$15. Does that open the door foranother buyer to step in?Every deal has its own twists and turns, and it really forces us toexamine the quality of the companies that are involved. When I say“quality,” I’m talking about their earnings consistency, the quality ofearnings, the transparency of their accounting, and the type of management that runs the company. What do the balance sheets looklike? What are the peer-group valuations relative to these two companies, and what is their competitive position within the industry? Whatfactors could impact any of those issues? And that’s just the basics.That’s just to get comfortable with where we are in the deal before weinvest in it.It’s much easier with larger companies and larger deals. Everybody knows Bank One and J.P. Morgan; you have 50 analysts following the two companies. But in some of the smaller deals, like in thehealth care technology field, software and hardware, it gets a littlemore complicated. We’re not experts in any one particular industry;we’re basically generalists.Over the course of my career, I’ve been involved in a couple ofhundred financial deals or dozens of HMO deals. You start to seethings again and again, and you begin to know what to look for.Having a history helps because typically you’ve seen the mergeragreements and the language before. You can get an early heads-upwhen something doesn’t look or smell right, or something is donedifferently.JA: Is there any type of deal you won’t do, like for instance the Bank OneJ.P. Morgan deal? Where would your edge or your margin of safety bein that deal if you were to play it? (A deal had just been announced atthe time of the interview.)JO: I don’t believe we have an edge when it comes to a deal that size,which is well covered by the Street and by the arb desks. If there is anedge to be had, it’s going to come from taking an independent view ofthe deal from a valuation and earnings standpoint, taking a look at
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what, for instance, the new management team from Bank One willbring to this combined entity and what it will do in terms of valuationoverall in terms of P/E multiples. We’ll look at how it will sit with theanalysts on the Street; we know that there will be a number ofupgrades as a result of this deal.At the end of the day, after we do all our work and look at thenumbers, the pro formas, valuations and peer-group valuations, we’lltalk to the analysts and get a feel from the company how quickly costcuts can take place. When all of our analyses are done, we may thinkthat J.P. Morgan is an undervalued stock now, whereas that wasn’tthe case before. Our edge is bringing our experience and analysis tobear in a situation and maybe coming up with a way to look at thisdeal that other people don’t.That might mean to be hedged instead of selling J.P. Morganshort. We’re going to pay some premiums for those puts. We may endup setting up J.P. Morgan-Bank One not at, let’s say, a five percentannualized rate of return, but using puts, we’re going to set it up at aworst-case—1.5 percent to 2 percent—annualized rate of return.When I say worst case, I mean our puts get an exercise and we put ourshort on 2.5 points lower than where it is.But the upside is that we’re going to give J.P. Morgan room to run.The stock opened up on the morning after the deal announcement. Itclosed at $39 and change, opened at $39.70, and traded down following that open, basically closing unchanged on the day. The stock isabove that level since, but we have never witnessed a bank deal ofthat size where the acquiring bank traded up.JA: What happened on the morning after that announcement? Did everybody in your firm get in early and start crunching the numbers?JO: We actually saw the announcement the previous night, so we hadsome opportunity to crunch numbers, take a look at the pro formas,see what the analysts had to say, and attend a conference call andwatch the press. We did get a head start, but we came in at 8 AM thenext day like we normally do. Some of my analysts are here earlier.They were watching J.P. Morgan initially trade down 50 cents at$38.70 and then begin to trade up. From 8 to 9, it went from $38.70 to$40 and a quarter as we got some bullish comments. Maybe the market was acting better overall. People liked the deal. Everyone likesJamie Dimon. Who knows why, but it traded up significantly, and wehad never seen a bank financial deal move up that much.
