Below is the second clip from my 2007 letter to partners. The first post was a case study of Tribune Co., an arbitrage situation we participated in last year.
"Give a man a fish and he eats for a day. Teach him to arbitrage, and he will eat for a lifetime." —Warren Buffett
Risk arbitrage (also called merger arbitrage) is where an investor buys stock in a company that’s expecting to be taken over. The investor’s goal is to profit from the difference in current market price and eventual buyout price. Here’s a simple example: Company A announces that it will acquire Company B for $20 per share. Immediately after the announcement, the share price moves from $15 to $19 per share. The arbitrageur then purchases the stock, hoping to make a $1 profit once the deal is complete.
Why doesn’t Company B just move straight to $20 after the announcement? Why the $1 difference? There are a number of reasons. First, since the merger usually takes some time to complete, part of the $1 represents the “time value” of not receiving the $20 right away. But most of the discrepancy usually represents the market’s uncertainty about the final outcome. The deal may fall through for multiple reasons, such as financing problems, regulatory roadblocks, or the acquirer simply changing their mind. So the risk arbitrageur has two questions to answer: will the deal go through – and if so, how long will it take? Merger arbitrage is like a simpler, time-constrained version of value investing. When screening for candidates, there’s no need to do valuation work because the value of the company has already been announced. Both arbitrage and value investing involve handicapping the odds and buying assets for less than they are worth. With that in mind, below are some important things to consider when making any arbitrage investment.
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Figure out the odds. Before serving as the Secretary of the Treasury under Bill Clinton, Robert Rubin worked in the risk arbitrage department at Goldman Sachs. I highly recommend his autobiography ::amazon("0375757309","In an Uncertain World")::, where he writes not only about his life but about the specifics of his job at Goldman.
To engage in arbitrage, you must estimate the odds of the merger going through, and what the possible outcomes will be if it does not. Once a deal was announced, Rubin would undergo rapid, intensive research, examining all available public information. He would weigh each factor, and create an expected value table for the deal.
An expected value table works like this. Take the example of Company A and B from above. If the deal goes through, there is $1 in potential profit, and maybe we think there’s a 90% chance this will happen. In the 10% chance the merger falls apart, it will probably decline $4 to its price before the announcement. The final equation is: 90% x $1 - 10% x $4 = $0.50. So our expected return is fifty cents on a $19 investment, or 2.6%. If the deal took two months to close, the actual annualized return would be 36%. But using our expected profit, annualized return is only 17%. Rubin normally accepted deals only if expected annualized return was 20% or more.
Bob Rubin’s most important lesson was this: you should use probabilistic decision making when confronting any problem. Success comes by evaluating all the information available to judge the odds of various outcomes and the possible gains or losses for each.
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Look at incentives. Incentives aren’t given enough credit in most arbitrage situations. Yet they are very powerful motivators and can have a huge impact on the final outcome. Look for monetary incentives on both sides of the transaction. Usually there will be a “break-up” fee to discourage the buyer from walking away. What do executives in both companies get out of the deal? Will there be synergies or huge cost savings that make the merger beneficial? Do major shareholders have enough incentive to approve the deal?
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Know who’s involved. In May of last year, Rupert Murdoch made a surprise bid for Dow Jones & Co., publisher of The Wall Street Journal. The $60 per share offer was a huge 67% premium to Dow Jones’ prior closing price. In the weeks after the bid, hostility from the Bancroft family (the controlling shareholders) caused the market to price Dow at a 10% discount to the offer. It seemed reasonable, considering the amount that Dow would drop if the deal fell through (30 to 40%).
Warren Buffett knows Rupert Murdoch. Not as in “he knows him as a friend,” but as in he knows who he is, as a businessman. The market was weary, but Buffett knew there was a very good chance the deal would get done. Between the announcement and the end of June, Buffett purchased 2.8 million shares of Dow Jones—another one of his classic arbitrage investments.
Knowing the background and personalities of those involved can help immensely. The Tribune takeover was a prime example of this. No matter what happened in the final stages, Sam Zell was the kind of guy who wouldn’t have let Tribune slip past him. He had the intelligence, resources, and determination to see the deal through to the very end. This aspect isn’t always present in every arbitrage situation, but when it is, it’s often overlooked by the market.
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Look for a margin of safety. What will happen if the deal gets cancelled? You don’t want to end up holding an overvalued or distressed security. Look for any “back-doors” if the initial thesis doesn’t play out. If the Tribune deal fell through, there were multiple bidders who may have stepped in to buy the company or its assets.
Find out if it’s a good deal in the first place. When you think the takeover target is more valuable than the price being offered, it’s beneficial for a few reasons. First, if the deal falls through, you’ll still end up holding an undervalued security. Second, there’s a better chance of someone coming in with a higher bid. Either way, your possible losses are minimal.
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Wait for the no-brainers. Most funds and institutions that are dedicated to arbitrage treat it like an actuarial business. They participate in dozens of investments at a time, hoping any losses in one will be made up for with gains in the others. With the risk that merger arbitrage imposes, this isn’t a terrible way of thinking. But it ensures only mediocre performance. Warren Buffett’s strategy in his partnership and early Berkshire days was a more concentrated approach. He would be in at most a handful of situations at any one time.
The advantage Buffett had (and we have) is that he wasn’t constantly forced to make new arbitrage investments. If the buyout market cooled off, he could wait on the sidelines for better opportunities. This is in contrast to the dedicated arbitrage funds who are forced to remain active and analyze every possible deal. The best thing to do is wait for the no-brainer buyouts where (forgetting the market) the target company is obviously mispriced. That was the case with our investment in Tribune Company.