12.58%10.96%15.39%11.64%4.09%
20.89%16.30%14.38%−8.68%28.56%14.17%−10.84%0.08%16.20%17.34%−18.77%−27.86%37.37%26.77%−2.98%8.54%24.40%33.23%−3.97%20.42%22.70%3.28%31.46%15.60%1.76%17.62%28.44%−6.02%33.59%9.03%11.49%−0.62%35.73%21.26%30.46%22.49%
3.13%3.48%3.94%4.69%4.05%4.75%6.49%6.17%4.15%3.93%7.17%7.97%5.63%4.91%5.25%7.41%10.42%11.33%14.50%10.38%8.86%9.62%7.38%5.93%5.17%6.50%8.16%7.53%5.32%3.36%2.90%3.98%5.47%5.14%5.11%4.70%
0.40%0.35%0.47%0.69%1.16%1.72%1.10%0.30%0.15%0.13%0.39%0.42%0.29%0.36%0.72%0.93%0.82%0.47%0.68%0.42%0.45%0.63%0.50%0.68%0.63%0.61%0.32%0.11%0.07%0.07%0.09%0.12%0.11%0.06%0.06%0.06%
Compound annualrate of return16.05%
10.64%
12.24%
6.22%
Annual standarddeviation of returns
9.29%
7.74%
15.08%
0.73%
Sharpe ratio(annual)
1.06
0.57
0.40
0.0
Source: Mark Mitchell and Todd Pulino, “Characteristics of Risk and Return in RiskArbitrage,” Journal of Finance 56, Issue 6, December 2001, Table II, pp. 2151.Reprinted by permission from Blackwell Publishers Journal Rights, Email:JournalRights@oxon.blackwellpublishing.com.
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The Value-Weighted Risk Arbitrage (VWRA) return in the exhibit refersto the return that would be generated if you were to value each merger byits size. The Risk Arbitrage Index Manager (RAIM) return represents whatwould happen if you played each merger subject to more realistic constraints—for instance, only limiting each position to 10 percent of yourportfolio and also restricting yourself to deals involving more liquid securities. The results demonstrate that even if you blindly play every singlemerger that exists you can still obtain a slight risk-adjusted premium to themarket. The spread between the risk-free return and the value-weightedreturn is 10 percent in the value-weighted index and four percent in theRAIM index.While I think this study demonstrates that merger arbitrage is a decentstrategy, it also is very conservative for the following two reasons:1. An arbitrageur won’t blindly do every deal, but will instead use a vari-
ety of factors to limit the risk in a deal.2. An arbitrage fund may use leverage to attempt to get the risk-adjusted
returns multiplied by the leverage factor.Also interesting is the fact that the VWRA portfolio in the above tablereturns more than the index, which does not take into account the size ofthe deal. This suggests that the larger the companies involved, the morelikely it is for a deal to succeed.Eliezer Fich and Irina Stefanescu,2 who are both from the University ofNorth Carolina, confirm this by demonstrating that when an acquirer is inthe S&P 500 Index the risk arbitrage portfolio returns are 85 percent higherthan when the buyer is not in the Index.Perhaps most interesting is to look at the results of the Crédit SuisseFirst Boston (CSFB) hedge fund sub index devoted to merger arbitrage.Exhibit 5.3 shows the summary tables.Since inception, the merger arbitrage index has underperformed theCSFB Hedge Fund Index (8.39 versus 10.59 percent), but the standard deviation has been much less (4.48 and 15.85 percent), making the equity curvemuch smoother.
2
“Expanding the Limits of Merger Arbitrage” by Eliezer Fich and Irina Stefanescu,University of North Carolina working paper, 2003.
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Mar
Apr
1.91%
0.15%
2001
2000
0.61%0.25%
0.63% 2.00%
0.63% −0.45%
1.86% −0.96%
1.88%
1.28%
1.02%
1.61%
0.57% −0.44%
1997
1996
1995
1994
.
