Is M&A a red flag?

Mergers and acquisitions (M&A) get more attention than any type of corporate event except a big bankruptcy. The business press is filled with news of the latest deals, for obvious reasons: takeovers, especially hostile ones, are the closest thing the corporate world has to an election campaign. But while M&A can be entertaining, it's often not good news for shareholders in the firms that are doing the buying. Multiple studies have found that they usually go on to underperform the wider market. Deals where the acquirer pays in shares usually do worse than those where it pays cash.

There are several reasons why this happens. Firstly, transactions costs, such as legal and banking fees, tend to be high. This is particularly likely to be the case if the deal is contested or there are regulatory obstacles to it taking place.

Secondly, many deals may not make business sense. For instance, during the tech boom of the late 1990s many firms spent huge sums buying internet companies. This culminated in the disastrous AOL-Time Warner merger in October 2000, when AOL paid $160bn for Time Warner, which had earnings of under $1bn. The combined company went on to post a loss of $99bn in 2003, and the whole sorry episode is widely regarded as one of the greatest mistakes in corporate history.

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Thirdly, executives may be more concerned about the greater perks, higher pay and added prestige that comes with running a larger company. Hence they may be acting more in the interests ofmanagement than of their shareholders when they plan big deals.

Indeed, these deals tend to perform so badly that a return of "merger mania" is frequently seen as a sign of excessive optimism and lax monetary policy, which means that it may be a red flag for the wider market, as well as investors in individual companies.

Major bear markets in the late 1980s, 2000 and 2007-2009 were all preceded by a surge in M&A activity. Similarly, in the run-up to the Wall Street crash of 1929 there was a major increase in mergers. Given that, it's worth noting that last year was the best ever for M&A, with buyers spending $3.8trn on deals, according to Bloomberg, but that major deals are now starting to fall apart.

Profiting from dealmaking

Large deals are usually bad for the company doing the buying, but not for shareholders in the firm being bought. In most cases, the buyer has to pay a premium above the target firm's initial share price to get the target's shareholders to agree to the deal. Sometimes this premium can be substantial. One study in 2011 found that the average premium in takeovers between 1990 and 2010 was 36%. This means that there is obviously money to be made from M&A, and traders use two main ways to profit.

The first is "merger arbitrage" (sometimes known as risk arbitrage). This involves buying shares in companies that are in the process of being taken over and shorting (betting against) shares in the company doing the acquiring. The idea is that if the merger goes through the share price of the company being acquired will rise, while that of the company doing the buying will fall (or at least stay the same).

In most cases, the market quickly prices in the value of any offer. So if Company A offers to buy company B for 100p per share, then Company B's shares should trade at something close to 100p, depending on factorssuch as the probability of the deal going through, how long it'sexpected to take and whether there is any prospect of another,higher bid.

Let's say Company B trades at 97p, you buy andhold the shares and the deal is completed. Then you get a smallprofit of 3p per share. Of course, if the deal unwinds then theprice of the target company will often fall a long way. So mergerarbitrage involves "asymmetric risk": you will usually get asmall, but fairly predictable return, but once in a while you maytake a large loss.

The second strategy is to invest in firms that could be a takeovertarget before the deal is announced. This can be more lucrative,because the trader who buys before the announcement of atakeover will be able to benefit from all the appreciation in theshare price. However, the probability of identifying in advancea company that will be taken over is lower than the probabilitythat a deal that has already been announced will be completed.So this strategy has larger potential returns than mergerarbitrage, but each individual trade is less likely to succeed.