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Mergers and Acquisitions

The words "Merger" and "Acquisition" are often used interchangeably but they are different.

In a merger, two or more companies must actively agree to join together as a single entity. A merger usually requires the approval of the shareholders of the companies.

An acquisition can be completed with the sole action of a single company. If the acquisition is done with the consent of the target company then we term it as "friendly takeover", else it is termed as "hostile takeover". In an aquisition, a company can go into the market and buy control of another company without anyone's approval and then replace the board of the target company with directors of its choosing.

Merger

There are many ways in which a merger can be structured. The following two are the most common ways.

1. Both companies merge together to form a new company. The shareholders of both the companies receive new shares of the new merged entity in exchange for their old shares. For example, let's say Company A and Company B merge together to form Company AB. Shareholders of A company will get shares of AB company in exchange for their shares of A company, and shareholders of B company will get shares of AB company in exchange of their shares of B company. The companies A and B will die after the merger and the newly formed entity Company AB will be the only one in existence.


2. Both companies merge together but instead of merging into a new company, one of the companies is retained and the other company is dissolved. This type of merger usually takes place when one of them is a slightly bigger company than the other, and the board of directors of both the companies agree for such a type of merger. Though it seems to be an acquisition, in real, it is a merger. For example, Company A and Company B merge together into Company A. Company B is dissolved. In this type of a merger, there is a possibility that one of the company is a dominant company and the other a subdominant company. The subdominant company is folded into the dominant company.

Trading opportunities in Mergers

The opportunity for trading exists when there is a discrepancy in the prices of their shares post announcement of the terms of the merger. The terms of the merger can be any one of the following.

1. Shares-for-shares exchange
2. Stock and cash deal
3. Cash deal only
4. Stock for stock deal with guaranteed value

The following discusses the trading opportunities for each of the above cases.

Shares-for-shares exchange
Let us understand this with the help of an example. Suppose that there are two companies - Company A and Company B. Both have agreed to merge. The closing date is 3 months from now. Company A has offered 3 shares of its own stock for every one share of Company B's stock. Let us further assume that at the time of announcement of merger, the share price of Company A is $25 and the share price of Company B is $65. Each shareholder of Company B will receive 3 shares of Company A as per the terms of merger. Curerntly, the value of 3 shares of Company A is $75 ($25 multiplied by 3). One share of Company B costs $65. Therefore, this exchange of company B shares for company A shares will result in a profit of $10 per share. This profit potential exists only on the date of announcement. As time progresses, everyone will notice this artibitrage opportunity and trade in a manner to ensure that such arbitrage vanishes.

If we want to lock in the profit, then we should act on or before the date of announcement of the merger. To lock our profits, we would buy one share of Company B and short 3 shares of Company A's stock. Then, on the closing date of the merger, we would exchange our one share of Company B stock for 3 shares of Company A stock. We would then take the 3 shares of Company A stock that we got in the exchange and use them to close our short position.

Stock and Cash Deal
In a stock and cash deal, we need to work on the stock portion of the deal as nothing much can be done for the cash portion. For example, let us suppose that Company A offers two shares of its stock and cash of $25 in exchange of a single share of company B. In this case, if we want to lock in the profits, we would buy one share of Company B and short 2 shares of Company A's stock. On the close, we would exchange our one share of Company B and receive two shares of Company A and $25 in cash. We can then use the two shares of Company A to close our short position in Company A.

Cash Only Deal
If case of a "cash only" deal, there is no need to short Company A stock. As soon as we buy the shares of Company B, we have locked in our profit. For example, if we buy one share of company B at its current price i.e. $65, we can exchange it on the closing date and receive $75. Timing is everything in these kind of trades. The decision to buy has to be made as soon the merger announcement is made. Infact, many would want to buy the stock a few days earlier than the announcement date purely on roumers so as to take advantage of the opportunity. Many traders wind-up their position a few days before the closing date without waiting to receive the money from the company - the reason is that sometimes deals can fall apart, and important the stock price might have moved significantly enough to get the money from the market instead of from the company.

Stock-for-stock deal with a guaranteed value This is a variant of the stock-for-stock deal in which instead of delivering 3 shares for every one share of Company B, company A promises to deliver a guaranteed value of the share price of company B at a particular rate, let's say $67. This is done to stop the short-selling of company A's shares in the market. In this kind of a merger, we can still make money, provided there is a noticeable difference between the current stock price and the guaranteed value.

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