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We actually shorted a little bit of stock in J.P. Morgan early,before the open as it moved up, without buying Bank One, becausewe thought we had a $62 billion deal here. If 10 percent of that dealis held by the arb, a significant amount of short selling will have totake place in J.P. Morgan over the next few weeks into the durationof the deal.You get the pre-opening kind of euphoria around the deal, butour history tells us this stock will most likely, at some point during theday, trade lower than its prior close. Sure enough, every share that wesold in the morning was a great sale. We were really able to set thatup—not at the spread at which it was trading at any one time—but atprobably a level two to three times that.JA: At that time, at the open, did you start buying Bank One shares as well?JO: We waited for the short sellers to come in. We waited for the arb community to come and put some pressure on J.P. Morgan. While we couldhave bought Bank One at the open and set it up at a decent spreadbased on where we had sold J.P. Morgan, we waited. I think on that day,Bank One opened at $51.20, and relative to J.P. Morgan, it had about a75- or 85-cent spread. We waited, and J.P. Morgan came down, duringthe course of the day, a dollar from its opening price. Then we began tobuy Bank One, and we set it up at a much more attractive spread. Butthat’s more of a trading opportunity that doesn’t always present itself.JA: What do you do when a deal is announced and by the time you startshorting, there are no shares left to borrow?JO: We’ll go to a prime broker and get them to commit to us the numberof shares early. And in some cases, we can lock those shares up. Evenif we don’t sell short on that particular day, we can lock up. We haveto pay a fee for it. But we can say we want to get a borrow at 100,000shares and commit to that for 30 days. So they’ll charge us eventhough we don’t actually effect the short sale. We may never affect theshort sale, and that’s the price we pay to be able to have that stockavailable to us.In some cases, we may have a problem maintaining our shortposition. But clearly if we’re working with our prime broker and theyknow what they’re doing, they’re going to borrow shares for us, andthey’re going to lock up shares for us that they consider to be a goodborrow and on not a short-term basis.
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If we have a concern that it’s a very difficult-to-borrow name,and let’s say they identify a certain amount of stock and one of theirclients is willing to lend it on the borrow, we’ll sometimes lock thoseshares up and actually enter into an agreement to maintain that shortposition, to maintain that borrow through the duration of the deal.Instead of earning a rebate, we end up paying a fee, and we’ll agreeto pay that for a period of 90 days, 120 days, or whatever. If we thinkthe deal will last 120 days, we’ll lock up the shares for 120 days.So there are ways to protect yourself, to protect your borrow andnot get caught having to go into the marketplace and buy the sharesbecause the borrow became too tight. So that’s not typically a problem for us.JA: What types of deals do you find to be safer, such as large-cap, smallcap, all cash, stock-for-stock?JO: There’s no rhyme or reason. The better we understand the companies,the higher the comfort level we have with the way we think thatdeal will play out. But across the board, some big deals are going torun into antitrust, regulatory problems, or they’re going to take longerto close. The longer it takes to close something, the more technology changes and the more the economy changes. Some utility dealthat’s announced today could close in 12 to 15 months. I don’t knowwhat’s going to happen in the utility sector between now and then, so it’stough to go out that far in any deal.So timing is a factor. The quicker the deal, the more certainty wehave that the deal will get done. Fewer things will happen along theway to interrupt it. The higher the quality of the companies, the largerthe bet we’re willing to take.So it’s all about managing your risk. If I have a stronger comfortlevel with the intrinsic value of a target, I might take a bigger position,knowing that even if the deal were to break, my downside is limited.I may have more risk in a deal break of my short position goingagainst me significantly. Another buyer may come in and make a bidfor the acquirer, or maybe the acquirer’s shares become severelydepressed during the duration of the deal. If it were to walk awayfrom the deal, maybe those shares will bounce back up to where theywere prior to the deal.We’re always examining where our risk lies. Is it on the target’sshares or on the acquirer’s shares? If it’s a cash deal, I only have one
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side to worry about. But I may have financing to worry about at thatpoint. Maybe it’s a cash deal, with a condition on financing.JA: How did you fare during the 2002 market? How did you survive that?JO: We survived by always anticipating the worst. We were nimble andsmall. We were in and out of deals in a heartbeat. If we got wind ofbad news, we were out and we could get back into it the next day.There was so much volatility in the market in general that if we werequick and nimble enough in watching our positions, we could trade inand out of positions.Arbs[arbitrageurs] aren’t always willing to stick their necks outand keep buying more and more, especially when there’s a lot ofvolatility in the marketplace. If we see a spread go out from a $1 to $2,it’s not going to be just a knee-jerk reaction to put some more into theportfolio. People want to know why it’s out at $2. Maybe it’s out justbecause of fundamental sellers of the target shares; there are notenough buyers among the arb community to absorb that selling. Italso could be that there are no more short notes, no more borrowingcapability of the acquirer’s shares, so arbs can’t put any more of it onbecause