an arbitrageurmust include that increase when taking into account the size of the risk.
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TRADE LIKE WARREN BUFFETT
In each type of merger, there are different methods of assessing thevalue of the deal for an arbitrageur and the value of the spread. Some typesof mergers are:
Cash DealCompany X offers cash to buy the shares of Company Y. In this situationan arbitrage exists, as in the previous example, when X trades below theprice being offered. The arbitrageur buys shares in X and holds untilthe price converges. The value of the deal to an arbitrageur is measuredroughly by this formula:V = P ( (D − T) / T )where V = the expected value of the deal if the deal works outP = the probability the deal will be completedD = the price the target stock will be if the deal works out (thedeal price)T = the price of the target stock when the arbitrageur acquires itExampleIf XYZ is being acquired for $11/share in cash, it is a small, friendlytakeover, you feel it has 100 chance of completion, and it trades at $10, thenV = 1 × (11 − 10) / 10 = 10%.This doesn’t present the full picture, but it’s a start. Next, the arbitrageur must consider the likelihood that the deal takes place within a certain number of days (let’s call it x) and then the annualized value (AV) ofthe deal can be calculated as:AV = V × (365 / x)To continue our example, if the deal is estimated to take a year, then theannualized value of the deal to an arbitrageur considering it would be10 × (365 / 365) = 10%If this annualized return is better than the returns the arbitrageur can makeon any other deal, then he or she would begin considering it.
Merger Arbitrage Like Warren Buffett
85
All-Stock DealCompany X offers to buy Company Y for Z number of shares. For instance,on April 2, 2003, First Data Corporation announced it was going to buyConcord EFS by paying 0.40 shares of each First Data stock for each shareof Concord EFS stock. First Data was trading at 34.68 at the time of themerger and Concord EFS had close to 500 million shares, valuing the dealat approximately $7 billion. Even though the deal placed the value of Concord EFS shares at 13.87, CE shares immediately traded from a range of9–10 to a range of 11–12 over the next several weeks. Why was there sucha big discount?The regulatory risk played a large part. The combination of ConcordEFS and First Data would create the world’s largest debt-transactionprocessor and the Justice Department was going to definitely have regulatory issues. This could potentially cause the deal not to happen but at thevery least it would slow the deal down, increasing the risk that there werebetter deals out there for arbitrageurs to enter. In January 2004, First Datareached a settlement with the Justice Department to avoid antitrust issuesand on February 26, 2004, the deal closed.In an all-stock deal, the problem of just going long the target stock(in other words, buying the stock of the company being acquired) is thatthe acquirer’s shares might go down, in which case the deal price alsogoes down (because the target’s stock is pegged in a fixed ratio to theacquirer’s stock).
Various Other Types of Deals, Including:• Mixture of cash and stock.• Mixture of cash, stock, and debt.• Stock deals where there is a collar, meaning the ratio changes upwardsif the stock of the acquirer falls below a certain price.• In a hostile takeover, the formula for calculating value would be similar to the example, but the risks of a deal falling through would bemuch greater, as well as the risk that another acquirer would step in.The formulas about determining the value of a deal are only a startingpoint. And even with those formulas there is a big, gaping hole: how toassess the probability that a deal will close and, if so, how to estimate the
86
TRADE LIKE WARREN BUFFETT
time needed for it to close. With most clear-cut, systematic strategies, a fairamount of discretion and reevaluation must take place. On top of this reevaluation and decision making is also deciding how much capital to put towork. Ideally, you would have more than 100 of capital at work, using leverage, in many uncorrelated merger arbitrage opportunities—uncorrelated sothat the success of one is not dependent at all on the success of the others.How does an arbitrage opportunity become uncorrelated with otheropportunities?••••
Different industries.Different sizes.Different countries.Different type of deal (for example, some deals in a merger arbitrageportfolio might be all-cash, others might be a combination of cash andstock, all-stock, stock and debt, and so on).
