Deal spreads and merger arbitrage, explained

When a company agrees to be bought, its share price jumps toward the offer but usually stops a little short. Headlines then talk about the spread "narrowing" or "widening" as news comes in. That small gap says a lot about how likely the market thinks the deal is to happen.

The deal spread

Say Company A agrees to buy Company B for $50 per share in cash. Before the announcement B traded at $38. Afterwards it jumps, but settles at $47.50, not $50.

The difference is the deal spread:

• In money: $50.00 − $47.50 = $2.50
• As a percentage: $2.50 ÷ $47.50 = 5.3%

These are illustrative numbers. The spread exists because the deal hasn't closed yet, and until it does, things can go wrong. If the deal collapses, B's shares will probably fall back toward their old price, so whoever buys at $47.50 is taking a risk.

Why the gap exists

Investors who buy the target to collect the spread are doing merger arbitrage. They are paid for three things:

1. Deal risk. The chance the deal fails.
2. Time. Money is tied up until closing, which can take months or more than a year.
3. The cost of money. Cash invested in the deal could earn interest elsewhere, so spreads are wider when interest rates are high.

Because of time, the spread is often looked at on an annualised basis. A 5.3% spread on a deal expected to close in six months is roughly a 10.5% annual return, if everything goes to plan. A very high annualised spread is the market saying it has real doubts.

What can stop a deal

Risk	What to look for in the news
Competition regulators	Reviews by the US Federal Trade Commission or Department of Justice, the European Commission or the UK's Competition and Markets Authority. A "second request" or in-depth investigation usually widens the spread.
Foreign investment and national security reviews	Common in deals involving technology, defence, energy or infrastructure.
Financing	Whether the buyer has committed funding, especially in leveraged buyouts.
Shareholder votes	Large investors objecting to the price.
A rival bid	Another buyer offering more. This pushes the target's price above the original offer.

Narrowing and widening

The spread moves as the market updates its view:

• Narrowing (the target's price moves toward the offer): good news for the deal, such as a regulator clearing it, shareholders approving it or a closing date being set.
• Widening (the price drifts away from the offer): growing doubts, such as an in-depth regulatory probe, political opposition or worries about the buyer's finances.

A headline like "spread narrows on report the regulator hasn't indicated it will block the deal" means traders now see a better chance of the deal closing, so the target's shares rose closer to the offer price.

Cash deals and stock deals

In a cash deal, the spread is simply the offer price minus the target's share price.

In a stock deal, the target's shareholders receive shares of the buyer instead, at a fixed ratio. If A offers 0.5 of its shares for each B share and A trades at $90, the deal is worth $45 per B share. The spread then moves with both companies' share prices, so arbitrage traders often buy the target and sell the buyer's shares short to lock in the gap.

Key takeaways

• A target trading below the offer price is normal; the gap is the market's price for the risk that the deal fails.
• Spread = (offer value − current price) ÷ current price. Annualise it to compare deals with different timelines.
• Regulatory reviews are the most common reason spreads widen.
• A target trading above the offer often signals expectations of a higher bid. Follow live deals in the Deals section.