Failure Risk, Risk Arbitrage, and Outcomes of Mergers and Acquisitions

Abstract

This paper examines how a target firm's trading volume, bid-ask spread, and stock return volatility respond over a two-week period to the announcement of M&A deals ("nonprice reactions"). I find that these variables are strongly correlated with changes in risk arbitrageurs' holdings surrounding the time of an announcement, whose ability to predict deal outcomes is often argued to be superior to that of other investors. I show that nonprice reactions predict deals that are more likely to be renegotiated, to feature slower completion times, and to fail even after controlling for merger arbitrage spreads and announcement returns. A trading strategy that involves investing in target firms with a low degree of failure risk, as predicted by nonprice reactions, yields positive abnormal returns. The presented results suggest that a target firm's volume, spread, and volatility after an M&A announcement reflect information about a deal's resolution not fully incorporated into stock prices and cast doubt on the notion that arbitrage spreads represent a deal's risk of failure as perceived by investors.