1.09%
2.38% 1.64%
−0.54%
1998
1.57%
0.22% −0.42% −1.67%
Oct
1.01%0.35%
1.31%
0.18%
2.07%
0.28%
2.39%
0.57%
1.56%
1.05%
1.21%
1.69%
0.60%
1.23%
0.57%
0.38%
1.14%
2.15%
1.48%
0.20%
0.16%
0.45%
0.02%
2.41%
0.80%
1.57%
0.23% −0.53% −0.37% −6.15% −0.65%
0.16%
1.58%
1.01% −2.65% −0.01%1.75%
1.22%
1.43%
0.68%2.16%
2.47%
0.05% 1.81%
2.56% 3.39%
0.68%
1.31% −0.43%
3.52%
3.81%
1.16%
Sep
0.52%
0.48%
Aug
1.21%
0.75%
Jul
0.95%
2.56%
Jun
Monthly Performance
0.03% −1.17% −2.73% −1.23% −0.56%
−1.51% −1.37%
0.33% 0.50%
1.00% 0.88%
May
1999
1.49%
0.29% −1.22%
−0.39% −0.71% −0.27% 1.52%
Feb
CSFB Merger Arbitrage Index
2002
2003
Jan
EXHIBIT 5.3
N/A
Dec
7.90%
Year
22.27%
25.84%
MSCIWorld$
9.84%
5.58%
0.61% 0.26%
5.25%
1.68% −0.16% 11.90%
0.45% 1.12% 13.81%
1.09% 2.01%
2.04% 1.55%
0.52% 0.47% 13.23%
1.32%
37.58%
22.96%
33.36%
28.58%
21.04%
5.58%
21.32%
14.00%
16.23%
24.80%
25.34%
−9.10% −12.92%
5.68% −11.89% −16.52%
0.28% 1.39% 14.69%
0.81% 0.67%
0.21% 0.53% −3.46% −22.10% −19.54%
0.42%
Nov
S&P500TotalReturn
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EXHIBIT 5.3
TRADE LIKE WARREN BUFFETT
Risk Arbitrage Index
Cumulative Performance
.
Draw Down Graph
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Merger Arbitrage Like Warren Buffett
EXHIBIT 5.3
(continued)
NetPerformance
HEDG RiskArbitrage
S&P 500Total Return
MSCIWorld $
1 Month3 Months6 Months1 Year2 Years3 Years3 yr Avg5 years5 yr AvgSince InceptionIncep Avg Annl
0.42%2.60%5.08%8.47%4.87%11.62%3.73%45.19%7.74%122.25%8.39%
0.88%5.46%10.80%15.09%−3.92%−15.66%–5.52%−2.34%–0.47%171.39%10.59%
1.55%8.28%14.90%19.76%1.90%−14.10%–4.94%−3.23%–0.65%95.38%6.99%
Statistics
HEDG RiskArbitrage
S&P 500Total Return
MSCIWorld $
0.68%3.81%−6.15%1.29%4.48%0.130.95
0.95%9.78%−14.46%4.58%15.85%0.970.41
0.65%9.06%−13.32%4.24%14.70%0.860.19
HEDG RiskArbitrage
S&P 500Total Return
MSCIWorld $
0.440.450.430.440.39
0.930.940.771.000.80
0.891.000.940.940.79
Avg MonthBest MonthWorst MonthMth Std DevMth Std Dev, Ann’dBeta(vs S&P 500)Sharpe
Correlations
DowMSCI World $MSCI EAFE $S&P 500 Total ReturnNASDAQ
Index data begins January 1994. Sharpe ratio calculated using a rolling 90Day T-bill rate
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None of this takes into account Warren Buffett’s own studies on thepossible results of merger arbitrage. In his 1987 letter he writes: “Thoughwe’ve never made an exact calculation, I believe that overall we have averaged annual pre-tax returns of at least 25 percent from arbitrage.”Although the academic studies as well as the practical results demonstrated by the hedge fund index show that merger arbitrage is a viable riskadjusted strategy, the one problem both of those studies and approacheshave is that they have to trade every year, and in almost every situation. Buffett, not being specifically an arbitrageur, can wait for the situations that he feels afford an extra level of safety. This leads to one of thebiggest aspects of Buffett’s career that I admire: He writes his own rules.Many hedge funds out there (and this is definitely the case for almost allmutual funds) are obligated to tell their investors their monthly results.These monthly results can be like a straitjacket. The second the results beginto dip or become volatile, there is always the risk that the investor can pullout. It is this desperation for smoothness to the equity curve that compelsmany hedge funds to be extremely risk-averse and not always take advantage of every opportunity available to them, even when the odds aregreatly in their favor. Buffett clearly stated to his investors, “I’m open forbusiness one day a year,” and that was