When taking into account whether you should use leverage, it is alsoimportant to take into account the interest rate you are paying on that leverage.The lower the interest rate, the longer the possible time frame to deal completion is allowed, depending on the initial spread after a deal is announced.Part of the decision-making process is the hedging method. In the basicstock-for-stock deal, you short the acquirer and buys the target. However,what if the acquirer’s shares are difficult to short? In order to short, youneed to find shares of the acquirer to borrow (the brokerage firm you tradethrough will tell you if shares are “borrowable” for shorting) in order to sellthem in the shorting process. Because there is a lot of money invested inmerger arbitrage funds, it quickly becomes impossible to find shares to borrow. All of the arbitrage funds have borrowed them already. Here are twopossible solutions:1. Don’t short as much as you should, thereby adding to the risk of the
deal but placing a bullish bias on the result.2. Most of the price movement in a stock is strongly correlated to the
prices of the market in general and even more so with prices of stocksin its sector. You can short a basket of stocks in the sector or indexexchange traded funds (ETFs) and futures. This leaves you with stockspecific risk, meaning that the company could suddenly fall apart with-
Merger Arbitrage Like Warren Buffett
87
out affecting any of the other companies in its sector. The beauty ofdoing this is that the “upside risk” of the hedge is now negligible. Inother words, if the deal falls through, the acquiring stock will shootupwards as the hedgers in the deal depart from their short positions,but the shares of other stocks in the sector will not go up as much.Merger arbitrage funds often have access to sophisticated resourcesranging from analyst reports to computers to constant evaluations of thespreads, probabilities, and so on. However, the average trader can certainlytake advantage of the Internet resources out there to compete on an almostequal, if not more advantageous, playing field (due to the lower amount ofmoney that he or she needs to put to work to have a successful annualreturn). My favorite Internet source for merger arbitrage data is atthedeal.com. Exhibit 5.1 shows a snapshot of the type of information thatthedeal.com provides to the aspiring arbitrageur.Thedeal.com does all of the basic calculating for you, in terms of figuring out the spread, the annualized return, and even the estimated datethat the deal is expected to close (all of this information is not shown inExhibit 5.1, but it is available on the Web site). The big question now is,What deals should you do? We saw in the first case mentioned above thatWarren Buffett likes to give himself more than one way out. In the Berkshire Hathaway example, when Berkshire came in with a tender offer Buffett was unhappy with, he was also content to simply buy up the sharesand ride it out a little longer.In his 1988 letter to Berkshire Hathaway shareholders, Buffett attributes much of the success of the 1987 portfolio to arbitrage—and this ina market that had suffered through the 1987 crash. In the letter, hedescribes how he evaluates the risk in an arbitrage situation, and thengoes through the specifics of the Arcata 1981 deal in which buyout firmKKR was involved.To evaluate arbitrage situations you must answer four questions:(1) How likely is it that the promised event will indeed occur? (2)How long will your money be tied up? (3) What chance is there thatsomething still better will transpire—a competing takeover bid, forexample? and (4) What will happen if the event does not take placebecause of anti-trust action, financing glitches, etc.?
88
Seacoast FinancialServices Corp.AdvancePCSCaremark Rx Inc.Allegiant Bancorp Inc.National City Corp.Amersham plcGeneral Electric Co.Applied MolecularEli Lilly and Co.Evolution Inc.Ashanti Goldfields Co. Ltd.AngloGold Ltd.Bank of Bermuda Ltd.HSBC Holdings plcBarnes & Noble.comBarnes & Noble Inc.BioReliance Corp.Invitrogen Corp.Business Bank of CaliforniaUnionBanCal Corp.CB Bancshares Inc.Central Pacific FinancialCCBT Financial Corp.Banknorth Group Inc.Cima Labs Inc.Cephalon Inc.Cinar Corp.TD CapitalCoastal Bancorp Inc.Hibernia Corp.Cole National Corp.Luxottica Group SpAConcerto Software Inc.Melita International Ltd.Concord EFS Inc.First Data Corp.Connecticut Bancshares Inc. New Haven Savings BankDenison International Corp.Parker hannifin Corp.Dial Corp.Henkel KGaADreyer’s Grand Ice Cream Inc. Nestle SA
Acquirer
−0.32
−0.131.08−0.242.140.180.900.000.020.000.435.550.620.95−0.010.64−0.53−0.060.160.390.040.265.73
−0.131.08−0.352.140.180.900.000.020.000.435.190.430.95−0.010.28−0.53−0.060.160.390.040.265.251.016.800.000.830.001.438.741.833.80−0.281.55−2.63−0.501.070.760.170.917.37
2.14−0.872.98
%
Spread w/dividends
$
Arbitrage Situations as of Market Close on January 9, 2004
Abington Bancorp Inc.