we can’t get a borrow.Spreads go all over the place for a number of reasons, especiallyin a volatile market. Is it an opportunity or a warning? That’s the toughpart: trying to figure out if a widening spread is indicative of a problem or a potential opportunity coming your way.We tried to put stuff on when it widened and take it off when itnarrowed, and we did that with enough frequency and stayed out oftrouble. A lot of the deals were structured with pricing mechanisms,so as the acquirer’s shares fell, we needed to have a greater shortposition. We needed to sell more to get their value. Or, you may havea static fixed ratio on an exchange. Maybe the acquirer’s shares arebetween, let’s say, $40 and $60, but they then fall below $40. You maybe getting a different type of consideration on the deal. You may haveto short more.So we try to anticipate that, and in 2001, 2002, and 2003, we tried tobe a little bit proactive in the way we hedged. If we anticipate the worstcase—the market looks heavy, and fundamentals aren’t really improving—the arbs are going to have to keep shorting more stock as it drops,so let’s get out in front of that selling and short early. Let’s buy someputs early so we have an opportunity to exercise those puts, establish ashort position if the shares do fall, and then leg in on the long side. We
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always wanted to be prepared for the downside in the 2001 and 2002and even in the 2003 market. That insurance—putting structure in collars around your acquirer’s shares by buying puts, selling calls, whatever—will typically cost you money.When you have as much volatility as we did in 2001 and 2002, ithelped protect us. It gave us an additional hedge, and it allowed us toset up some deals at extremely wide rates of return. In 2003, it probably cost us a couple of percent because we were so cautious.JA: Do you find that when an acquiring stock is starting to get near itsfloor—the bottom of the collar—there’s a magnet effect?JO: When the acquirer’s shares begin to trade down toward the bottom ofthe collar, people worry that if it breaks through that, the deal couldsuddenly be off and we’re also going to have to short more stock.You’re going to see arbs panicking.Northrop fell through the bottom of its collar in one day. Ittraded between $105 and $130, which was the collar for six monthsof the TRW deal. Then, before that deal was closed, in the pricingperiod now, the stock opened down 15 points one day. Now it notonly opened down 15 points, but it opened below the collar. Soyou had to be short that much more, and many arbs were preparedfor it.We kind of structured the deal. We put a collar on the shares; webought the 95 put and we sold the 125 call to pay for it. Our risk cameif it went well north of 125 because we’re going to be short the 125early. It didn’t come to that. It broke through the bottom of the collar.We had our puts on, and we were set. We didn’t lose money there. Itactually gave us a chance to buy more TRW cheap.We hate to be in a position where we’re panicking with the rest ofthe Street. To the extent we can anticipate that or maybe be a little bitprepared, we’re going to try to do that. It doesn’t always work, butthat’s what we try to do.JA: It seems like as soon as a deal is announced, the entire merger arbitrage community gets in and the spreads go down to almost nothingvery quickly. It sounds like you’re able to overcome that by tradingaround the initial position like you did with J.P. Morgan and BankOne, but is that possible in general?JO: In today’s environment, spreads are really tight, and they typicallyget very tight very quickly. So how do we add value as managers in
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this space? We’ve got to look to add value by understanding what’sactually happening in the transaction. If we want to take a directionalbet, if we want to find another way to hedge other than by shortingstock, it’s about being able to look at other ways to play the deal,waiting for the right opportunity, just being patient. But it meansyou’ve got to monitor these things every day. On that one day whensomething gets out of whack because the market sells off or a fundamental seller comes in and knocks the spread open, you’ve got tobe there. You’ve got to be ready to act, and you can’t do that ifyou’re not following the deal from day one or at least being on top ofwhat’s going on. It’s tough to do that when you don’t have a positionto begin with.We have to add value by watching these spreads and deals constantly and by just sitting there waiting to pounce. This environmentis really tough. With interest rates as low as they are, we have a lot ofmoney in the space that has a low cost of capital. So they’re able toput on deals with a very low rate of return and still make money. Thatwon’t always be the case.We’ve been through other cycles where it looks like spreads werelousy and then within a couple of years, they were back to pretty widelevels. We’re very opportunistic. We’re not just playing. If the spreadsaren’t there, then we’re going to pass.JA: Do you ever use leverage to attempt to increase your returns?JO: The Arbitrage Fund, which is a public mutual fund, doesn’t utilizeleverage. Many players out there do utilize leverage, but we don’t.JA: Is that because of restrictions on mutual funds?JO: Well, there are some restrictions in terms of our ability to leverage.But primarily, it’s because we don’t think it’s a good practice. In ahedge fund or a privately managed account, if the clients are comfortable with that and we think that leverage makes sense, then we’lltake a look at it. We just don’t do it in the public mutual fund.JA: Do you put most of your own personal money into the fund?JO: Yes. Virtually all of my net worth is tied up in this business.JA: In 1998, Warren Buffett said that essentially, through using arbitrage,he feels it’s possible to make 50 percent a year. This was roughly thequote. Do you think that statement still holds?
