The following post describes the “Reverse Merger Arbitrage.” Actually it’s not really an arbitrage at all, as you are not selling and buying the same financial asset and locking in a guaranteed profit via a spread.

However, that being said, it is I believe an attractive speculation, albeit that you can only utilize small amounts of capital.

From Which is a sub-blog of SMB Capital in the blogroll.

I’ve been meaning to write this post for a couple of days now. This is an arbitrage opportunity that I have found to be successful and requires the minimal use of capital for about 2 weeks at a time. Rather than go public via an initial public offering, some companies are going public via a reverse merger. What these private companies do is purchase a public shell, which is a stock that is publicly traded but is basically out of business. The private company gets issued preferred stock which is convertible to normal shares on a 10:1 basis (varies on each deal).

With all these preferred shares converted to regular shares, the private company takes control of anywhere from 90-95% of the float. Talk about dilution of shares huh? So at this point you’ll have anywhere from 50 million to 300 million shares outstanding. Anywhere in the range of these numbers, the stock price will be worth pennies for years until it grows into its valuation.

So once the private company converts its preferred shares, it immediately completes a reverse merger, maintaining the private company’s equity stake of 95%. Here’s where the opportunity of arbitrage presents itself. When the company completes its reverse merger, in an effort to preserve round lots, it usually includes a provision to for any shareholders holding either 100 or 99 stocks or less to not be affected by the reverse merger.

So to illustrate how its done, let me show you what was done in the two instances that I was involved in.

In the first instance, I purchased 99 shares of MJET on May 25, 2005 at $.22 a share for a total of $21.78. In the company’s current report at the time, it stated the company’s plan of action. After the 1-29 reverse merger occurred, I then sold those 99 shares at $9.00 a share under the company’s new symbol, BLHL on June 10, 2005 for a total of $891.00.

In 17 days I received a 4090% return on my investment! In the second instance, it was still a profitable trade, although the return wasn’t as high mainly because the initial share price was so much lower.

I purchased 99 shares of TDIH at $.058 on August 25, 2005 for a total of $5.75. In the company’s current report at the time, it stated its plan of action. After the 1-21.8 reverse merger occurred, I then sold those 99 shares at $1.25 a share under the company’s new symbol, FHHI on September 1, 2005 for a total of $123.75

In 8 days I received a 2152% return on my investment. Even though it wasn’t as good as the first deal, it was still free money. I must note that later I did get back into FHHI at $.79 a share and that it is currently one of my holdings. I will be posting on the company in the near future.

So arbitrage opportunities do exist in the stock market. The reason this one exists is because so little money is involved when you compare it relatively to the rest of Wall Street. One note I need to make though: I have friends that have Scottrade and I know they had trouble with it because of some problem within Scottrade’s back office I believe. I use Etrade and experienced no problems. I believe they still kept their shares, but had to wait a little bit longer.

Although I have not been as up to date with this market as I should be, I will post on here when I know of any new reverse merger arbitrage opportunities.