that. Once a year he could tellinvestors how he was doing, and if they didn’t like it, so be it.Modern hedge funds also abhor “style drift,” the propensity to switchstyles midstream; a fund will not go from value to growth stock-picking,or suddenly start day-trading futures after having advertised itself as abiotech investor. The primary reason for this is that the primary allocatorsto hedge funds or fund-of-funds have very specific mathematical modelsfor how to allocate and diversify their own portfolio. If they invested inyou because they thought you were a merger arbitrage fund, then you hadbetter remain a merger arbitrage fund. Buffett didn’t care for any of that.He did what he wanted to do, and told investors their results when he feltlike it. Power to him.
HOW TO ARBITRAGE LIKE WARREN BUFFETTBuffett mentions in his 1988 letter the four conditions that an arbitrageurmust ask, in addition to the obvious question. What is the spread? They are:
Merger Arbitrage Like Warren Buffett
101
1. What can cause the deal to fail?2. What is the time it will take for the deal to occur?3. What other opportunities might be available?4. What are you going to do if the deal does not go through?
It is this fourth question and the way he phrases it that most intrigues me.The question is not “What is your downside risk?” as is most often asked intextbooks on arbitrageurs, but, What are you going to do if the deal is notcompleted? This emphasizes the importance of having a backup plan, anextra exit in case the deal does not go through.Also, before making a trade, it is possible to eliminate the cases thatstatistically offer more risk.• Buy deals in which an S&P 500 company is the bidder.• Buy deals in which the targeted company is trading for less than book.• Don’t do a deal when it is a hostile takeover (it is less likely to becompleted).• Try to do deals in which you are bullish on the fundamentals of theunderlying company or its sector.• Buy a deal in which there are multiple bidders.Some examples of having an “out” in an arbitrage trade are when thetargeted company also happens to be trading below its liquidation price.Deals like that do not happen very often, but occasionally they do. A recentexample from the penny stock world was when Liberty Media-controlledOpen TV (OPTV) was making a bid for IATV in mid-2002. IATV was burning a lot of money, but also happened to be trading at a market cap wellbelow the cash it had in the bank and with no debt. It had approximately$1/share cash in the bank and the deal was priced at approximately $1.10in OPTV stock. Because OPTV was itself a penny stock, trading around $2,there were no shares around to borrow; the spread was therefore enormous. In addition, on several occasions the deal was postponed and Liberty Media, run by John Malone, was notorious for changing deal termsat the last minute. IATV traded down as low as $0.50 before finally consummating the deal in March 2003. It was a roller coaster ride for the arbitrageur, but the ride was worth it, and the consolation if the deal did not
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work out was the solid $1/share in cash that the company had left in itscoffers.As Buffett has said, “I’d rather have a lumpy 15 percent than a smooth12 percent.” That said, it usually doesn’t get any smoother than a portfolioof merger arbitrage situations.The next section is an interview with John Orrico, a merger arbitragespecialist who strives to take as many risks as possible out of the tradebefore making the trade. The Arbitrage Fund is a mutual fund that focuseson merger arbitrage situation.