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JO: Well, back in ’98 and ’99, the environment was one in which thespreads available in the marketplace, following deals, were mirroringthe types of valuations that you were seeing in general in the marketplace. Market caps were inflated. Deal values were inflated. It was abuoyant, frothy market, and spreads reflected that.There were a number of reasons why spreads reflected that,but it was primarily because of the risks associated with the stocksyou were buying back then. If you were involved in a deal betweenTellabs and Ciena or JDS and Uniphase, these were multibilliondollar deals with stock prices in the hundreds of dollars. And weknow what happened in 2000 and 2001 when these stock prices camein to something representing fair value. They plummeted by 90 percent, 80 percent, or more.So, there were opportunities in ’98 and ’99, at the peak of the market in terms of valuation, to capture some enormous spreads. Thosespreads were really, really out of whack. The market capital of thosedeals was far greater than the dollars pursuing merger arbitrage strategies at the time. Through the use of leverage, you could probably get a30 percent, 40 percent, maybe even a 50 percent rate of return. But therisk you had to assume back in those days was enormous.JA: Since starting your firm, what would you say is the worst trade youhave entered into?JO: It’s been in those deals that have fallen apart due to fundamentalproblems on the part of the target company.JA: What’s a specific one?JO: Well, we could talk about Cardinal Health making an acquisition ofSyncor International. The deal was announced in June 2002, and Ithink the deal was scheduled to close in the mid-November timeframe. In the first week of November 2002, the companies announcedthat the auditors, as part of their due diligence, had uncovered thatbribes were paid out of the foreign subsidiaries of Syncor. So the dealwas on hold.That’s the kind of deal where you’re caught completely off-balanceby some type of fraudulent activity on the part of the insiders of thetarget company. That leads to the transaction being put on hold pending an investigation, due diligence, legal settlements, what have you.In this case, while it was a short-term pickup for us in terms of impact
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on the portfolio, that deal eventually did close, and we were able toposition ourselves to make money on this deal and to also increaseour position.JA: So you didn’t unwind your position when you heard that news?JO: No, because by the time we heard the news, the stocks weren’teven trading. The stocks will then open up reflecting a worst-casescenario.At that point, we go back to fundamental analysis. What is thiscompany worth on a worst-case basis? If we’re looking at a problemin the foreign subsidiaries and the wrongdoing has been limited tothose foreign subsidiaries, then what’s the value of the rest of thecompany, assuming we take a value of zero for those foreign subsidiaries and assuming that there’s some kind of penalty or fine that’swill result out of that wrongdoing? And we try to put a valuation onthis company.Ultimately we felt the two companies were committed to doingthe deal, regardless of the wrongdoing that took place. The wrongdoing and the dollars involved were small relative to the overall sizeof the deal. So our job at that point was to determine if Cardinal wasgoing to go forward with this deal and whether it would change theterms. How would it possibly change those terms, and when wouldthis deal close?Now we’re going to have a new merger agreement and a newshareholder vote. There may be other issues that come into play. Soyou have a number of variables that you try to define, such as theextent of the wrongdoing, the fines involved, the extent of the investigation in terms of timing, and how the Justice Department, Securitiesand Exchange Commission and Cardinal Health will view the merger.You’re looking at an opportunity for Cardinal to lower the price, substantially perhaps.So we take all that in[to] consideration, all with an eye towardvaluation. Ultimately we have to understand what we’re owning. Andwe felt pretty comfortable, based on what the companies told us—through their press release, on the phone, by talking to CardinalHealth, by speaking to lawyers—that the incidents involving foreignbribes had been confined to the Asian subsidiaries. That being thecase, it made our job a lot easier.The more typical deals that fall apart are those in which the targetcompany fails to meet its earnings or revenue estimates. That’s going
