Merger Arbitrage: Profiting from Deal Spreads

Merger arb looks like easy money (2–5% over 3–6 months), but the risk is asymmetric: you gain a small spread if the deal closes, but can lose 20–40% if it breaks. One broken deal can wipe out a year of successful arb profits.

Professional merger arb funds assess deal break probability, regulatory risk, and financing contingencies before taking positions. The spread is the market’s consensus on deal risk — you profit only if you’re right and the market is wrong.

Going Deeper — the Wyser-Pratte 7-step risk-arb process. (1) Read the deal: cash, stock, or mixed; what conditions are in the merger agreement? (2) Determine the legs: cash deal = long target only; stock deal = long target + short acquirer at the exchange ratio. (3) Calculate annualised ROIC: spread divided by entry price, multiplied by 365 over expected days to close. (4) Weigh the five break risks — regulatory, financing, shareholder vote, MAC clause, competing bid — and estimate the probability and magnitude of each. (5) Settle the tax structure (taxable cash deal vs. tax-free stock-for-stock). (6) Confirm borrow availability and rate on the acquirer if shorting is required. (7) Size the position so the worst-case break-loss is a known fraction of capital, not a discovery. Worked example: Tirebridge announces an all-cash $44 acquisition of Westmoor Optical, which trades at $42.50 with 110 days expected to close. Spread is 3.53%; annualised, about 11.7%. If you assess the regulatory probability of break at 10% with a $36 deal-break price, the expected return is 0.9 · 11.7% − 0.1 · (110/365) · (($42.50 − $36) / $42.50 · (365/110)) ≈ about 9% net of break risk. AI prompt: "For the announced acquisition of [TARGET] by [ACQUIRER], walk me through the seven-step risk-arb analysis: deal terms, leg construction, annualised ROIC, the five break risks ranked, tax treatment, borrow availability, and a recommended position size given a 10% break probability."