What are merger arbitrage investment strategies and are they tax efficient?

June 23, 2023
Written by Amar Pandya
What are merger arbitrage investment strategies and are they tax efficient?

As featured in the Financial Post: FP Answers, June 23, 2023

Q: I’m a keen DIY investor and enjoy investing for the long term as well as trading a small basket of stocks. I’ve been doing some reading about merger arbitrage investment strategies and have some questions. What are they? How do they help tax efficiency in a portfolio? Are there any simple merger arbitrage strategies that are now available to regular investors? If so, when should they be used and how can they enhance investment returns? — Thanks, Dino

FP Answers: Dino, merger arbitrage is not a new strategy, yet it was only available to a select group of accredited investors such as pension funds and high-net-worth individuals until recently. That changed in 2019 when regulatory changes allowed retail investors, such as yourself, to access what are termed “alternative mutual funds,” more commonly known as liquid alts, some of which employ merger arbitrage strategies.

Adding these types of strategies to an investment portfolio can offer several benefits, including the potential to generate tax-advantaged, consistent positive returns in a variety of economic environments with low correlation to other traditional assets like stocks or bonds.

For example, in 2022, a year most investors would prefer to forget due to big losses in both equities and bonds, alternative strategies such as merger arbitrage generated positive returns. These strategies are well-positioned to benefit from market stress and dislocations in value. Despite their virtues, many investors don’t fully understand merger arbitrage strategies or may be intimidated by them.

Put simply, arbitrage is an event-driven investment strategy that takes advantage of the difference in prices for the same asset in different markets.

Here is an analogy to make it simpler to understand. You order a crate of 100 pink lemons at a cost of $100 in June from a wholesaler that will be delivered in July. You believe the demand for pink lemons will soon jump because of a series of outdoor concerts planned for July. As the weather heats up and the expected consumer demand for cool, refreshing pink lemonade increases, you’re able to contract with a local lemonade stand to sell your pink lemons for $120. You bought at $100, sold at $120 and kept the “spread” or difference of $20.

In the world of finance, merger arbitrage is also an event-driven strategy. It seeks to capture the difference between the share price of a company from when a merger is announced until its successful completion. The announcement of a merger or acquisition will provide an expected closing date and indicate the offer price. As the offer price is generally higher than the share price of the day, we call this the takeover premium.

The reason for the takeover being priced at a premium is to entice current shareholders to accept the offer. Sometimes the offer is rejected by shareholders and occasionally a higher offer is made. The share price of the target company typically rises near to but still below the offer price. That remaining gap between the new share price and the offer price is called the arbitrage spread. Shareholders are paid the offer price and this spread will close when the deal goes through.

An investor who believes there’s a strong probability in a deal closing can purchase the target company’s shares at the slightly discounted price and later sell the fully valued shares upon completion of the deal to generate a profit. Even smaller profits compound to generate a healthy total return when this process is repeated in a series of mergers and acquisitions.

Merger arbitrage strategies have several key advantages. One is that they are market neutral. Unlike index-tracking mutual funds and exchange-traded funds (ETFs), the goal of merger arb strategies is to generate positive returns under all market conditions. They are not swayed whether interest rates are rising or falling, inflation is high or low, or geopolitical tensions are great or small. 

They also protect a portfolio from excess volatility. Their low correlation to equity and bond markets makes them an excellent diversifier with the ability to smooth out portfolio volatility. Merger arb strategies are designed with the aim of providing portfolio protection and smoothing out performance. Each merger arb deal is idiosyncratic with a low correlation to other deals.

Furthermore, many merger deals close in a short period, typically three to five months from the announcement. The short duration means the capital from closed deals can be quickly redeployed into new ones.

They are also tax efficient. Because returns are taxed as capital gains, not income, merger arb strategies provide tax efficiency, which means investors keep more of their gains compared to investment income from fixed income.

Finally, return potential increases as interest rates rise. For example, arbitrage investors demand a premium over the risk-free rate of a government bond. This strategy has historically proven to be an effective interest rate hedge when interest rates are rising, with return potential increasing with the rising rates.

For individual investors, liquid alt merger arb strategies can be accessed just like mutual funds. These strategies can be considered a tax-advantaged complement to the fixed-income allocation in a portfolio. Ideally, an investor should seek advisers or portfolio managers with a successful track record of identifying potential merger and acquisition companies.


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