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to happen now and again in many deals. But sometimes a companysubstantially underperforms, and a lot of times it’s due to the fact thatthere’s a deal on the table. There’s a lot of disruption involved when acompany is being bought out. Some customers will sit back and waitto see what happens. After the deal closes, employees may quit. Certain facets of the business may begin to suffer because of the disruptions associated with a corporate transaction.Most companies and most partners to a deal will account for thatahead of time. They anticipate there may be some slowdown on thepart of customers. There may be some interruption in terms of overall business because of a deal. But during the recessionary environment of 2001 and 2002, there were quite a few companies whosebusinesses just fell off a cliff because of the industries they operatedin—telecom, technology, software, hardware. Some of those dealsran into big trouble.JA: When will you actually not do a deal? Let’s say a deal is announced.When would you look at it and say, “Ah, we’re not going to getinvolved in that. That’s too hairy.”JO: When we don’t have any confidence in the buyer, number one. Also,when we don’t have confidence that the financing—if there’s financinginvolved—will be successfully obtained. When we view the target’sbusiness as being severely impaired and having a strong likelihood ofnot being able to go it as a stand-alone company. So for the most part,we’re going to avoid certain distressed situations where we think ourrisk far outweighs the spread we could capture through setting thedeal up.JA: What’s an example that you didn’t play right from the get-go?JO: Well, there are a lot of small, tiny deals that we don’t play. We look atthem, but they’re too illiquid; there’s not enough of a spread there.And they’re too numerous for me to name.But some of the higher-profile deals may have a lot of potentialrisk for regulatory problems, such as Nestle’s and Dreyer’s. We didn’tplay that deal for nine months. We played in the last inning, after someturbulence came into the deal, once it began to become problematicdue to antitrust issues.There are going to be deals and opportunities that we miss. Butwe’ve got to have a comfort level that what we’re looking at makessense from a risk-reward standpoint.
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JA: Do you ever give preference to all-cash deals or all-stock deals? Or isthere any type of deal that statistically you’ve found works out morethan other types?JO: Not really. We tend to play wherever the deals are. The ratio of cashto stock deals is going to change. And there are many deals in whichwe’re involved that have a component of cash and stock in the consideration. But no, there’s no preference on our part.JA: Do you ever play relative value deals, like for instance, the Palm/3Comarbitrage that occurred when Palm was spun off?JO: We’ll look at spin-offs. I guess our presence in those types of transactions is going to be dictated by the valuation work we do. Deals forthose types of transactions are a little tougher because you don’treally have a defined return laid out for you. But we’ll look at any typeof corporate transaction if there’s an opportunity.JA: Can the average investor do this? You have a full staff and have beendoing this for many years. Can a retail investor make money playingthe merger arbitrage game?JO: Yes, but on a very limited basis, I think. Certain deals will be conducive for individuals to get involved with. It may be a cash deal; itmay be a straightforward stock-for-stock deal where they want tocontinue to own the shares that they acquire. Those individuals needthe capability within their brokerage accounts to sell short, but theyare unlikely able to capture a rebate on those short proceeds.Can they analyze the deals and be kept abreast of the regulatoryissues that come during the duration of the deal? You know, it’s toughto do that on more than a limited basis if you’re an individual watching positions in your account. You can pick and choose and then bevery selective about how you play.A firm like ours has a much broader mandate in terms of the dealswe play and our presence across a wide variety of deals, with a widedifferentiation in terms of the types of deals, the risks associated withthe deals, and the duration of those deals.It’s just like any other type of portfolio. Some people feel they canmanage their own. But they may not be as well diversified as a mutualfund that focuses on the same sector. And we stay pretty well hedgedin the portfolio, and that may not be the case for individual investors,
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who may decide that they like the combined entity and they’re justgoing to stay long and not hedge. In that case, they’re not really doingmerger arbitrage; they’re not really capturing a defined rate of return.They’re just basically owning an acquirer’s shares at a slight discountfor when the deal will get done.I think there are people who are probably qualified to do it individually, but they are few and far between. They probably come outof this business and are basically managing their own portfoliosgoing forward.But it’s hard because there are so many moving pieces. If wehave 50 or 60 deals on in the portfolio, we’re watching another 50or 60. Within those deals, there are all different terms: the tenures,the durations, the players, the issues, the risks. So there are a lot ofthings to watch.
