There are some misconceptions among small investors about the stock price movements in the situations when one company acquires another.
It is true that following the announcement of acquisition usually the shares of the acquiring company tend to fall and the shares of the target company rise. It is sometimes explained in the media by the potential impact of the deal on earnings, involved debt, adjustment of different P/E ratios, reserves or even by claims that the owners of the target company will sell the new stock as they will no longer be interested in holding position. However, the real reason for this price movement is something else and it can be understood with a simple calculation.
First of all let's review the reasons why a company may be bought. Shares magazine identifies 5 reasons why a company might want to acquire another one and they all revolve about whether the acquiring company can profit from the purchase -:
When one company announces an intent to buy another at a premium to the current stock price, the price of the target company's stock predictably goes up. However, it usually does not reach the full offering price, and this is so because of the risk that the deal might fail. When it is a cash offer, those who believe that the announced merger will take place just need to buy the stock of the target company and wait.
However, when the offer involves payment with the buyer's stock, they must also hedge against the possibility of this stock's price falling, and they do this by selling it short. So, this is the reason why when one company buys another, the shares of the first tend to fall and the shares of the second rise.
Imagine a stock-for-stock transaction in which one company, with stock trading at $55, offers one share of its stock for each share of another company, currently trading at $40. Big financial institutions with fast access to market will immediately try to buy the target stock and short the buyer in order to lock in as much of this premium as possible. Even the fastest of them will find it hard to make the trades near these prices but let's imagine that they can buy the target company's stock at $45 and sell short the stock of the buyer at $50. This $5 spread soon narrows as the prices of the two stocks converge, and they make profit.
This happens very fast and by the time a small investor is able to do anything the shorting of the buyer's stock and buying of the target stock will make the difference between the two stocks very small. The prices of the two stocks are locked to each other; as some institutions take profit and close their positions the spread reappears which is used by other institutions able to profit from small price inefficiencies due to their high leverage, so the lock remains in place. Small investors, being too late and having to pay for bid/ask spread and for broker's commission, are out of this game.
If the announced merger takes place the target stock will be converted to buyer's shares and the institutions can profit from the initial spread regardless of the buyer's stock price at that time. (Target company shares are converted into buyer company shares, which they deliver to cover the short sale).
Just to illustrate this let's imagine that you managed to buy the target stock at $45 and sell short the acquirer at $50 and that you decided to hold these positions until the merger takes place. For example, if during the interim the market falls, sending the acquirer's stock down to $40, you make $10 on the short sale which you entered at $50 minus the loss of $5 on the target company shares for which you paid $45. If the market goes up and the buyer is trading at $60, you lose $10 on the short sale but gain $15 on the shares of the target company. When the merger takes place they become the same stock so in any case your profit is $5 ...unless the deal fails. This strategy is mostly market-neutral, but not fully as in a case of a serious drop in market prices, one of the companies might decide to back off from the deal.
However, this is all theory and in the real life it can be different. Let's look at one example:
In 2006 a mining company Phelps Dodge announced planned acquisition of INCO, a Canadian nickel producer. This was a stock deal, at a premium, and followed the pattern described above. Phelps Dodge stock dropped and INCO went up. A classic case.
However, a couple of months later, before the merger was approved, the Brazilian mining giant Companhia Vale do Rio Doce, or short CVRD, stepped in with a new offer for INCO, at about the same price, but with an all-cash offer. Since INCO management and shareholders preferred cash to Phelps Dodge stock, their offer was accepted.
Phelps Dodge stock recovered but INCO did not jump up as there was no premium in the new offer from CVRD as the stock was already trading around the offered price. Hedgers that were short Phelps Dodge and long INCO suddenly lost money as the two were no longer coupled.
On the other hand, the idea of buying Inco and shorting CVRD could not work either. Initially some investors perceived the deal as bad for CVRD because of a huge debt involved and there was some selling pressure, but it was very short-lived as it soon turned out that it was a brilliant move leading CVRD to a new all-time high within several months.
A merger arbitrage can take place only when there is a premium on the stock of acquired company and when the acquisition is at least partially paid with the acquiring company's stock. And while it is mostly market neutral it is not risk free, as the announced deal might fail. Some takeover candidates have even been known to end up into administration due to poor trading performance and considerable debts (or pension liabilities) putting off potential acquirers.
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