Target
EXHIBIT 5.1
0.130.010.050.130.10−0.010.000.00−0.02N/A0.000.030.01−0.02−0.13−0.03−0.010.06
0.05−0.40.45
0.04
Change fromprevious day
5.6037.600.006.000.0022.7018.404.709.70−2.605.10N/A−30.305.907.504.704.103.66
9.50−3.9013.30
−1.10
Annualizedreturn %
3/153/152/252/282/52/16/305/315/312/174/30N/A1/153/152/151/223/311/13/06
3/313/313/31
4/30
Exp. close
89
Duane Reade Inc.Oak Hill Capital Partners LPEsperion Therapeutics Inc.Pfizer Inc.First Essex Bancorp Inc.Sovereign Bancorp Inc.FirstFed America Bancorp Inc. Webster Financial Corp.FleetBoston Financial Corp.Bank of America Corp.Franklin Financial Corp.Fifth Third BancorpFTD Inc.Leonard Green & PartnersGA Financial Inc.First Commonwealth FinancGarden Fresh Restaurant Corp.Centre Partners ManagementGlobespanVirata Inc.Conexant Systems Inc.Gucci Group NVPinault-Printemps-RedouteGundle/SLT EnvironmentalCode Hennessy & SimmonsInc.Holly Corp.Frontier Oil Corp.Igen International Inc.Roche Holding Ltd.John Hancock FinancialManulife Financial Corp.ServicesManufacturers’ Services Ltd. Celestica Inc.Mid Atlantic Medical Services I UnitedHealth Group Inc.MONY Group Inc.Axa Financial Inc.Moore Wallace Inc.RR Donnelley and Sons Co.New Focus Inc.Bookham Technology plcNewhall Land and Farming Co. LNR Property Corp.OneSource InformationValueAct Capital Partners LPServicesPatriot Bank Corp.Susquehanna Bancshares Inc.PeopleSoft Inc.Oracle Corp.PetroCorp Inc.Unit Corp.Pinnacor Inc.MarketWatch.com Inc.1.370.29−22.321.492.260.60−1.121.241.870.351.170.84−13.982.870.51
0.250.08−13.580.590.150.39−0.350.240.100.140.110.24−3.170.390.01
0.250.08−13.580.590.150.39−0.350.240.100.140.110.24−3.170.390.01
1.131.27−0.650.052.521.570.810.951.871.05−0.09
0.190.44−0.390.011.070.480.200.330.300.07−0.08
0.190.44−0.310.011.070.480.200.330.300.07−0.08
6.7037.403.30−8.1010.10−76.002.508.602.20N/A47.508.50
−0.060.29−0.50−0.02−0.01
6.10N/A−370.40
−0.040.28−0.350.010.05−0.040.090.05−0.02−0.04
2.884.15−8.500.308.204.008.002.4013.904.70−0.30
−0.09−0.020.24−0.030.09−0.200.000.28−0.01−0.010.11
2/285/31N/A1/311/31
3/311/313/152/282/2312/312/28
3/31N/A1/31
5/314/302/63/154/305/312/155/312/273/314/30
90
(continued)Acquirer
Annualizedreturn %
−29.305.401.904.7036.1019.20N/A4.706.102.403.9014.705/31−70.702.105.106.70
Change fromprevious day
−0.170.27−0.18−0.310.18−0.12−0.02−0.05−0.350.00−0.080.0915.10−0.68−0.39−0.03−0.08
%
−11.490.330.741.051.191.160.131.431.860.430.875.740.09−0.770.832.432.06
Spread w/dividends
−1.850.100.230.320.220.320.020.610.410.070.190.985.93−0.270.340.601.96
$
−1.850.100.230.320.220.320.020.610.410.070.190.981.01−0.270.640.601.96
1/135/316/304/30
5/311/315/313/311/211/311/94/304/303/153/315/31
Exp. close
Source: The Deal website, http://www.thedeal.com, January 8, 2004.
Spreads, including deals with collars that are not yet in the pricing period, are calculated using stock figures available at marketclose. The final terms for deals with collars may be different. When estimations for pricing periods are not available, the spreadis determined by the acquirer’s share price at the market close. The close date is estimated. Spreads do not include dividendpayments that have not been announced.
N/A = not available
Plains Resources Inc.Vulcan CapitalProgress Financial Corp.FleetBoston Financial Corp.Republic Bancshares Inc.BB&T Corp.Resource Bankshares Corp.Fulton Financial Corp.Right Management = Consultants Manpower Inc.Sicor Inc.Teva Pharmaceutical IndustSoundView Technology GroupCharles Schwab Corp.Southern Financial Bancorp = Inc. Provident Bankshares Corp.Staten Island Bancorp Inc.Independence Community BSystems & Computer Technology SunGard Data Systems Inc.Titan Corp.Lockheed Martin Corp.Travelers Property Casualty Corp. St. Paul Cos.Travelers Property Casualty Corp St. Paul Cos.1.01Troy Financial Corp.First Niagara FinancialTrust Co. of New JerseyNorth Fork BancorpUniSource Energy Corp.KKR, J.P. Morgan, WachoWellPoint Health Networks Inc.Anthem Inc.
