Wednesday brought more volatility to the stock market. After posting early gains to push further into record territory, most major market benchmarks pulled back by midmorning. At 11:45 a.m. EST, the Dow Jones Industrial Average (^DJI 2.68%) was down 7 points to 31,369. The S&P 500 (^GSPC 3.06%) had fallen 6 points to 3,905, and the Nasdaq Composite (^IXIC 3.34%) had moved lower by 54 points to 13,954.
Investors remained squarely focused on marijuana stocks, as ongoing activity in the cannabis space continues to draw interest from those looking to put their money to work in areas with solid growth prospects. However, one thing that's getting a rising amount of attention is the growing disconnect between shares of Tilray (TLRY) and shares of Aphria (APHA), with some seeing the divergence as a potential merger arbitrage opportunity.
How the Tilray-Aphria merger should work
Both Aphria and Tilray shares soared in mid-December, when the two companies first announced their merger. Investors were pleased to see consolidation in the cannabis industry, and the combination of Tilray and Aphria promised to create the largest marijuana company in the world in terms of revenue. That would potentially put the combined company in a much better competitive position against industry giants like Canopy Growth (CGC 4.72%).
Under the terms of the deal, Aphria investors could expect to receive 0.8381 shares of Tilray stock. Tilray shareholders will simply keep their shares. Because Aphria was the larger company by market capitalization, it was Tilray shareholders who ended up getting a premium price in consummating the deal.
As you'd expect, shares of Tilray and Aphria started to trade more or less in lockstep in the weeks following the merger. Since buyers of Aphria stock would end up with a set number of Tilray shares after the closing of the deal, investors became indifferent to which stock they owned.
However, in recent weeks, that dynamic has changed. As you can see below, Tilray shares have taken off, while Aphria has seen much less dramatic increases. On Wednesday alone, Tilray is up 28%, while Aphria's gains were limited to 7%.
The risks of merger arbitrage
Now Tilray shares are worth roughly double those of Aphria. That opens up a potential arbitrage opportunity, as investors should theoretically be able to do the following:
- Sell short 0.8381 shares of Tilray stock and receive about $45 in proceeds, based on recent share prices around $54
- Buy one share of Aphria for $25 to $26 per share
- Wait for the merger to happen, at which point the Aphria share will turn into 0.8381 shares of Tilray
- Close the short position with the newly acquired Tilray stock and pocket the $19 to $20 in cash
However, there are always risks with merger arbitrage. The biggest is that the merger might not go through. When a deal ends up not happening, the shares often reverse whatever trends they've seen in the run-up to the merger.
In addition, it's not always possible to do the transactions to capture the arbitrage opportunity. Especially with recent short squeezes, institutions are likely reluctant to put their capital at risk trying to exploit the spread.
Watch what you're doing
If you're bullish on the Aphria-Tilray merger and actually want to hold on to shares of the combined company, then the obvious choice here is to buy Aphria rather than Tilray. Yet it'll be interesting to see whether it actually plays out that way -- or whether rallying investors end up bidding Tilray higher while leaving the arbitrage opportunity to get even bigger.