For investors, the announcement of a corporate merger can cause excitement or trepidation. Public company tie-ups involve negotiations, regulatory hurdles, integration–all of which hopefully leads to value creation for stockholders.
When a merger is taking place, the classic stock market reaction is for the acquiring company’s shares to decline, while the target company’s stock experiences a lift. Here’s a deeper dive into what investors can expect if one of their companies enters into an M&A deal.
What is M&A?
Mergers and acquisitions (M&A) are corporate transactions that involve two companies combining, or one buying a majority stake in another.
A CEO typically embarks on an M&A transaction with the objective of finding “synergies”–Wall Street lingo for creating value through consolidation. Synergies are typically found by reducing costs or finding new avenues for growth.
Stock-for stock mergers–when the target’s shares are converted into the buyer’s shares–are the most common type of M&A transaction. That’s why there’s often a burst of M&A activity after a prolonged bull market: Companies with high stock prices can use their shares to make pricey purchases.
For instance, in early 2020, M&A had a slowdown as the repercussions of COVID-19 took hold of the global economy. Dealmaking during the pandemic eventually came back as share prices soared and executives sought opportunities or looked to adjust to the new business environment.
Meanwhile, in an all-cash merger, the buyer either has to spend the cash they have on hand or raise new capital to fund the purchase of the target.
What is a Merger of Equals?
A true merger of equals (MOEs) is rare. Most mergers are really acquisitions. But MOEs could signal to investors that two similar, roughly equal-sized companies are uniting because there are significant tax or cost savings to be had. Investors may find that with MOEs, the premiums paid aren’t as significant.
What Is Private Equity?
Private equity (PE) firms, alternative investment funds that buy and restructure companies, also participate in M&A. They seek deals when there’s “dry powder”–funds that have been committed by investors but aren’t yet spent.
How Do Stocks Move During Mergers?
After an M&A announcement, the most common reaction on Wall Street is for the shares of the acquiring company to fall and those of the target company to rally. That’s because the buyer typically offers a premium for the takeover in order to win over shareholders.
The rally in the target’s stock can be an eye-popping move, often leaving investors with the dilemma of selling then or after the deal is complete. The target’s shares usually trade for less than the acquisition price until the transaction closes. This is because the market is pricing in the risk of the deal falling apart.
Deals can get scrapped because of a key regulatory disapproval, stock volatility, or CEOs changing their minds. That would mean money spent on investment bankers, lawyers and consultants to put together the M&A terms would have all been for nought. Not to mention the specter of a costly break-up fee.
Hence the investor skepticism towards M&A. However, research has shown that some 98% of the deals in the last five years have gone through.
Different Stock Reactions to M&A
The stock market is a key way to gauge how shareholders feel about a deal. Here are some different scenarios of how the market could react:
Buyer rises alongside target: This is obviously the best case scenario for companies and investors. It occurs when the stock market believes the deal is a smart acquisition for the buyer and that the deal’s been made at a good price.
Buyer falls dramatically: The buyer’s shares may plummet if investors believe executives are overpaying for a target or if they think the target isn’t a good purchase.
Target moves little: The target’s shares may see little change if rumors of a potential deal already sent share prices higher, causing the premium to be baked in. Alternatively, the premium being paid may be low, causing a muted market reaction.
Buyer rises, target falls: In rarer cases, a deal gets called off and the buyer’s shares rise while the target falls. This could be because investors have soured on the merger and believe that the acquiring company is getting out of a bad deal.
Target falls: If a target company needs money, a private equity firm could buy a stake at a discount. In such cases, the target company’s shares could slump.
Do Mergers Create Value?
There’s long been a debate among investors and academics whether M&A actually creates value for stakeholders and shareholders. Recent research has shown that frequent acquirers do tend to add value, while bigger deals are riskier.
The stock market is famously fickle and it can take time before the market gives credit to the combined company for any cost or revenue synergies. In general, cost-saving synergies are much easier to pledge, while revenue synergies could be tougher to deliver.
Investors should also pay attention to executive changes that result from the merger. Leadership turnover can make a difference when it comes to making sure a merger adds value and two companies integrating well.
What Is Merger Arbitrage?
Merger arbitrage–also known as merger arb or risk arbitrage–is a hedge-fund strategy that involves buying shares of the target company and shorting shares of the acquiring company. Returns are usually amplified through the use of leverage.
The so-called “spreads” between the takeover company and the offer value are a way to calculate the odds the market is placing on the deal successfully closing.
When it comes to retail vs. institutional investors, some of the former may want to try merger arbitrage. However, there are key points to keep in mind:
Typically most of the arbitrage opportunity has already been taken immediately after the deal gets announced.
As mentioned, mergers fall apart for all sorts of reasons. The biggest hurdle usually is getting regulatory approval. Regulators often reject a deal for being anticompetitive. A crash in the stock market could also make buyers back out.
Shorting a stock is a risky strategy that isn’t appropriate for all investors. The potential gains for a stock are unlimited, so betting against one can lead to unlimited losses.
When a merger is announced, the typical reaction is for the acquiring company’s stock price to fall, while the target company’s stock price gains. But different scenarios in the market can give clues on how investors are feeling towards an M&A deal.
There’s also the risk that a deal gets derailed altogether. However, stock investors can take heart in knowing that some 98% of the deals in the last five years have gone through.
It’s important for those who own shares of companies with a pending merger to monitor the news flow on the deal carefully and pay attention to price fluctuations in the market. Separately, it’s also key to know that stock-for-stock mergers can often dilute some shareholders’ voting power.
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