Target
EXHIBIT 5.1
Merger Arbitrage Like Warren Buffett
91
Arcata Corp., one of our more serendipitous arbitrage experiences, illustrates the twists and turns of the business. On September 28, 1981, the directors of Arcata agreed in principle to sell thecompany to Kohlberg, Kravis, Roberts & Co. (KKR), then and nowa major leveraged-buy out firm. Arcata was in the printing andforest products businesses and had one other thing going for it:In 1978 the U.S. government had taken title to 10,700 acres ofArcata timber, primarily old-growth redwood, to expand RedwoodNational Park. The government had paid $97.9 million, in severalinstallments, for this acreage, a sum Arcata was contesting asgrossly inadequate. The parties also disputed the interest rate thatshould apply to the period between the taking of the property andfinal payment for it. The enabling legislation stipulated six percent simple interest; Arcata argued for a much higher and compounded rate.Buying a company with a highly speculative, large-sized claimin litigation creates a negotiating problem, whether the claim is onbehalf of or against the company. To solve this problem, KKR offered$37.00 per Arcata share plus two-thirds of any additional amountspaid by the government for the redwood lands.Appraising this arbitrage opportunity, we had to ask ourselveswhether KKR would consummate the transaction since, among otherthings, its offer was contingent upon its obtaining “satisfactoryfinancing.” A clause of this kind is always dangerous for the seller: Itoffers an easy exit for a suitor whose ardor fades between proposaland marriage. However, we were not particularly worried about thispossibility because KKR’s past record for closing had been good.We also had to ask ourselves what would happen if the KKR dealdid fall through, and here we also felt reasonably comfortable:Arcata’s management and directors had been shopping the companyfor some time and were clearly determined to sell. If KKR went away,Arcata would likely find another buyer, though of course, the pricemight be lower.Finally, we had to ask ourselves what the redwood claim might beworth. Your Chairman, who can’t tell an elm from an oak, had notrouble with that one: He coolly evaluated the claim at somewherebetween zero and a whole lot.
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TRADE LIKE WARREN BUFFETT
We started buying Arcata stock, then around $33.50, on September 30 and in eight weeks purchased about 400,000 shares, or fivepercent of the company. The initial announcement said that the$37.00 would be paid in January 1982. Therefore, if everything hadgone perfectly, we would have achieved an annual rate of return ofabout 40 percent—not counting the redwood claim, which would havebeen frosting.All did not go perfectly. In December it was announced that theclosing would be delayed a bit. Nevertheless, a definitive agreementwas signed on January 4. Encouraged, we raised our stake, buyingat around $38.00 per share and increasing our holdings to 655,000shares, or over seven percent of the company. Our willingness to payup—even though the closing had been postponed—reflected our leaning toward “a whole lot” rather than “zero” for the redwoods.Then, on February 25 the lenders said they were taking a “secondlook” at financing terms “in view of the severely depressed housingindustry and its impact on Arcata’s outlook.” The stockholders’ meeting was postponed again, to April. An Arcata spokesman said he “didnot think the fate of the acquisition itself was imperiled.” When arbitrageurs hear such reassurances, their minds flash to the old saying:“He lied like a finance minister on the eve of devaluation.”On March 12 KKR said its earlier deal wouldn’t work, first cutting its offer to $33.50, then two days later raising it to $35.00. OnMarch 15, however, the directors turned this bid down and acceptedanother group’s offer of $37.50 plus one-half of any redwood recovery.The shareholders OKed the deal, and the $37.50 was paid on June 4.We received $24.6 million versus our cost of $22.9 million; ouraverage holding period was close to six months. Considering the trouble this transaction encountered, our 15 percent annual rate of returnexcluding any value for the redwood claim was more than satisfactory.But the best was yet to come. The trial judge appointed two commissions, one to look at the timber’s value, the other to consider theinterest rate questions. In January 1987, the first commission saidthe redwoods were worth $275.7 million and the second commissionrecommended a compounded, blended rate of return working out toabout 14 percent.In August 1987 the judge upheld these conclusions, which meanta net amount of about $600 million would be due Arcata. The gov-
Merger Arbitrage Like Warren Buffett
93