INTERVIEW WITH JOHN ORRICOOF THE ARBITRAGE FUNDJA: Can you give us some personal background?JO: When I got out of Georgetown, I went to Morgan Stanley and workedin corporate finance for two years and institutional equity for twoyears. From the mid-’80s to the mid-’90s, after Morgan Stanley, I helda variety of positions in trading, institutional equity, as an analyst andas a portfolio manager.JA: When you say trading, that’s primarily . . .JO: At Morgan Stanley, I was at the Institutional Equity Desk. I was on theover-the-counter desk and actually making markets on stocks there.When I went to Instinet, when that firm was still in its infancy, I ranthe Institutional Equity Desk there, but we didn’t commit capital sothere was no principal trading involved. It was really more agencybrokerage. Then, you know, Instinet got bought out by Reuters . . . andI wanted to get to the buy side. So, I took a couple of steps back to dothat, among other things. And I’ve worked as an analyst for a while atone firm. I got a job as an assistant portfolio manager at another firm.JA: What kind of portfolios do you normally pick?JO: When I worked as a portfolio manager for the U.S. investment arm of aJapanese life insurer, they were clearly just long-only portfolios, bonds,and stocks. The hedge fund was pretty much a rapid-trading hedge fund(when I had some experience working for a small hedge fund), butagain, long and short strategies, but primarily looking for trading ideas.
Merger Arbitrage Like Warren Buffett
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JA: So like something that would pop on earnings?JO: Exactly—special situations, deep-value type of situations.JA: How did that work out overall?JO: Unless you’re a great stock picker or you really want a balancedportfolio in terms of the long-short strategy, I think those strategiesare really kind of victim to the ups and downs of the market. It’seasy to make money if you’re a long-only type of trader when themarkets are rising. It’s, of course, much more difficult in flat, volatile, or down markets.I just think it’s a lot harder than it seems to a lot of people, and Ican speak for myself and say that early in my career I had no clue.When I look back, I really had no knowledge of the type of hedgingtechniques and strategies that are or were out there and available. It’sreally about getting in front of the right people, working for the rightpeople, getting into the right shop where you can learn a lot of thosethings, whether it’s on the buy side or the sell side.A lot of people do run funds, limited partnerships and tradingvehicles. But I think the number of people who do it really well consistently over time is quite limited. That’s just my own feeling afterhaving seen it all and knowing a lot of people in this industry.My history prior to going to work for Martin Gruss at Gruss &Company, which is a private family trust where I learned a skill setaround merger arb[itrage], was really as a kind of a trader, a moneymanager with kind of a long focus.I then went to work for the Gruss family; for their family privateaccounts, they have been utilizing merger arb and event-drivenstrategies for decades. So I went into a shop that really had a historywith this particular strategy and knew what they were doing, whereI could learn.JA: What was your initial attraction to those strategies?JO: I really didn’t know when I first went there. When I walked in the door,it wasn’t to go work with the merger arb team; it was to work on ateam that was running the internal hedge fund there, a long-short kindof fund. But after getting introduced to the merger team and theirstrategies, it became clear to me that the merger arb and event-drivenstrategies—whatever you want to call it, although they do talk aboutevent-driven as inclusive of merger arb—really force you not only to
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understand the underlying companies that you’re involved with butalso to take a directional bet. You can still take a directional bet if youhave a strong feeling one way or the other, and that comes into the wayyou hedge and into the strategies you develop around your position.So what attracted me to it? The very analytical and quantitativeskills that come into play are very important in that strategy in termsof analyzing the underlying assets that you’re investing in or sellingshort. You need to understand the situation and be able to follow thestrategic rationale behind each event. And you can describe many ofthese events as binary, or events that are not predicated on overalldirectional moves in the marketplace.JA: Can you give an example of one situation in which you might havetaken a directional bet?JO: Back in the late ’90s, when Conrail put itself up for sale, we had twoof the largest railroads in the country