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nother type of arbitrage that both Buffett and his mentor BenGraham specialized in was “relative value” arbitrage. This became abread-and-butter part of Buffett’s “workout” strategy. The idea ofthe relative value arbitrage is to buy an asset when it is convertible intoother assets that have more value than it does.The most prominent example of the past few years is the case of PalmComputing and 3Com. Palm was a division of 3Com when 3Com decided tospin off Palm’s shares to the public. On the first day of trading, Palm sharesshot up so much that the stake that 3Com held in Palm was actually worthmore than the market cap of 3Com. The market was effectively valuing3Com’s ongoing business at less than zero—business that had been aroundfor thirty years and was immensely profitable. We will discuss this examplein more detail later.Another example is from Benjamin Graham’s first steps in this arena.In 1915, when Graham was working for Newburger, Loeb, & Company, hestumbled upon the following relative value arbitrage: Guggenheim Exploration Company. The Guggenheim family, now known for its art museum inManhattan, made most of its fortune by buying and developing mining properties. The Guggenheim Exploration Company was a holding company formany of the family’s mining properties. On September 1, 1915, the company
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Guggenheim Exploration Company Value on September 1, 1915
1 share of Guggenheim Exploration Company would equal:
.7277 share Kennecott Copper @ $52.50 =.1172 share Chino Copper @ $46.00 =.0833 share American Smelting @ $81.75 =.1850 share Ray Consolidated Copper @ $22.88 =Other assets =Total:
$38.20$5.39$6.81$4.23$21.60$76.23
decided to dissolve and distribute the shares it held in other companies to itsshareholders. On that day it was trading for $68.88. Graham added up thevalue of its holdings and came up with the table shown in Exhibit 6.1.So Graham figured that buying one share of Guggenheim would nethim an arbitraged profit of $7.35. He bought up Guggenheim and sold shortshares in the corresponding companies, locking in his profit.Another example occurred in the 1920s when DuPont, capitalizing onthe cash it earned in its wartime successes, bought a large block of sharesin General Motors. The market at that time, though, discounted DuPont’sother businesses in the same way the market later discounted 3Com’s business and valued DuPont shares only at the value of its GM shares, valuingDuPont’s other businesses at zero. Graham was able to buy Dupont andshort GM to capitalize on this spread.One can say “But all of this was 80 years ago—how can such an obvious example of information arbitrage (the idea that information is notreceived equally by all market participants) exist now, with the existence ofthe Internet, analysts, computers to analyze these situations, etc.?” And yet,we see from the first example—PALM and 3Com—that the situation waseven more extreme.Buffett first dabbled in relative value arbitrage when he was workingfor Graham at the firm Graham-Newman. An amusing story about this isthat Graham at first refused to hire Buffett because Buffett wasn’t Jewish.Graham felt that Jews couldn’t get jobs at the mostly Waspish Wall Street,so he sought to counterbalance this by only hiring Jews. Buffett, not to bedissuaded, kept sending Graham ideas for stocks until Graham finally hiredhim. Graham called his results in arbitrage “Jewish Treasury Bills.”
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When Buffett first came to Graham-Newman, he was 24 years