Why invest in a company before a merger?
May 4, 2010 11:44 AM   Subscribe

I'm curious about investor behavior with regards to merger announcements.

The other day, United and Continental announced a merger. At the end of stories on the news about mergers, the reporter will usually say something like, "Company X closed 3% higher and Company Y closed 5% higher on news of the merger." Sometimes the price goes down instead of up when a merger is announced.

I think I understand the mechanics of the merger itself - shareholders get some number of stock in the new company based on a buyout rate, and people end up with a number of shares in the new entity. What I'm more interested in is what the motivations or strategies are of the people who are now suddenly pumping money into (or taking money out of) companies that will not exist in their present states for much longer. The stock isn't suddenly going to be worth more (or less) once the merger is finalized, right? The whole point is to end up with an equivalent value of New Company stock that you had in Old Company stock, albeit maybe in a different number of shares.

Is it just pure speculation? Or is there some deeper strategizing that I'm not aware of?
posted by backseatpilot to Work & Money (11 answers total)
Merger arbitrage.
posted by procrastination at 11:51 AM on May 4, 2010

This is called merger arbitrage, and there are various strategies of varying complexity. Basically, they are betting that the price available to them at the time they are executing their strategy either does not fully take into account newly available information related to the proposed merger (e.g. "The market has not priced in all the merger synergies accordingly - I'm going to buy now and the price in the future will be higher!"), or does not correctly account for information newly publicly available (e.g. "There's no way that merger's going to actually close - it won't get antitrust approval, so I'm going to short the stock after those big gains today!") or other similar strategies.
posted by iknowizbirfmark at 11:56 AM on May 4, 2010

In addition to merger arb, if one of the stocks is a component of one of the larger indices, money managers that mimic that index will need to buy or sell the stocks accordingly. Also, depending on your fund's mandate, you may not be allowed to hold shares any longer in the company. Also, some traders could be hedging an option play with the stock. If you were long calls, rather than sell them outright, you would sell the stock. This gives you a free synthetic put in the event the deal does not go through while locking in profits. It also will give you a net credit to your account and you would get short stock rebate interest.

With respect to merger arb, a lot of it is an interest rate play and some factor as to whether or not you expect the merger to go through.
posted by JohnnyGunn at 12:19 PM on May 4, 2010

wait what? Good lord that's not merger arb. merger arb is saying company X trades at a premium/discount to the offer from company Z and going short/long X and long/short Y betting that the spread narrows to zero. Not related at all to how the shares initially react to a deal.

What this person is talking about is merger reaction. Its all about how the market perceives a deal at the time it is announced (often it is totally wrong) in the example you gave the argument is CAL + UAL will be able to create synyrgies by optimizing their fleet and cutting overhead - so in theory 1+1=2.1. In the other example you give of the acquiree going up - that's usually because deals are done a premium to the premerger share price. The acquiror's shares usually go down because the market perceives the transaction as being especially expensive or risky and unlikely to produce value for their current shareholders.

JohnnyGunn - Indicies don't change until the deal closes.
posted by JPD at 1:25 PM on May 4, 2010

JPD, ok I will concede that the examples I gave aren't really true merger arbitrage and are just basic reaction to the news, but isn't the higher volume immediately prior to and following public announcement mostly related to true merger arbitrage?
posted by iknowizbirfmark at 2:37 PM on May 4, 2010

Merger arbitrage is one strategy to take advantage of a merger. Seems like it answers the question...

Merger reaction is really reaction to the change of the risk profile of the target company (and the acquiring company). There is a risk of the deal not happening, or the price being lowered below your entry point, but many investors feel the amount of risk is acceptable considering an explicit public announcement has been made about a likely future value of the equity. And others might feel that they can capitalize by taking a short position and welcoming bad news that could sour the deal.
posted by uaudio at 3:02 PM on May 4, 2010

no this has nothing to do with merger arbs. wash that out of your mind. The arbs push things back inline they don't create the original spread.

but isn't the higher volume immediately prior to the announcement

no that's called insider trading.
posted by JPD at 5:28 PM on May 4, 2010

There is really no such thing technically as a "merger." It is just a descriptive term that speaks to the relative size of the companies, and qualitative factors like if both management teams will survive and if members of both boards of directors will survive. Legally, everything is an acquisition in some form at the end of the day. One company always buys the other company and survives (even if the surviving company changes its name), even in a so-called "merger of equals" like the airline deal.

That said, acquisitions are either done in stock, cash or a combination of the two.

Cash acquisitions are easy to understand since the purchase price is almost always a fixed dollar figure. The first-day "pop" is, in general, the difference between the acquired company's stock price (say $50) and the offer price (say $60). Usually the acquired company quickly trades up to some modest discount to the offer price (say $58). The difference is accounted for, usually, by a combination of the time-value of money between announcement and expected closing and the risk of the deal not closing. In a low interest rate environment like we are in today, the time-value of money will be small. Therefore, you can extrapolate usually as to how likely the market perceives a deal is of closing, for various reasons. These two factors are what the "merger arb" hedge funds bet on, and they in effect keep things from getting too out of wack.

In rare circumstances, an acquired company will trade above the acquisition price (say $65). This is the market's way of saying that either the acquisition price is too low (i.e., the deal will be re-cut, because shareholders will litigate and complain, or vote to not approve the deal), or because the market thinks a third party company will make a higher offer, often resulting in a hostile battle. Once a company agrees to be bought, it effectively has a giant For Sale sign on its door and the board of that company has a fiduciary duty to entertain superior offers that are made.

You may think a stock deal is complicated, but it is really just the same as a cash deal, except you are constantly re-calibrating the purchase price based on real time fluctuations in the buyer's stock price. Suppose the buyer's stock price doesn't move (or doesn't move much), in the case where a giant company buys a tiny company, and it's really no different than a cash deal; you are just doing one extra calculation to determine all of the above.

In a stock deal where the buyer does not over-shadow the seller, hedge funds and investors play both sides of the fence, often shorting the buyer and they go long the buyer.

Synergies or integration risk are other factors that ordinary investors look to to decide if the deal is smart or stupid, but valuation is the key factor that drives a lot of the initial movement, at least until both sides have time to present pertinent information to investors and let investors make informed decisions. Once the market contemplates the intelligence (or lack thereof) of a deal in more detail, they may make bets accordingly, but at that point you are dealing with a confluence of factors at play.
posted by jameslavelle3 at 6:16 PM on May 4, 2010

It is all voodoo and tea-leaf-reading. Short term moves like this can't possibly explained by a simple "oh, it's this because of that" thing. Too many individuals making too many different decisions. jameslavelle3 explains quite well what those individuals are thinking about.

(It's kind of like a mid term election. Lots of districts shift parties, but the margin in each district might only be a few points- a couple thousand votes. But in aggregate, those single digit shifts can seem like a huge shift.)
posted by gjc at 6:45 PM on May 4, 2010

no that's called insider trading.

That's not necessarily true - in the United/Continental example, it was clear from reports in the popular and financial press towards the end of last week that they would shortly be announcing a stock for stock merger. Higher volume towards the end of last week wasn't all or even mostly a result of insider trading.
posted by iknowizbirfmark at 8:51 PM on May 4, 2010

I was being flip.
posted by JPD at 6:08 AM on May 5, 2010

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