Evaluating Merger Arbitrage in the US Stock Market: An Empirical Analysis

Abstract

Investors can base their security selection on various investment strategies. One of those strategies is merger arbitrage, where investors seek to profit from the price movements between an M&A announcement and deal completion. It is thus a bet on successful deal completion, which is the case in 82.5% of the deals considered. Using a sample of 6,190 US mergers and acquisitions from 1998 to 2021, we analyse merger arbitrage's risk and return characteristics. We constructed ten merger arbitrage portfolios subject to three different portfolio construction methods; equal, value weighted, and a practitioner's portfolio. The portfolios are equivalent to a buy and hold strategy of the available deals in the sample and are thus quantitative in nature, as no discretionary analysis is applied to deal selection. The returns to merger arbitrage are analysed using the calendar time approach through time-series analysis using both linear and non-linear models when assessing the returns. Our results are not robust to portfolio construction as our findings are mixed. We find merger arbitrage to generate abnormal returns of -0.96% to 9.84%, but those have decreased over time. Similar findings are observed on absolute returns, which may be attributed to increases of capital into the strategy causing increased competition and more efficient inefficient markets combined with increased systematic risk and decreasing levels of the risk-free interest rate. Merger arbitrage cannot be considered a market neutral strategy in the sample period but instead a low-risk investment where especially the practitioners' portfolios prove a valuable hedge in depreciating markets. Moreover, the practitioners' portfolios significantly outperform the market in terms of Sharpe ratios.