The Arbitrage Series - Part 2

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'Merger arbitrage', a form of 'risk' arbitrage,  is the term given to buying stocks involved in a takeover situation to capture the spread between the market price and the takeover price. The target stock usually trades at a discount to the takeover price to reflect the risk the takeover fails as well as the time value of money until the deal completes.  

However, unlike 'classic arbitrage', there is a risk the deal won't happen. If a deal breaks, the target stock price generally falls back towards it's pre-deal level [the price can fall lower or retain some of the premium depending on the situation] leading to large losses. Thus the term 'risk arbitrage'.  

In a cash deal, the investor will buy the target's shares at a discount to the takeover price which are exchanged for cash at deal completion. In a scrip deal, the investor will buy the target's shares and short the acquirer's shares, in the appropriate ratio, to lock in the 'spread'. At completion the target's shares will be exchanged for the acquirer's shares which will be used to net off the short position.  

"Say you get a $50 offer from a company that was trading at $35 and it immediately jumps to $49. Now most investors don't want to stick around for the last dollar and risk losing $14 if the deal breaks. They made a good profit and want to take the property and go home.  On the other hand, the arbitrageur steps in, and for that extra dollar, takes the $14 risk of deal completion. Now a dollar may not sound like a lot. But a dollar over $50 is roughly a two percent return. And let's say it's a tender offer and will close in 60 days. That means you can do the deal six times a year so six times two is a 12 percent rate of return. That can be an attractive rate of return for a relatively short term investment" John Paulson

The key attraction of merger arbitrage compared to investing in a company based on fundamentals is that you are less exposed to the broader influences of the stock market given the somewhat specific price and time outcome.  

"The beauty of arbitrage is you can earn good returns that are non-correlated with the market"  John Paulson

However, in stressed markets and/or economic environments, merger arbitrage returns tend to become more highly correlated with the broader market given financing can dry up, market-out and/or material adverse change clauses get triggered, and funds face redemptions.

Buffett has been actively involved in merger arbitrage in both the Buffett Partnership and then Berkshire Hathaway. Buffett only participated in deals once they had been announced, unlike many investors who look to participate in pre-announced deals, where a deal maybe rumoured [rumourtrage], a company may disclose they are considering corporate actions/strategic alternatives or there is speculated to be further corporate action given significant merger activity in a sector.

"The other way we differ from some arbitrage operations is that we participate only in transactions that have been publicly announced. We do not trade on rumours or try to guess takeover candidates. We just read the newspapers, think about a few of the big propositions, and go by our own sense of probabilities"  Warren Buffett 1988

Merger arbitrage is a specialised area requiring skills in valuation, portfolio/risk management, takeover laws/regulatory rules, industry dynamics, human psychology, tax rules etc.  

"A legal education helps us in the analytical process. It instills discipline" Brian Stark

“One of the things you have to be good at in the risk arbitrage business is valuation: you need to be able to understand your downside” John Phelan

"To be successful requires very specialised skills unique to the arbitrageur. One must be an expert in evaluating the financing, legal, regulatory, accounting, market and business issues that may affect a deal's outcome. To properly evaluate these risks, the arbitrageur must have expertise in analysing merger agreements, financing agreements, strategic issues and financial statements, as well as federal, state and local regulatory issues." John Paulson

Given the merger 'spread' is normally quite slim, the profits from merger arbitrage tends to be small relative to the loss you incur if a deal fails. In the example above, an investor risked fourteen dollars to make one dollar. This asymmetry is why it is analogous to 'picking up nickels in front of a steamroller'.  

“The strategy, while properly executed, can produce non-correlated, low-volatility returns, [however] any individual deal may carry substantial risk. This is because the upside in a transaction is very small compared to the potential downside. While the annualised return may be high, the absolute return is small, and the downside can be 10 times, 20 times or even 30 times the amount of potential gain” John Paulson

“When things go wrong in merger arbitrage, they can go very wrong – often in an asymmetric way.” Joel Greenblatt

"Premiums, ranging generally from 10 percent to even 50 percent - exceptionally even 100 percent - maybe offered for acquisition targets.  An arbitrageur, when he takes his long position, is thereby assuming a great part of this premium in the price he pays.  Should the deal be sabotaged for some reason, the downside price slide can be rather large.  So one must carefully calculate the downside risk" Guy Wyser-Pratte

To make money in merger arbitrage the investor needs the deal to complete. As a starting point it's worth considering a few basics. Prior to analysing a deal it's worth asking a few questions with regards to the jurisdiction of the deal. Roddy Campbell of Cross Asset Management poses the following three question: Is there 1) a level playing field? 2) a decent body of precedent of corporate law decisions? and 3) an ability to predict the behaviour of participants and comprehend their motives? If you answer NO on any of those, it's probably best to move on t0 the next opportunity.

