Everyone wants to hold a share that receives a takeover bid. The prospect of a price rising meteorically means investors are happy to give up precious time searching for acquisition gems. At Investors Chronicle detailing which companies we think could be subject to a deal.
But second-guessing the City deal-making machine is a difficult art, and you could often be left waiting a long time for a deal to materialise. Even more frustrating is when a company you were eyeing up gets a bid before you've bought in. The deal is announced at seven o'clock, the price shoots up the minute the market opens, and you're left high and dry on some purgatorial island for laggard investors. All that's left is the last few crumbs of upside.
Admittedly, this analogy contains a liberal dose of journalistic colour. But you'll be glad to hear that there is hope. Because even if you didn't hold shares in the target before the deal announcement, the opportunity to benefit from merger arbitrage could still provide a ticket to riches after it. And, as our examples below demonstrate, the best thing about merger arbitrage is that you don't necessarily need to buy as soon as the deal is announced in order to benefit.
But before we rush on to the details, let's consider the basic principles of the concept. Firstly, the notion of arbitrage actually refers to a price discrepancy, whereby buying one security on one market, then selling on another, will result in an almost riskless profit. In that sense, the phrase 'merger arbitrage' is misleading, as the process is really about event-driven investing, whereby you speculate on an outcome based on the details of a possible merger or takeover.
Simply put, this speculation involves weighing up the upside to the deal, the downside to it not happening, and finally making a judgement on the probability of completion. In the ideal cases, there could also be pricing inefficiencies that arise from the event, which are easy to take advantage of if you have the know-how.
The advantage for private investors is that trying to make money from takeovers and mergers removes the risk related to the stock market as a whole. The macroeconomic, credit and social factors that affect the markets are largely irrelevant. So, in that sense, there is less to consider. What's more, an investor can move from trying to profit on one deal to another.
The first hedge funds tended to be merger arbitrage specialists looking to buy the target company after a deal announcement, while simultaneously shorting the acquirer in anticipation that the shares would go down as the completion date neared. And, having weathered the financial crisis, hedge funds are now back in the game.
For example, when Cadbury's board agreed to recommend the takeover by Kraft Foods earlier this year, more than 30 per cent of the group was owned by hedge funds, compared with about 5 per cent before the acquirer first became interested. Merger arbitrage funds have seen $841m (£538m) of net inflows since January, according to Hedge Fund Research, and outperformed all other classifications of hedge fund, but returned just 2 per cent.
Ken Heinze, president of the research group, thinks the "consistent returns with low volatility" account for the sector's popularity among hedge fund investors. "You look around at the economic data and it's mixed," he says. "But one consistency is corporate earnings. They have been improving, so companies that have cash on the balance sheet are asking 'how can we continue to improve earnings looking ahead'." Due to this, Mr Heinze predicts that the opportunities for merger arbitrage are likely to continue into next year. With that in mind, let's see how private investors can benefit.