Yesterday saw the Arbitrage – drama film directed by Nicholas Jarecki and starring Richard Gere. A troubled hedge fund magnate desperate to complete the sale of his trading empire makes an error that forces him to turn to an unlikely person for help.
It is well-known that risk arbitrageur play an important role in the market for corporate control. After a tender offer, the trading volume increases dramatically in large part because of risk arbitrageurs activity. They take long positions in the target stock, in the hope that the takeover will go through. They are also usually hedged by taking short positions in the acquirer’s stock.
Risk arbitrage used to be a very inconspicuous activity, but in mid-70s, the emergence of Ivan Boesky and the increasing volume of corporate takeover deals contributed to make it more visible. Attracted by the high rewards, many firms started new arbitrage departments and more people became involved in this activity.
As a consequence of the large volume of new arbitrage capital, in more recent years spreads narrowed and the share price, after a takeover announcement, rises much more rapidly. The arbitrage community has often come to control, in total, 30 to 40 per cent of the stock and therefore it has become the single most important element in making many deals happening. Risk arbitrageurs are perceived as a crucial element in determining the success of a takeover. They are typically perceived as favoring the acquirer since they are more likely to tender.
One can abstract from differences in attitude towards risk and focus on the explanation most commonly given: difference in information. It is often argued that arbitrageurs have better information about the chance of a successful takeover and purchase shares as long as their forecast of the “correct”security price exceeds the current market price. One can argue that it is not necessary to assume that risk arbitrageur have specific knowledge on the takeover fight. Instead, the information advantage can arise endogenous from the choice of a risk arbitrageur to enter the contest. The intuition is quite simple: if the presence of risk arbitrageurs increases the probability of a takeover, then the fact that one risk arbitrageur bought shares is per se relevant to the value of these shares. Therefore, an arbitrageur who has bought shares has an informational advantage: he knows he bought shares. After all, risk arbitrageurs are often quoted saying that a crucial part of their activities is trying to predict what other arbitrageurs will do.
One can model the decision of risk arbitrageur to enter the contest and the way they can facilitate the takeover. We start from a company with diffuse ownership, with no large shareholders who can facilitate the takeover. After a bidder has made a tender offer, arbitrageur decide whether to buy shares. If they succeed in accumulating non-trivial stakes they become temporary large shareholders. Unlike small shareholders, they tend to sell their shares to the bidder and therefore facilitate the takeover. For this to happen, however, it is necessary to show how they can be successful in accumulating these positions without driving the price up so much that they end up losing money. In other words, there may be a question how arbitragers can afford to pay a price, which is high enough to persuade small shareholders to give up their shares.
The value of the shares depends on the probability that the takeover will take place, and therefore it should be higher the larger is the number of risk arbitragers in the market (since they are more likely to tender). Both small shareholders and risk arbitragers do not know how many arbitrager have entered the contest and update their beliefs looking at the trading volume. However, a risk arbitrageur always has an informational advantage over the small shareholders: he knows that at least he is buying shares. This informational advantage guarantees that he is willing to pay a price, which is high enough to persuade the small shareholders to sell their shares As the trading volume increases, small shareholders think it is more likely that some arbitrageurs are buying shares.
Consequently, the share price increases. There exists a range of trading volumes at which risk arbitragers buy shares from small shareholders.
As long as the expected profits are strictly positive, more arbitragers will choose to buy shares. If too many arbitragers are trying to buy shares, however, the price will rise too much and they will not buy any shares. There exists a symmetric equilibrium where each arbitrageur randomized between entering or not and the takeover has a positive probability to succeed.
It has been often depicted risk arbitrageurs in an unfavorable way but they can actually increase welfare, facilitating takeovers which in-crease the value of a company. Moreover, small shareholders, who sell their shares to risk arbitragers, do not lose money but they actually appropriate the ex ante surplus, which would be lost if the takeover did not succeed .
A widely observed phenomenon is that, after the takeover announcement, both the stock price and the transaction volume of the target rise tremendously relative to their pre- announcement levels. There is a positive relationship between trading volume and the probability that the takeover is successful. One can also predict that the more liquid is the target stock, the better risk arbitrageurs can hide their trade and, consequently, the higher are their returns if they decide to invest in the deal and their presence in the deal. Similarly, a higher takeover premium increases arbitrageur’s interim profits and in-equilibrium we should expect a higher number of arbitrageurs investing in the deal.