It's worth establishing a checklist of key considerations to ensure items are not overlooked. Some considerations include:

Deal type - is the deal announced or rumoured? Announced deals carry significantly lower risk.
Type of Buyer - is the buyer a financial buyer [ie private equity] or a strategic buyer? Sensible strategic acquisitions by larger companies in the same industry tend to have a higher likelihood of success [in the absence of competition issues].
Nature of Target - was the company being shopped for sale? A company being shopped means the company is 'in play' and the board is open to a transaction.  Other buyers may emerge if the deal breaks. Conversely, the list of alternate buyers may already be exhausted. If the market was aware the company was being shopped the pre-deal price is likely to have some takeover premium in it which may disappear if the deal breaks.
Type of Bid - is the buyer paying cash or scrip, a combination of both, or some other form of payment? Is the deal a takeover, scheme of arrangement or other type of transaction? 
Borrow - if the deal is a scrip deal, is there ample borrow? What are the borrow costs?
Hostile or Friendly - has the seller agreed to the terms of the deal or is it a hostile takeover? Friendly deals have a much greater chance of proceeding.
Size of the deal - is the target company a small or large company relative to the buyer. Smaller deals relative to the size of the acquirer tend to be lower risk.
Funding of the Buyer - if a cash bid, does the bidder need/have financing in place and if not what is the appetite among lenders? Are the financial metrics acceptable, is the acquirer or the proposed combined entity too heavily geared? Will the financial metrics limit the acquirers ability to pay more?

"Among other things, it's offer was contingent upon obtaining 'satisfactory financing'. A clause of this kind is always dangerous for the seller: It offers an easy exit for a suitor whose ardor fades between proposal and marriage" Warren Buffett 1988

Value of the target - are the deal metrics comparable with other takeovers? Is the company valuation fair at the bid price? Could the bidder pay more for the company? A low valuation increases the chance of a contested bid and generally means less downside risk. A target or their shareholders, however, are more likely to reject a hostile bid at a low valuation.
Track record of Buyer - does the buyer have a track record of closing similar transactions?
Synergies of the deal - what is the upside from putting the companies together, how important is the deal to the acquirer? Could another party get more synergies?
Target Agreements - do the target's customers, financiers, suppliers etc have change of control clauses?
Shareholders of the target - will the target shareholders agree to the deal and is there any shareholder or group of shareholders who could block the deal? Are there any other corporates on the register who may bid?
Pre-bid stake - has the acquirer already built up a stake in the target? i.e. how committed are they? Is it sufficient to block alternative bids?
Break fees/No Shop clauses - is the acquirer/target liable for break fees? Will they put off another buyer? Is the target prevented from seeking a higher bid?
Post deal announcement price of the acquirer - has the market reacted favourably to the proposed acquisition? Are the acquirer's shareholders supportive of the transaction?  
Potential Counter bidders - is it likely another buyer for the company will emerge? The potential for a contested takeover can improve the asymmetry of returns.

"Generally, the characteristics that lead to a higher bid include: a low relative valuation, an attractive target, an industry experiencing consolidation, no lock-ups and the company not having been shopped prior to deal announcement" John Paulson

