There are two strategies that can be used to profit from takeover candidates. Most investors are familiar with the strategy of investing in speculative takeover candidates. Buying takeover candidates just prior to a merger announcement can be highly rewarding. Returns of 30–50% in a matter of weeks are possible, but there is also significant risk. If not done with discipline, investing in prospective takeover candidates can be a perilous strategy.
To safely profit from takeover candidates, you want to buy companies that are the target of a publicly announced merger. This is called merger arbitrage. Here’s how the strategy works. Assume there are two companies, Company A and Company B. Also assume that Company B agrees to acquire Company A for $40 per share and that prior to the announcement of the takeover, Company A shares trade for $30 per share. Following the announcement, Company A shares jump to $36 per share. A merger arbitrage investor would acquire shares of Company A at $36 per share and hold his shares until the acquisition closes at $40, earning a profit of 11%. The reason that Company A shares do not immediately rise to $40 per share is that there is some risk that the merger won’t be completed. The discount to the acquisition price compensates the merger arbitrage investor for taking this risk. Of course, since there is risk involved here, diversification is paramount. Investing in a single merger arbitrage deal can be highly risky. Successful investors own a portfolio of merger arbitrage opportunities.
I am not recommending that you go out and start acquiring the shares of companies that are the targets of publicly announced merger deals. My example above is only the most basic of merger arbitrage situations. More complicated deals involve both cash and stock, and require a short position in the acquiring company. Some deals also involve price collars, which can further complicate things. If you want to invest in merger arbitrage, I would advise you to take the mutual fund route. As always, stick with no-load funds with no 12b-1 fees and low expense ratios (under 1.3%, in this case).
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