Merger Arbitrage and Idiosyncratic Risk

The practice of merger arbitrage is one of the more popular and profitable strategies employed by many hedge funds. At its core, the strategy is one that earns an excess return for the assumption of a specified risk. Merger arbs purchase shares of a company targeted for acquisition after the announcement has been made public. Shares of the target company usually trade some measure below the agreed-upon merger price, due to the risk that the merger might not actually occur. If all goes well and the merger is consummated as planned, merger arbs earn this spread between the market price at time of purchase and the deal price. If, however, the deal is cancelled, then shares of the target company often fall precipitously. The risk to an individual risk arbitrage investment, then, comes from one specified source: the risk of deal completion. (Actually, deal postponement – where the deal is eventually completed, but at a later date than originally expected – can be considered a second source of return-reducing risk.) If this risk was purely idiosyncratic, then a large arbitrageur could easily invest in many such deals and drive the portfolio risk to zero. Not surprisingly, this does not appear to be the case. It is therefore very important to fully understand the nature and magnitude of the risks inherent in merger arbitrage. This paper identifies a merger arbitrage risk factor that is superior to market beta in explaining the risks assumed by a merger arbitrage portfolio. Previous research has documented a weak tie between market beta and merger arbitrage returns. Mitchell and Pulvino (2002), for example, note that the beta to a merger arbitrage strategy appear to be nonlinear; they are close to zero in a flat to rising market but large in a falling market. However, when our risk factor is added to market beta in a two-factor risk model, the resulting beta cannot be statistically distinguished from zero in all market conditions. Identifying the risk side of a merger arbitrage portfolio is particularly important, because the returns are relatively well specified. The return in the case of success is known precisely – the spread between the deal price and the current market price. The return in case of failure must be estimated, and often is done so by measuring the difference between current market price and the price at the time of announcement. This return must then be balanced against some unknown amount of risk