Risk Arbitrage

This page will serve as a living document for things I learn related to Risk Arbitrage. Meaning mergers and acquisitions, buyouts in cash or stock (including tender offers).

Book Resources:

  • Warren Buffett and the Art of Stock Arbitrage by Mary Buffett and David Clark

It provides case studies, gives some simple criteria, emphasizes leverage, highlights the good historical returns and notes additional “special situations” to monitor. A pretty basic read, but there was still interesting stuff for me.

  • You Can Be a Stock Market Genius by Joel Greenblatt

Pretty good – recommends that the typical retail investor not practice merger arbitrage though. Does recommend that one look into spinoffs.

  • Barbarians at the Gate by Bryan Burrough and John Helyar

Interesting from a merger arb perspective because it reminds the arbitrageur that mergers decisions are driven, at the highest level by people, and as such may be governed by their emotions and desires.

Webpage Resources:

Warren Buffet’s Shareholder Letters (specifically 1988)

Puthenpurackal and Martin analysis of Buffett’s portfolio from ’76-’03

A risk arbitrage primer from John Paulson

Merger arbitrage tables

Yahoo M+A newsfeed

History:

In Dec 2010, I started studying merger arb tables from Bloomberg which, like SinLetter, listed deal types (stock/cash/combo), acquisition value, merger spread, and annualized profit from the spread. Clearly, the focus is on the annualized profit, but there are some finer points of interest.

My Thesis:

I observe that large annualized profit (>30%) spreads are commonly seen in mergers involving one or a combination of

  • small acquisition value
  • small absolute spread/small timeframe.

Why It Works:

I contend that these spreads are not indicative of increased deal risk, and will provide me with excess return due to difficulty of exploitation.

  1. To the institutional investor, these deals are too small. Say, the company is <$100mm market cap, you want to stay under 5% ownership, that means you can put in <$5 mm. That’s not worth their time. Putting in >5% would have substantial market impact on already small spreads.
  2. To the retail investor, risk arb is obscure and the cost of information to find deals is high. I don’t know of any free merger arb tables available besides the one provided.
  3. Also, the retail investor is wary of transaction cost in commissions (whereas the i.i. sees market impact). Let’s say we put in $5000 into a 2% spread over 1 month (~27% ann) stock deal. Your profit might be $100, but you might pay $20 in commissions, making the deal ~21% ann.

Tips on Trading Risk Arb as a Retail Investor:

  • As a retail investor, minimizing commission is huge. I use Scottrade. If you whore out the ReferAll code at sites like retailmenot.com, you “refer” new customers and both of you get 3 free trades (expiring in 6 months).
  1. Interactive Brokers at $.005/share on the Flat Rate (min $1, max .5% per transaction) and $.0035/share on the Cost Plus Plan (with reg/exch fees/rebates) seems dirt cheap and pretty good. I may test them after I run out of my 50 or so free trades.
  • Know your broker’s margin requirements and commissions cold. For example, at Scottrade, the long/short account is separate, meaning that even if I have buying power, if I’ve spent all the cash in my account, I will be charged for a loan. This also means that, to the extent that you’re not doing other shorts, a short isn’t costing you anything extra, just eating into the margin generated by your longs and cash. Since there’s always a ton of this margin for me, the notional I’m calculating return against for stock deals is the same as for cash deals.
  1. It took me awhile to figure things out properly, so don’t worry if that didn’t make sense the first time around. As another example, I found out the hard way that Scottrade tacks on .5% commission for penny stocks and $25 for tendering shares in a tender offer.
  • Use a tax-free 401(k)/IRA type account for risk arb trades. Risk arb profits are nearly always short-term (<12m) and thus taxed at your marginal income tax rate if not in an IRA.
  • Don’t leave limit orders on overnight; day trade into positions. First, spreads could blow up if the deal is cancelled ahead of the open. Second, for stock deals, the acquired company’s share price will closely track the acquirer. If you’ve got a buy order on the acquired and the acquirer opens down, you’re screwed.
  • Likewise, for stock deals, close both sides out ASAP. You might get greedy after grabbing one side of the trade and think, “what if I just wait and see if the spread widens?” Don’t do it. You’re making a directional call which has nothing to do with your edge. And typically you’ve got very little spread to bet with.

Extensions to Short Time/Small Spread Strategies

  • Medium spread/medium time deals can be more worthwhile than a short/small with the same annualized return, because payoffs tend to take some time to actually enter your brokerage account. To quote a previous post

CASB, and SHMR represent a different opportunity. For some time, they were putting out 8% spread for a 2Q (June 30) close, i.e. over three months. On a straightforward calculation, this is a lower annualized return than in other deals.

However, consider this: a 2% spread over 2 weeks opportunity represents 1.02^26 = 67% annualized, while 8% spread over 10 weeks reps 1.08^5.2 = 49% ann. But let’s say that it always takes another week past closing for money to get to your account. In this case, the 2%: 1.02^17.3 = 41% and the 8%: 1.08^4.72 = 43%. So the tables have turned, Dr. Evil…. “Absolute spread” is a number worth looking at on top of “annualized spread.”

  • If you trade naked options, selling naked puts on a company being acquired with cash is an alternative source of leverage (vs. margin loans). For stock deals you could try selling puts on the acquiree while selling calls of same expiration adjusted for delta and share-exchange numbers. I have not tested any of these methods.

General Guidelines on Picking Deals: Buffett

  1. Only considers deal after it’s been made public. Don’t try to anticipate.
  2. Concentrates on fewer transactions. “Put all your eggs in one basket and watch that basket.” Leverage limited to 25% of net worth.
  3. Calculate an annualized expected return (prob loss * % loss + prob win * % win).

Friendly Deal Specifics

  1. Prefer strategic buyers over financial buyers (LBO/private equity) since typically provide self-financed cash. Bigger the buyer the better.
  2. How financed/purchased?  If cash, cash is own or loaned? If stock, worse than self-cash because stock price fluctuate. Calm credit markets good for financed deals.
  3. Management shopping out good, can find other buyer if first walks away.
  4. Shareholder approval happens if board approves and no major shareholder blocker. Find out who major shareholders are.
  5. Stay away from reg approval deals due to time.

ME

  • Break up fee and reverse break up fee.
  • Check buyer’s past history of doing or backing out of deals
  • Mssage boards. Proxy statement. Acquirer currently holds how much.

Tender offers. Untendered portion.

  • If the deal is bad for shareholders (i.e., very low bid over trading), then it’s an even better buy – less distance to fall as well as potential for a bidding war


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