Your co-worker mentioned he’s in the middle of a merger arbitrage and is having second thoughts. “Could relying on a merger arbitrage strategy example be a major mistake?”, he asked. Not knowing the details of his investment, you share some general guidelines, and here’s what you told him …

Could Relying on a Merger Arbitrage Strategy Example Be a Major Mistake?

Relying on a merger arbitrage strategy example can be a major mistake under certain conditions. Merger arbitrage is buying the shares of the firm being acquired, known as the target, at a discount to its current trading price. The company purchasing the target is the acquirer and is offering to purchase the target’s stock at a premium. Event driven investors called arbitrageurs (arbs) seek to profit from the discrepancy, or spread, between the acquirer’s offer price and the target’s current stock price.

Could relying on a merger arbitrage strategy example be a major mistake? Merger arbitrage is a strategy inherently risky and challenging, let’s examine:

Pitfall and Risks

Transaction Failure – Arbs profit when the merger is completed. If the deal does not close, the target firm’s stock price plummets, usually retreating to where it was prior to the merger announcement or can be lower. Investors can lose their investment for a variety of reasons such as shareholder opposition, or inadequate financing.

Regulatory and Legal Risk – Regulatory and legal scrutiny can adversely affect a merger arbitrage strategy. The European Commission (EC), Federal Trade Commission (FCC), and the Department of Justice (DOJ) can impose divestiture prerequisites or request additional supportive documentation that can delay or block the merger. If the transaction is not consummated, then money is lost.

Complex Strategy Structure – All cash offers, cash and stock offers, and an all-stock transaction with a dangling earnout are complex merger strategies. Each strategy is structurally different and carries specific risks and tax implications. Intricate terms and conditions, contingent value rights and complex break-up fee agreements increase the outcome’s unpredictability and can jeopardize profit potential.

Could relying on a merger arbitrage strategy example be a major mistake? Under certain conditions, a merger arbitrage strategy can be a fast way to permanent capital loss. However, given the right acquirer and target the strategy is very lucrative.

What is an Example of a Merger Arbitrage Strategy?

Berkshire Hathaway’s (Berkshire) acquisition of Burlington Northern Santa Fe (BNSF) Railway is an example of a merger arbitrage strategy. The Warren Buffett led-acquirer, Berkshire Hathaway, announced on November 3, 2009, its intention to purchase the target firm, Burlington Northern Santa Fe Railway for $44 billion.

Pre-merger announcement, BNSF shares were trading at $76.00 a share. Berkshire was to purchase the remaining 77.4% of BNSF it did not own for $100 a share in a cash-and-stock transaction. BNSF’s stock rocketed to $97.00 a share.

Event driven investor’s quick risk assessment yielded Berkshire a financially strong suitor with a successful acquisition history and BNSF would be a complimentary strategic fit. With no foreseeable regulatory hurdles, merger arbs sensed a profit opportunity in the $3.00 spread and began buying, highly confident the deal would close.

On February 12, 2010, Berkshire’s acquisition of BNSF was completed. Berkshire’s new acquisition was a strategic investment gaining them exposure to a vital transportation infrastructure and its long-term earnings and growth potential.

Merger arbitrageurs recognized and capitalized on a low-risk arbitrage strategy served up by an extremely strong acquirer with vast resources to successfully close the transaction.

Could relying on a merger arbitrage strategy example be a major mistake? Yes, a merger arbitrage strategy example can be a major mistake for experienced and inexperienced investors, alike. A balanced approach built on thorough due diligence, diversification and risk mitigation is advisable and prudent investing.

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