bidding for this property, whichhad no peers, couldn’t be replicated, and most likely would never befor sale again. In that particular case, our analysis told us that thisbidding war between the two interested parties was likely to continue, driving the asset price much higher than what we thought mightbe its intrinsic or fundamental value. That doesn’t mean that there isno risk, but it means there might be a way for us to increase our exposure to that particular deal.The option markets are very liquid, and typically with a lot of thebigger situations, there are ways to hedge yourself. The outcome maytake a couple of months to unfold, but when we’re playing a situationin which we think prices will go higher amid more aggressive bidding,we will buy some stock, marry a put to it, and just go to sleep. It maybe an out-of-the-money put, but as long as we can measure our downside, in a general sense, that’s how we view our business. We want tobe able to understand what our downside looks like. In some cases,our upside is well-defined; in other cases, it’s not.That’s what attracted me to merger arb. It’s a much more interesting strategy than just taking a bet on a stock. You can always takebets on stocks, and we can always figure out ways to hedge ourselves. However, in the context of a deal or how a deal will be viewedby the Street—whether it’s a merger, a takeover, or a hostile bid—there are always other ways to look at the event as it unfolds andother ways to play it.
Merger Arbitrage Like Warren Buffett
105
There may be an event unfolding that we’re quite bearish on,where we don’t like the probable outcome; even if the deal goesthrough, we may not like the combined entity. We may think it’s toooverleveraged. We may think the market may not like it. We think theshareholders may vote it down. So it doesn’t mean we’re always betting on a successful conclusion. We can anticipate a successful conclusion, but anticipate share prices going lower.Every deal has its own twists and turns, and there’s always a different way to look at any particular deal. But as long as we can geta sense for what our downside is, that allows us to continue to run abusiness day in and day out and always be around to play another day.JA: In the Conrail example, do you think that Conrail initially was tradingbelow its own intrinsic value or your calculation of intrinsic value?JO: I guess the question is, Were we looking at the stock before the internal decision was made at Conrail to put itself up for sale? In thatcase, those shares trade based on the fundamentals of that particularindustry, relative to their peer group. But as an entity that had somegovernmental oversight and some government control to a certainextent, once we understood that transaction was given a green light—meaning that the sale of that asset was going to be allowed to go forward by the regulators—then it puts a whole different light on whatunderlying value might be. Then you’re talking about the types of synergies that a potential buyer will be able to extract from that particular asset. That could increase by some factor related to the synergythat the new buyer brings in. How much traffic can the new buyer runover those rails that it’s now shipping in expensively by truck or by air?Once we understand the rationale of the deal, then we’re able toexamine what the benefits are and what benefits will accrue to thebuyer or the entity on a pro forma basis. It puts a whole new evaluation on the deal. In this particular case, it’s a one-of-a-kind asset.There aren’t going to be any more rails into the Northeast or into theports of New York, Philadelphia, or Boston. Once this thing is offthe market or not available to other buyers, that’s it. It will nevercome up for sale again. So if you’re a strategic buyer and that assetcould be strategic to your firm’s overall growth, you’re probably goingto pay more than what it’s worth because it can’t be replicated.So that’s a special kind of situation, and that doesn’t always happen. Look at a deal that’s taking place today, such as Pfizer’s deal to
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buy Esperion Therapeutics, a company that doesn’t have any products on the market—just in development—and Pfizer is willing to payalmost $2 billion for this asset. You have to ask yourself: What doesEsperion control, what has it developed, or what potentially does ithave in the way of technology that makes it that desirable?If it’s that desirable to Pfizer, does it mean that other players areaware of this technology or this drug pipeline and may be interestedas well? Or is it just more valuable to Pfizer than anyone else becausePfizer has such a big stake in this particular segment of the healthcare industry already?Here we’re talking about cardiovascular disease and the drugs thathave