Simply put, merger arbitrage is when two companies plan to merge, and the stock price of the target company trades below the proposed acquisition price due to uncertainty of if the deal will actually be completed.

This difference in price, in turn, allows for an investor who believes the merger WILL happen to purchase stock of the target at a discount and realize a profit once the transaction is complete.

The Aphria Opportunity

On Dec 16, 2020, Tilray and Aphria entered into a definitive agreement to combine their businesses (a.k.a. merge) and to continue operations under the Tilray corporate name with shares trading on NASDAQ under ticker symbol “TLRY”. The transaction is expected to close in Q2/2021.

The terms of the merger stipulate that shareholders of Aphria will receive 0.8381 shares of Tilray for each of their Aphria common shares.

Aphria’s stock price has been steadily increasing since the start of February; however, there is still a difference of over 100% between Aphria’s current price ($26.30 as of close on Feb 10, 2021) and the implied deal price ($53.56 based on TLRY price of $63.91 as of close Feb 10, 2021).

This means that if the merger is successful, an investor who buys Aphria stock at the current level would double their money at the time the merger closes, all else being equal. CHA-CHING!

FEB 23rd UPDATE: A big selloff in the stock of Tilray has shrunk the spread between the deal closing price and Aphria’s current price to a less attractive but more typical level of 12%. 

Source: Ycharts, Grizzle Estimates

The Hedge

Typically, with merger arbitrage professional investors seek to profit off the deal spread without taking a bet on the direction either stock will go.

If the deal closes they make money, if it doesn’t they lose some, simple as that.

Retail investors could do the same by buying the target company stock (APHA) and simultaneously short a proportionate amount of the acquiring company’s stock (TLRY).

Shorting a stock requires an investor to:

1) borrow the stocks they want to sell now and

2) return the stocks at a later date, as well as

3) pay a fee or interest for the time they borrowed the stock to the lender.

The difference between the price they sold for today and the price they pay to buy the stock back at a later date (less fee/interest) is equal to the profit on the short trade.

Specifically with this stock-for-stock merger, at the time of the deal closing, each share you own of Aphria will convert into a share of Tilray.

You then can use your new Tilray shares to close out your short trade on Tilray by giving your new Tilray shares back to the broker who you originally borrowed them from.

But why would an investor choose to buy APHA stock AND short TLRY stock?

This strategy is known as a hedge, and a hedge is an investment made to reduce risk.

In this case, there are many risks if you simply buy Aphria stock hoping the deal closes.

  1. Tilray’s stock price could fall, shrinking the spread, or upside.
  2. Aphria’s stock price could fall for any number of reasons handing you losses on your position in the short term (assuming the deal closes)

These very real risks are why professional investors often choose to lock in the spread and avoid risking losses should either stock move in the wrong direction.

So You Want to Short Tilray Huh?

Houston we have a problem.

No brokers are lending TLRY stock to retail investors for shorting.

This means the best way for investors that believe this merger will be successful to play the situation is to buy and hold APHA.

That being said, this strategy is not without its risks.

First of all, as mentioned above, there is a risk the merger closes but TLRY’s price declines prior to the merger.

Alternatively, another risk is that the merger does not close and APHA share price falls.

And finally, there is the ever-present risk that industry fundamentals decline and the whole sector crumbles.

So while there is often a modest price difference, or “spread”, prior to a merger going through due to the potential of something going wrong and the deal falling apart, it is important to note that this deal has a massive spread, the size of which we rarely see.

A large spread is usually an indicator of investor skepticism that the deal will really happen.

Historically, some common hurdles for a merger to close may include anti-competition laws or an acquisition of the acquiring company.

For this deal, the likelihood of Tilray being acquired prior to this merger being complete (which would terminate the deal) is extremely low in our opinion.

So why is the spread so large?

After talking with an institutional investor in the know, he told us the reason for the large spread is that hedge funds and other large investors are scared to short Tilray after the whole Gamestop fiasco.

With Gamestop, anyone shorting the stock lost 4x-10x the amount of money they initially invested.

$1,000 shorted turned into $4,000-$10,000 of losses!

Investors are worried Tilray could go to the moon, driven by a retail investor buying frenzy and Aphria’s stock price won’t keep pace.

If this happened they would be looking at steep losses.

This is why the spread between Aphria’s current price and the implied price if the deal closes has ballooned as Tilray’s stock price has shot up.

What is an Investor To Do?

As a retail investor, you only really have one option.

Buy Aphria or don’t.

If you believe in the long term upside of the stock and are willing to ride out the bumps, you will be owning a company with solid upside in our view.

If Tilray can maintain its current price of $64/sh you are looking at a massive 90%-100% gain when the deal closes in the second quarter of 2021.

However, the risks are significant when stocks are running this hot.

If Tilray eventually cools off, Aphria stock will fall in price as well.

Upside and Downside for Aphria
Tilray has to maintain a share price of $30/sh for you to not lose money buying Aphria and holding it until the deal closes.  Tilray is currently at $56/sh but was as low as $12/sh one month ago.  You are looking at a 90% gain and as much as a 50% worst-case loss. 

Now you have the tools to potentially take advantage of a unique opportunity in the cannabis market.

But really at the end of the day every investor needs to make the decision that’s right for their risk tolerance and time horizon.

About Author

The opinions provided in this article are those of the author and do not constitute investment advice. Readers should assume that the author and/or employees of Grizzle hold positions in the company or companies mentioned in the article. For more information, please see our Content Disclaimer.