Chapter 5: Hedge Funds

act67812

Member
Hi

I don't really understand the example given on risk arbitrage in chapter 5 of the notes. The example is:

Suppose a hedge fund manager believes that A plc is planning to acquire a certain target company, T plc, by offering one A share for each T share. The manager will take a long position in (ie buys) the shares of T and goes short in the shares of A. If the takeover goes ahead, the price of T will converge upwards towards the price of A. By taking a long position in one share and a short position in the other, the manager gets the profit from the relative movement of the share prices and is immune to the movement of the market as a whole.

Why does the fund manager need to take a short position in A here to make profit? Is it in case the merger doesn't go ahead? Some additional explanation/ an alternative example would be much appreciated!

Thanks
 
Hi. Yes, the example is an over-simplified case, where in reality the complexities of the hedge fund strategies would be eye-watering. Generally, if an acquisition is successful the target company shares will move up to the full offer price, so going long of that is a clear winner if the takeover event is successful. In most cases this would be all that would be required (as most 'event driven' hedge funds are not also market neutral). The event driven fund would probably concentrate on getting on the Board of the target, and influencing the takeover. Indeed it is often the case that the hedge fund would get onto the Board of a company that is in difficulties, and actively make the company a target.
But in this case, the example also suggests that the manager wants to hedge out market movements, so a short position is required. Any share would work, but the share of the acquirer is not a bad option. Generally the acquirer will have its hands full after a major acquisition: raising the debt & equities, merging the management teams, sacking a lot of surplus staff, IT systems, ... As a result, the acquiring company shares often underperform the market during and after the takeover. So as a short position suggestion, its not a bad one. I hope that helps.
 
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