Acquirer bid - is there a chance another party could bid for the acquirer? Was the acquirer buying for defensive reasons? Will the deal break if an offer is made for the acquirer? This is a major risk to a trade, particularly if you have bought the target and short the acquirer. 
Fraud -  Is the acquirer buying to mask an earnings hole/structural decline in their own business?  Is the target likely to reject the acquirer's scrip? Are there question marks over the acquirers financials/cash flows/roll-up strategy?
Conditionality of bid - does the bid have few or a lot of conditions that need to be fulfilled for the deal to complete? How onerous are the conditions? The more conditions, the more chance of a deal break.
Market Out-clause - does the bidder have a market out-clause if stock markets or commodities etc fall or interest rates rise? Absence of out-clauses reduce the risk of a deal break.
Defence Options - what could the target company do to scuttle the deal, poison pills etc?
Anti-trust/Competition issues - are there any issues which may mean the deal is blocked by a competition regulator? Are there useful precedents?
Timing/Delays? - are there likely to be delays to the completion time? Competition /regulatory/ court rulings/ due diligence etc. Delays ordinarily reduce the returns unless the deal compensates for a delay in the timetable.
Regulatory Issues - are their regulatory issues outside competition? Are there national interest/sovereign issues? Is the deal in a country with a strong rule of law? Are there deal precedents?
Tax Issues - does the deal require a favourable tax ruling?
'Break' downside - where is the stock likely to trade if the deal breaks?  Does the bid highlight value not previously appreciated by the market, or is it likely to fall back to levels prior to the deal being announced or speculated? Is there a risk that new and disappointing information may come to light during the negotiation?
Company Performance - the underlying performance of both the target and acquirer can impact the probability of a deal closing. The more cyclical the industry the more risk either party's business may change significantly which may alter the deal outcome.

The investor must consider the above issues at a minimum to determine whether to participate in a deal. Every transaction is different.  

Often investors will work out a probability weighted outcome based on different scenarios [ie 15% chance of deal break which will see stock fall to 5% below undisturbed price [ie price stock trading before deal], 60% chance of deal complete at stated time, 25% chance of competing bidder paying 20% more for target].   The investor will calculate the annualised return the current spread provides. The difficulty is in weighing up the factors and estimating the probabilities.

"It's very easy to compute what the returns are from a spread. But what's not easy to compute is what the risks of the deal breaking apart are" John Paulson

The investor is unlikely to have concrete answers to all the necessary questions and will need to make informed judgements.   

"In arbitrage you have to be able to pull the trigger, even when your information is imperfect and your questions can’t all be answered. You have to make a decision: should I make this investment or not? You begin with probing questions and end up having to accept that some of them will be imperfectly answered – or not answered at all." Robert Rubin

"One of the things I do very well in investing is I gather a lot of information, but I never know the whole picture. I have a lot of inputs, but never everything.  And I have to make a decision on incomplete information. And I feel very comfortable doing it" James Dinan

"Investing isn't black or white. It's different shades of grey, and what was common to all of us [in Goldman's risk arbitrage team] was that we could see the different shades of grey and handicap them. There were very few second chances. The process had to be good" Richard Perry

The investor must constantly monitor the takeover's progress as well as general market and industry conditions to manage risk and optimise returns.  

"The odds of a merger reaching closure changed constantly over time, as risks emerged and receded and share price fluctuated. We had to stay on top of the situation, recalculating the odds and deciding whether to commit more, reduce our position, or even liquidate it entirely"  Robert Rubin

"Merger arbitrage is not a one decision investment. It is an ongoing process: prices fluctuate, the economy changes, government actions are taken, stock is always being bought and sold.  Merger arbitrage is not a part-time activity. It required constant vigilance"  Ivan Boesky

Ultimately, an investor must be comfortable with the worse case outcome and the effect on their overall portfolio.  I've seen plenty of situations where a deal break results in a share price trading significantly below the pre-bid trading price. For example when a takeover premium was already in the price and the register has become dominated by non-natural holders who need to sell, an acquirer walks due to any one of a number of possible reasons, or the target fails to act in the shareholder's best interests.   

“Risk arbitrage sometimes involved taking large losses, but if you did your analysis properly and didn’t get swept up into the psychology of the herd, you could be successful. Intermittent losses – sometimes greatly in excess of your worst case expectations – were part of the business” Robert Rubin

Pure merger arbitrage funds limit position sizes and look to participate in many transactions to spread risk and minimise the loss from a single deal breaking.     

