Merger Arbitrage Blowing Up

Felix Salmon of Portfolio magazine comments about some blow-ups in the merger arbitrage world. He wonders whether Sam Heyman, who runs a merger-arbitrage hedge fund, has lost $1 billion with his bet on the Sallie Mae takeover by Chris Flowers. That deal fell apart and is the poster child of a failed merger. It's working its way through the courts so who knows what will happen in the end but, whatever the ultimate outcome, the merger arbitrage investors likely lost money. I looked at the Sallie Mae merger but didn't want anything to do with mortgage, finance, housing, or other related companies at the time (Sallie Mae is in education finance). I went with the Tribune risk arbitrage instead.

On top of hedge funds not disclosing details, it's difficult to say how much a merger arbitrage fund actually loses. The sophisticated funds will likely hedge their strategies. Who knows if Heyman shorted some financial stocks or some index to hedge their risk? What's working against some merger arbitrage firms is the fact that they use a lot of leverage. Leverage is a double-edged sword.

An ominuous thought from Felix:

In any case, it seems that merger arbitrage might be the new statistical arbitrage: a strategy which performed very well, until it didn't.

A thought like this is what makes me kind of scared of risk arbitrage right now. But then again, it's time like these when you actually get big spreads (15%+).

The way Warren Buffett seems to look at merger arbitrage is from a statistical probability point of view (I get this impression from Robert Hagstrom's Warren Buffett Portfolio. Assuming I'm not mixing up this book with another, there is a bit that talks about Buffett's merger arbitrage strategy). If the expected return is higher than his benchmark (generally risk-free interest rate; but I never use that as my benchmark), he takes a position. The fact that you can lose money on some deals is not a huge concern. The reason is because merger arbitrage is not a concentrated bet (at least not for the investors who use it as their primary strategy--this doesn't apply to small investors like me who don't have enough money to enter a large number of positions). Instead, it is a bet on many events. If you enter 50 to 100 positions in a period of 5 years, a few losses here and there don't matter. It's sort of like operating a casino. The fact that you lose on some bets doesn't mean much as long as your expected profit over thousands of bets is positive.

Having said that, one extremely point I note from Buffett is that he basically implies that the merger arbitrage deals need to have independent probabilities. I intrepret this to mean that you should be taking positions in different industries with different characters making the deals.

Of course, the difficulty with merger arbitrage is that you have to come up with the probability of success and failure (deals are generally a binary choice). A business may be good but the takeover party may (legally) back off so how do you gauge the probability of doing that...


My plan was to allocate 15% to 20% of the portfolio to risk arbitrage but the situation is very dicey right now. You know there is huge uncertainty when BCE's stock is trading way below its takoever price. BCE is a blue-chip Canadian telecom company with an interested takeover party so I have always viewed this as having an 85%+ chance of being completed. However, the market is getting concerned, especially given that this will be the biggest takeover in Canadian history and will involve a lot of debt. If you are interested in taking a position, you should check to see who is providing the bridge loans (I can't recall off the top of my head). If the loans are mostly from Canadian banks, I think financing is safe; if most of the money is from Wall Street firms, it's a risk. The Canadian banks, except CIBC, have been spared the big hit from the US subprime problems so they are more willing to finance deals. The debt buyers will still be more nervous than an year ago but BCE, like most of the big telecoms, is a solid company with a continuous stream of profits.