Arbs - Smart, Influential, or Both?

Consider several interesting, stylized facts about the role of arbitrageurs in acquisitions:

• Once a firm is in play, the new shareholder base is likely to be the arbitrageurs as existing shareholders sell out to lock in the jump in price surrounding the announcement of the deal and avoid the risk of deal failure.
• Arbs make a living taking this risk of deal failure.
• Most arbs don't try to predict who will be a target but take a position after a deal has been announced
• The risk profile of arbs is very low - arbs hedge their positions to minimize as much risk as possible.   In a stock deal, for example, they might go short the acquiring firm and go long the target, locking in the spread between the post announcement price and the offered price - usually a few percent.
• Arbs favor the rapid completion of a deal and when deals close quickly the few percent gained in the spread becomes a very high return when annualized.
• Arbs can lose their shirt if a deal collapses or they are not properly hedged.
• Arbs tend to earn superior returns around acquisitions.

So lets take the last point.  It has been known that arbitrageurs can earn abnormal returns around mergers.  What hasn't been clear is why.  There are two theories - one that arbs play a passive role and the other that they play an active role in facilitating deal completion.

The passive theory is that arbs are better at predicting deal success - studying the dynamics of a deal, the positions of the players and the likely regulatory positions.  They then take a position when the odds are in their favor.

The active theory is that arbs actually influence the outcome of a deal - that their shareholdings help tip the balance of power and facilitate deal completion.

In that article below, published in the Journal of Financial Economics co-author Jim Hsieh and I find evidence supporting both theories.  The abstract is below.  A copy of the published article is available through the link above.  A copy of the working paper is available here.

Determinants and Implications of Arbitrage Holdings in Acquisitions

Abstract:      

This study investigates arbitrage activities and their impact on acquisitions. The literature contains arguments for both passive and active roles of arbitrageurs during the takeover process. Larcker and Lys (1987) suggest that arbitrageurs are passive, having superior ability to predict offer success. Cornelli and Li (2002) and Gomes (2001) model arbitrageurs as active, influencing the terms and outcome of offers. We find evidence supporting both arguments. Using a simultaneous-equations framework to recognize endogeneity, we analyze 608 acquisition bids over the 1992-1999 period. Consistent with the passive arbitrage argument, the change in arbitrage holdings is greater in successful offers. However, changes in arbitrage holdings are also shown to be an important determinant of the probability of success, bid premia, and arbitrage returns. In addition, the change in arbitrage holdings is positively associated with both revision returns and the occurrence of subsequent bids within one year after initial bids are terminated. Overall, we find that merger arbitrageurs play an important role in the market for corporate control.

All the best,

Ralph