"Of course, an arbitrageur would be involved in many deals at any one time. You had to do a lot of them, because arbitrage is an actuarial business, like insurance. You expect to lose money in some cases but to make money over the long run thanks to the law of averages”  Robert Rubin

"A common approach to managing a merger arbitrage portfolio is to diversify a portfolio across a broad range of small positions. By minimising position sizes, the manager can protect himself from significant drawdowns [loss] in the event of an adverse deal outcome.  This broadly diversified approach, however, should lead to no better than average returns"  John Paulson

“Of course, some investment strategies for instance, our efforts in arbitrage over the years require wide diversification.  If significant risk exists in a single transaction, overall risk should be reduced by making that purchase one of many mutually-independent commitments. Thus, you may consciously purchase a risky investment - one that indeed has a significant possibility of causing loss or injury - if you believe that your gain, weighted for probabilities, considerably exceeds your loss, comparably weighted, and if you can commit to a number of similar, but unrelated opportunities. Should you choose to pursue this course, you should adopt the outlook of the casino that owns a roulette wheel, which will want to see lots of action because it is favoured by probabilities, but refuse to accept a single, huge bet.“ Warren Buffett

While Warren Buffett recognised the benefits of a diversified approach he tended to concentrate in a small number of attractive deals. The merger activity was part of a broader portfolio of investment styles that could absorb any large loss.

"Our relatively heavy concentration in just a few situations per year (some of the large arbitrage houses may become involved in fifty or more workouts per annum) gives more variation in yearly results than an across-the-board approach. I feel the average profitability will be good with our policy" Warren Buffett, Buffett Partnership Letter

"Because we diversify so little, one particularly profitable or unprofitable transaction will affect our yearly result from arbitrage far more than it will the typical arbitrage operation.  So far Berkshire has not had a realy bad experience. But we will - and when it happens we'll report the gory details to you." Warren Buffett, Berkshire Letter

“We do not do a lot of arbitrage, but participate in extreme opportunities”  David Einhorn

Like many investment strategies, when there has been a history of returns money flows into the strategy which lowers its returns. Similarly, in the absence of deals, too much money chasing too few opportunities affects returns.  

Easy credit and a bull market leads to increasing deal activity and the potential for contested deals. The merger boom leading into the Financial Crisis was a case in point.  Deals regularly traded at premiums to the takeover prices as a credit bubble fuelled a private equity buying binge resulting in a flurry of contested deals.  Sell-side research analysts spent their days running LBO screens over company financials to identify the next potential target. All was well until the credit markets closed.

“When an area of investment such as risk arbitrage or bankruptcy investing becomes popular, more money flows to specialists in the area. The increased buying bids up prices,  increasing the short-term returns of investors and to some extent creating a self-fulfilling prophecy. This attracts still more investors, bidding prices up further. While the influx of funds helps to generate strong investment results for the earliest investors, the resultant higher prices serve to reduce future returns.” Seth Klarman

"The strategy has its cycles based on the overall level of deal activity as well as the supply of capital" John Paulson

Buffett succinctly outlined the requirements for successful merger arbitrage in his 1998 letter..

“To evaluate arbitrage situations you must answer four questions 1) How likely is it that the promised event will indeed occur? How long will your money be tied up? 3) What chance is there that something still better will transpire – a competing takeover bid, for example? And 4) what will happen if the event does not take place because of anti-trust action, financing glitches etc?” Warren Buffett

The key to successfully employing merger arbitrage is to avoid deal breaks.  

"Risk arbitrage is not about making money, it's about not losing money" John Paulson

"The common characteristics of deals that break are poor earnings, an inability to consummate financing and/or regulatory obstacles. By eliminating deals that exhibit these characteristics, one can reduce the insistence of deal breakage" John Paulson

John Paulson, of Paulson Partners outlines his strategy for success..

"Our particular strategy to manage the portfolio for outperformance is comprised of five basic principles: 1) avoid deals that may break, 2) optimise returns from the spread portfolio, 3) weight the portfolio to possible competitive bid situations 4) focus on deals with unique structures that offer high returns; and 5) selectively short the weaker transactions"  John Paulson

While merger arbitrage is unlikely to offer the same opportunity for returns as finding compounding machines, at times it can be a useful complement to value investing.  Over the years, the best merger arbitrage opportunities I've witnessed are deals with very low conditionality that provide optionality for a bidding war. In these situations the return profile can move from negative to positive asymmetry.  It's interesting, that despite John Paulsen's history in merger arbitrage it was buying sub-prime CDS's with massive positive asymmetry that made him billions. He risked a small amount for a massive pay-off.  

Further reading -