against using borrowed funds for investments. However, in this case, it made sense to use debt to take advantage of merger arbitrage opportunities.

The Texas National Petroleum Company was in the process of being acquired by Union Oil of California. Although small, the company presented a great opportunity for the acquirer to expand their operations. Buffet and his team of merger arbitrageurs were able to capitalize on this merger by buying the company’s bonds and profiting from the difference between the market price of the bond and its convertible value.

American Express: As one of Warren Buffett's most famous investments, this is a great example of merger arbitrage at work. Although American Express may seem like an old technology (credit cards), they were the new in-demand product as the end of the 1950s approached. American Express helped the U.S. population reduce the burden of transacting in cash. It was also a way for citizens to access capital in a convenient manner. Although the interest rates were high, the convenience factor was unparalleled.

Buffett was able to capitalize on this merger of convenience and safety by buying the debt of American Express before the merger announcement. He also took advantage of a scandal when American Express experienced a problem win what's now known as the 'Salad Oil Swindle'. Basically, a commodities trader (Tino De Angelis) used borrowed funds to buy and sell vegetable oil futures.

Eventually, this led to a collapse in the futures market because he was selling water, not vegetable oil. In turn, American Express' stock dropped. This is because it discovered that one of its subsidiaries had made loans to Tino De Angelis' company. Despite the drop, Buffett saw the opportunity to buy securities in American Express at a discount.

Risks of Investing In Merger Arbitrage opportunities

As with any investment, merger arbitrage carries its own unique risks that must be taken into consideration. Many merger deals require regulatory approval and can take months or even years to complete, resulting in losses for investors if the merger does not go through.

In addition, merger arbitrageurs may have to wait until the merger is completed to reap any returns on their investments. As a result, there is always a chance that merger opportunities could evaporate at any moment, costing merger arbitrage investors time and money.

Merger arbitrage also involves taking positions on both stock prices of the target and acquirer companies involved in the merger deal-which can carry additional risk as well. For example, if the stock price of the acquirer falls, merger arbitrageurs may find themselves in a difficult situation. This is because merger arbitrageurs need merger deals to close to realize any profits.

Despite the risks associated with merger arbitrage, investors can use the Benjamin Graham Risk Arbitrage Equation to calculate expected returns on merger and acquisition investments. Warren Buffett has been using this equation for years and continues to rely heavily on merger arbitrage opportunities to power his investments.

Merger arbitrage is not a basic investment strategy such as dollar cost averaging into the S&P 500. It requires a unique mindset and risk analysis.

Investors looking to employ merger arbitrage should consider using the Benjamin Graham Risk Arbitrage Equation as a tool to help them make informed decisions regarding merger deals. Warren Buffett has used it for years and continues to use it to capitalize on merger opportunities, however, it's not for everyone.

Understanding the Pros and Cons of Mergers For Businesses Before Investing

Before investing in merger arbitrage, it’s important to understand the potential benefits and disadvantages of merger deals for the businesses involved. Mergers can help businesses expand their market share, reduce costs, streamline operations, increase efficiency and gain access to new technology.

On the other hand, mergers can also lead to cultural clashes between two companies, lead to job losses, or raise concerns about antitrust violations. Merger arbitrageurs need to understand both sides before jumping into a merger deal.

By understanding the pros and cons of merger deals from a business perspective as well as risk analysis from an investor's point of view, merger arbitrageurs can make more informed decisions when deciding which merger opportunities are right for them.

How To Make A Successful Merger Arbitrage Investment

There are four key questions to ask when deciding if a merger arbitrage presents a profitable opportunity. Warren Buffett outlined these questions in one of his letters:

“To evaluate arbitrage situations you must answer four questions: (1) How likely is it that the promised event will indeed occur? (2) How long will your money be tied up? (3) What chance is there that something still better will transpire — a competing takeover bid, for example? and (4) What will happen if the event does not take place because of anti-trust action, financing glitches, etc.?” - Warren Buffett

Question 01 - How likely is it that the merger will occur?

This is important to know because merger deals require regulatory approval and can take months or even years to complete. If the merger doesn't occur, this could result in a loss of profits.

Question 02 - How long will your money be tied up?

Opportunity loss can occur if the money is tied up for too long. This is because you could miss out on other profitable opportunities.

Question 03 - What chance is there that something still better will transpire?

To determine this answer it’s important to do your research and monitor the merger deal. Paying attention to news reports can help you stay informed of any changes that could result in a better outcome.

Question 04 - - What will happen if the merger does not take place due to anti-trust action or financing issues?

Is the underlying investment still a good company with long-term prospects without the acquirers' help?

Answering these questions can help merger arbitrageurs decide whether or not a particular merger opportunity is right for them.

By evaluating the merger arbitrage opportunities presented by these deals through the lens of the four questions above, merger arbitrageurs can decide which merger to invest in. Understanding the risks involved and utilizing the Benjamin Graham Risk Arbitrage Equation can help merger arbitrageurs minimize risk and maximize returns when investing in merger deals.

The merger arbitrage market is always changing and it’s important to stay up-to-date with the latest merger news. That being said, merger arbitrage can be a great way to capitalize on merger opportunities as long as investors understand the risks involved and take a disciplined approach to evaluate merger deals.

Conclusion

Merger arbitrage is a great investment strategy for those looking to make money from mergers and takeovers. By understanding how this process works, you can be in a better position to profit from these situations. While it takes some time and effort to learn the ropes of this strategy, it can be very profitable for those willing to do the work. Are you ready to start profiting from merger arbitrage?

“We have practiced arbitrage on an opportunistic basis for decades and, to date, our results have been quite good. Though we’ve never made an exact calculation, I believe that overall we have averaged annual pre-tax returns of at least 25% from arbitrage.” - Warren Buffett.

As you can see, Warren Buffett has been relying on merger arbitrage as an investment strategy for years. By understanding the Benjamin Graham Risk Arbitrage Equation, investors can make informed decisions when deciding which merger opportunities are right for them.

It’s important to consider the potential risks along with the rewards to have a successful merger arbitrage portfolio. With proper analysis and research, merger arbitrageurs can potentially generate returns similar to those of Warren Buffet's top deals throughout his legendary investing career.

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Hi, I'm Alexander Kelm.

Serial entrepreneur, value investor and angel investor. Founder of Wall St. Nerd. Join me here on wallstnerd.com to learn how to read financial statements, find healthy companies, and invest your money wisely.


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