How to Trade Corporate Merger and Acquisitions – Introduction
This weekend, International Business Machines (IBM) announced that it would acquire another company known as Red Hat. Red Hat is an enterprise provider of open source software and is currently valued at more than $20 billion. IBM will pay more than $34 billion for the company. IBM on the other hand was once the largest IT company in the world. Its star faded when competition from companies like Amazon, Google, and Microsoft heated up. Today, it is a shadow of its former self. This article will explain the concept of Mergers and Acquisitions and what it means for traders.
What is Merger and Acquisition?
A merger refers to a situation where two companies join forces. They do this for a number of reasons. For example, a company an insurance company in the East Coast can merge with another one in the West Coast. By so doing, the companies will have be at a position to reach more customers. An acquisition on the other hand is a situation where a larger company acquires another one outright. The M&A industry is a very large one. This year alone, deals worth more than $3.3t trillion have been made globally.
Why Companies do M&A
Companies conduct M&A for various reasons. First, they buy companies with the goal of acquiring a competitor. A good example of this is what Google and Facebook have done. Google acquired YouTube for about a billion dollars. Today, YouTube is worth more than $200 billion. Similarly, Facebook acquired Instagram for about a billion dollars. It is now worth more than $100 billion.
Second, companies do M&A to create synergies. For example, if a software development company has 5000 employees and another software company has 4000 employees, merging the two into one can lead to synergies. For example, the combined company can have just 5000 employees who will be doing the same thing.
Third, companies do M&A to accelerate growth. The Facebook example mentioned above is a good. Facebook realized that its legacy platform will start seeing reduced growth. To accelerate its growth, it acquired Instagram and Whatsapp. It also sought to acquire Snapchat before it became a public company.
How to Trade M&A news
A good way to explain this is the IBM’s acquisition of Red Hat. At its close on Friday, Red Hat was trading at $116. IBM will acquire it at $190 per share. Therefore, when the market opens, the likely scenario is that IBM’s stock will decline sharply while Red Hat will increase to $190. This is because IBM has already agreed to pay $190 for the stock. IBM will drop for a number of reasons. First, investors will flee the stock for dilution purposes. They believe that the money would have been better elsewhere. Second, the deal will likely increase IBM’s debts.
Third, historically, mergers and acquisitions have not worked out as expected. In fact, they have been value destroyers. A good example of this is the acquisition of Monstanto by Bayer. After the deal was closed, Monsanto lost a major lawsuit that threatens its existence.
Therefore, when a deal is announced, the best way to trade is to go long the company being acquired and shorting the one doing the acquiring. In fact, this has created a large group of investors who specialize in what is known as merger arbitrage.