Merger arbitrage, sometimes known as “risk arbitrage,” is an investing strategy in which the investor bets on announced M&A deals. After a merger is announced, shares of the target tend to trade below the offered price (due to deal uncertainty), representing the arbitrage spread; if the deal is successful, the price moves up and the investor earns the spread.

Merger arbitrage situations are generally of two types:

Merger arbitrage funds tend to grind along offering bond-like single-digit returns, and in theory, should provide a premium that is uncorrelated with the market and thus offer diversification benefits.

So Why isn’t Everyone doing Merger Arbitrage?

As Charlie Munger says, “invert, always invert,” so let’s start with why merger arbitrage may NOT be such a great strategy.

The main risk in any merger arbitrage trade is that the deal fails to close. When that happens the target’s stock may fall to the level where it traded before the announcement, and if the buyout premium was substantial, this can result in a loss for the merger arbitrage investor (so much for “arbitrage”).

Thus, in general, the merger arbitrage trade is one in which you can make a little, but can lose a lot. It’s like picking up nickels in front of the proverbial steamroller. One of the best academic papers on this subject comes from Mark Mitchell and Todd Pulvino in their paper, “Characteristics of Risk and Return in Risk Arbitrage.” Here is an old post on the subject that summarizes their research along with the core graphic from the paper that highlights the dynamic beta of merger arbitrage: