Merger arbitrage is one of the most common hedge fund strategies that can produce relatively small correlations with market returns. This doesn’t mean that the strategy is risk-free though. When a merger is announced the acquired company’s stock price increases close to the merger price but usually stays a little bit below the announced price. The spread between actual price and the announced price is what merger arbitrageurs aim to make for their investors. One of the best pieces on merger arbitrage is written by Joel Greenblatt in You Can Be A Stock Market Genius. Here is how he explains the risks in merger (or risk) arbitrage:
First, the deal may not go through for a variety of reasons. These may include regulatory problems, financing problems, extraordinary changes in a company’s business, discoveries during the due diligence process, personality problems, or any number of legally justifiable reasons people use when they change their mind. In the event of a broken deal, (acquired) Company B’s shares may fall back to the predeal price of $25 (from $38) or even lower, resulting for big losses for the arbitrageur. The second risk that the arbitrageur is underwriting is the timing risk.