ernment then appealed. In 1988, though, before this appeal washeard, the claim was settled for $519 million. Consequently, wereceived an additional $29.48 per share, or about $19.3 million. Wewill get another $800,000 or so in 1989.”Another example of arbitrage, similar to the example at the beginningof this chapter, occurred in July 1992 when General Dynamics made a tender offer for 20 percent of its stock. The price would be determined byDutch auction at prices ranging from $65.37 to $72.25 per share. Buffettbegan buying shares in anticipation of tendering them. But once he startedbuying them, he decided that he liked the fundamentals of the company andchose to hold onto the shares instead, quadrupling his investment. Againthis is an example where he could have taken the safe money of the arbitrage, but he had the extra “out” for himself by knowing after studying thefundamentals that he could hold onto the shares and ride the investment.In his 1963 letter to investors in his partnership, Buffett presented thedetails of a very straightforward merger arbitrage situation in TexasNational Petroleum (TNP). Buffett mentions that he had heard rumors thatTNP was going to be acquired by Union Oil of California, but he did not acton those rumors and in fact reported, “I never act on such information.”And there is no need to, when profits can be straightforward once the dealis announced.A deal was announced and Buffett determined what he would do witheach category of security that TNP had:• TNP had debentures yielding 6.5 percent that would be called once thedeal was done.• Common stock for which Union Oil was going to pay $7.42 per share.• Warrants.Buffett was able to acquire each class of security in the six monthsleading up to the merger at a reasonable spread between his buy price andthe acquiring price. In particular, on the debentures, he was also able to geta nice 6.5 percent interest rate while he was waiting.Additionally, Buffett noted that:• “Risk of stockholder approval was nil” since the deal was negotiated bythe controlling shareholders.• There were no anti-trust problems or legal problems.
94
TRADE LIKE WARREN BUFFETT
Buffett therefore had a high degree of comfort that the deal would bedone. The only issue on the timing was that TNP needed a tax ruling by theIRS. The ruling took slightly longer than expected by about two months,and Buffett’s return on the entire investment when it concluded was anannualized return of approximately 21 percent. The longer time span allowedBuffett to get more payments on the bonds.His comment on this, which applies to most arbitrage situations, is that“(1) the deals take longer than originally projected and (2) the payouts tendto average a little better than estimates.” He also notes that “I definitely feelsome borrowed money is warranted against a portfolio of workouts, butfeel it is a very dangerous practice against generals.”
THE BIG QUESTION IS: DOES MERGERARBITRAGE WORK IN GENERAL?There are three directions in which we can look to determine an answer tothis question. The first is academia, where studies have been done on everymerger announcement over the past twenty years to determine what theresults would have been had one blindly played each situation possible.The second is the results of hedge funds and mutual funds devoted onlyto merger arbitrage. The third is statements by Warren Buffett, who hasengaged in merger arbitrage for almost fifty years. Each of these directionshas problems in determining a complete answer, but perhaps the aggregation of the answers will give us insight.On the academic side, perhaps the most comprehensive study hasbeen done by Mark Mitchell and Todd Pulvino.1 I categorize them as “academic,” but both of these professors have been active in actually trading mergerarbitrage deals, having become partners in AQR Capital’s Merger Arbitragefund. In their paper, “Characteristics of Risk and Return in Risk Arbitrage,”they analyze every merger from 1963 to 1998 and blindly play the spread thatexisted on the day after the announcement in every case. Altogether theystudied the results of 4,750 mergers. The results are roughly summarized inExhibit 5.2.1
“Characteristics of Risk and Return in Risk Arbitrage,” Mark Mitchell and ToddPulvino, Journal of Finance, vol LVI, No. 6, Dec. 2001.
95
Merger Arbitrage Like Warren Buffett
EXHIBIT 5.2
Risk Arbitrage Returns
Year
Value-weightedRisk Arbitrage(VWRA)Return
Risk ArbitrageIndex Manager(RAIM)Return
CRSP ValueweightedAverageReturn
Risk-freeRate ofReturn
$ Value ofAnnouncedDeals/TotalMarket Value
196319641965196619671968196919701971197219731974197519761977197819791980198119821983198419851986198719881989199019911992199319941995199619971998
14.51%10.27%9.09%11.46%14.45%−8.65%22.10%14.18%19.93%16.65%20.38%12.95%12.83%19.93%28.56%20.40%17.15%29.30%38.44%38.41%17.35%21.45%15.65%13.32%13.81%27.23%6.83%6.69%18.19%9.12%14.16%17.07%12.57%11.32%9.48%12.64%
6.64%4.44%3.30%−4.03%9.06%−2.88%3.18%5.70%5.79%3.52%−7.45%12.93%12.29%19.20%8.27%18.03%13.85%38.54%35.15%31.99%12.67%8.13%15.00%20.61%3.81%27.63%5.36%4.38%12.13%4.48%12.31%