Chapter 2
Merger Arbitrage


An arbitrageur is not an investor in the formal sense of the word: (i.e., he is not normally buying or selling securities because of their investment value). He is, however, committing capital to the “deal” (the merger, tender offer, recapitalization, etc.) rather than to the particular security. He must thus take a position in the deal in such a way that he is at the risk of the deal, and not at the risk of the market. He accomplishes this by taking a short position in the securities which are being offered, as part of the deal, in exchange for the securities which he purchases. So, in a merger of Company X into Company Y, the arbitrageur’s investment is one of X long and Y short, or, the merger of X into Y. Once he has taken his hedged position, then the arbitrageur is no longer concerned with the vagaries of the marketplace—so long as the deal goes through. “If you’re caught when a merger falls through, then you become . . . an investor.”1
There is a definite and fairly common sequence to the arbitrageur’s financial analysis that allows him to arrive at his investment decision. He (a) gathers information about the particular deal, (b) calculates the value of the securities offered, (c) determines the length of time he can expect his capital to be tied up in the deal, (d) calculates his expected per annum return on invested capital, (e) determines and weighs all the possible risks and problem areas that might preclude consummation ...

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