to do with controlling cholesterol levels in the body. Pfizer has abig platform that’s already dominant in the field. This particular company has new technologies on the horizon and new products in thepipeline, and a lot of people in the industry think it can be quite valuable.Does it ensure Pfizer’s success in this field into the next decade? Doesit give them a platform by which they can then extend the patent life ontheir current drug portfolios? I mean, what’s it really worth to Pfizer?It’s hard because then this asset is worth different values to different players. To a player that wants to get into the market anddoesn’t have a presence in cardiovascular treatment, maybe this is aspringboard into that, avoiding the startup costs related to doing iton your own. For Pfizer, which is looking to extend its current platform and develop the new technologies it may feel are needed toensure it remains No. 1 in the field, it needs to pay top dollar for thisand keep it out of anyone else’s hands.Who knows what it’s worth to any one particular buyer unlessyou understand how that buyer is positioned, how it competes, how itwould potentially compete with or without this particular deal andhow the regulators are going to look at it? It gets complicated becauseas much as you try to put yourself in the shoes of the buyer, it’s hard.You’ll never know everything they know. You’ll never know what’s intheir product pipeline or what’s on their drawing boards. So we canguess a lot. We can try to understand by talking to the companies, bytalking to analysts, by talking to other players in the field about whatmakes this asset so attractive to a particular player and really try tobuild our own models around what we learn.JA: Why is it so necessary to know what’s on the mind of the buyer? Youknow they want to buy the company, and at that point, let’s say there’s
Merger Arbitrage Like Warren Buffett
107
a regulatory risk or a risk that the deal is not going to go through. Howdoes knowing what is on the mind of the buyer help you deal withthose and other risks?JO: Well, for instance, in the biotech sector, a buyer is also concernedabout how the trials are going. When do the new benchmarks orresults come out? During the course of the next three months, we mayhear some significant news on some of these drugs in developmentthat may torpedo a deal if they find that the endpoints were not met.Look at First Data’s deal to buy Concorde, which ran into someregulatory problems. The potential for regulatory problems is alwayson our minds. What’s also on our minds, though, was that these wererelated to Concorde’s economic performance. For the duration of thisdeal, many Concorde contracts with some of its largest banking customers come up for renewal, and many of those customers may notrenew their business relationships with Concorde in terms of debitand credit card processing.How much of Concorde’s business could bleed to the loss ofrenewals or the loss of new business before First Data says the economics of this deal don’t make sense anymore? That was a concernbecause there’s always a disruption to the target’s underlying business:concern among customers, concern among employees, you may losesome top salespeople when you’re going through a potential transaction. Caremark, which is in a whole other field in terms of pharmaceutical delivery, is buying Advance PCS, which just lost a large contract toa competitor. And we know it has other contracts up for renewal.So we ask ourselves what the merger agreement says with regardto business losses. In Caremark’s merger agreement, it does nothave to go through with this deal if revenues exceeding a certain percentage of Advance’s business disappear between now and the close.They can weigh that condition and go through with the deal anyway,but these merger agreements contain numerous conditions not onlyon the regulatory side but also on how much business it’s willing todivest in order to meet regulatory requirements. Clearly that’s usuallycarved out.Also, what are the economic requirements? Are there revenuetargets, EBITDA [earnings before interest, taxes, depreciation, andamortization] targets, earnings targets? Many of the merger agreements today have conditions such as those. Say you have a deal that’sbeen negotiated based on a particular value; let’s say $30 in stock is
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going to be distributed at close. Well, if the acquirer shares fall from$30 to $15, it goes from a one-to-one exchange to a two-for-oneexchange. Some companies will not go through with a deal if theirshare prices fall to a level such that they have to issue significantlymore shares. What was an accreted transaction then turns into adiluted transaction. But again, you have to ask yourself why theacquirer’s shares fell from $30 to