Risk Arbitrage... the Warren Buffett Way

“Give a man a fish and you feed him for a day. Teach him how to arbitrage and you feed him forever.” -- Old Wall Street Saying

I have been reading James Altucher's Trade Like Warren Buffett--a very good book looking at Buffett's less popular strategies--and thought I would comment about Warren Buffett's thoughts on risk arbitrage (here is an old interview with James Altucher about some topics covered in the book). James referred to Warren Buffett's arbitrage comments in the 1988 Berkshire Hathaway Shareholder letter and I thought I would go straight to the source.

Risk arbitrage falls into the category that Buffett calls workouts. Buffett supposedly earned as much as 50% of his returns in some years from arbitrage during his hedge fund days. Nowadays, with Berkshire Hathaway, Buffett rarely does much arbitrage; although he dabbles from time to time, with the Dow Jones takeover by Rupert Murdoch last year being one of his rare acts.

Once, the word [arbitrage] applied only to the simultaneous purchase and sale of securities or foreign exchange in two different markets. The goal was to exploit tiny price differentials that might exist between, say, Royal Dutch stock trading in guilders in Amsterdam, pounds in
London, and dollars in New York. Some people might call this scalping; it won’t surprise you that practitioners opted for the French term, arbitrage.

Since World War I the definition of arbitrage - or “risk arbitrage,” as it is now sometimes called - has expanded to include the pursuit of profits from an announced corporate event such as sale of the company, merger, recapitalization, reorganization, liquidation, self-tender, etc. In most cases the arbitrageur expects to profit regardless of the behavior of the stock market. The major risk he usually faces instead is that the announced event won’t happen.

The attractive thing about risk arbitrage is that, as Buffett points out, returns are not dependent on the market. Instead, the returns are generally a time-limited binary outcome that depends on the specifics of the situation. I always wondered how Buffett managed to end up with positive returns during tough periods (this is what makes Buffett the greatest investor in my eyes--not his billions but his ability to post consistently positive returns (kind of like Cal Ripken in baseball)). Arbitrage (and workouts in general) is the secret answer.

My goal is to have around 15% to 20% of my portfolio allocated to risk arbitrage depending on what I find attractive. If anyone wants to test the arbitrage waters, now is an attractive period. Due to the squeeze in the credit markets and shortage of capital at some banks, there is a lot of uncertainty regarding many deals. An arbitrage situation that would have yielded 5% a few years ago is now around 15%. It's risky but the returns are pretty high. The one I find most attractive is the BCE takeover (others like PENN, CCU and HUN are worth looking at as well).

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 that something still better will transpire - a competing takeover bid, for example? and
(4) What will happen if the event does not take place because of anti-trust action, financing glitches, etc.?

The above quote contains the most important information in the letter. I`m going to use those 4 questions in my arbitrage template from now on. The answers to the BCE takeover (in my opinion) would be:

(1) I would say 75% chance of going through. The lead takeover party, Teachers Pension Fund, is already a shareholder of BCE and hence likes the company.
(2) This deal shows how things often take longer than initially forecast. Original deal was supposed to close in 1Q 2008 but now it looks like late 2Q 2008.
(3) Chance of something better is zero. All interested parties submitted a bid and this company is way too big for some random party to show up.
(4) There is a big risk with financing. If financing causes the failure of the deal, the stock will likely drop 10% to 15% (my guess). There is a possbility that Telus, a competitor that dropped out of bidding, might bid at a lower price than the current takeover price. In the worst case, I think BCE is the type of company that one can hold given its stable operations that should not be impacted too much during an economic slowdown or recession.

We have no idea how long the excesses [referring to the takeover bubble in 1989] will last, nor do we know what will change the attitudes of government, lender and buyer that fuel them. But we do know that the less the prudence with which others conduct their affairs, the greater the prudence with which we should conduct our own affairs. We have no desire to arbitrage transactions that reflect the unbridled - and, in our view, often unwarranted - optimism of both buyers and lenders. In our activities, we will heed the wisdom of Herb Stein: “If something can’t go on forever, it will end.”

The scariest thing in arbitrage is the notion that 'risk arbitrage works until it does not'. For newbies like me, who doesn't have the experience of multiple market cycles, it's hard to say if I may end up being the last one holding the bag. But then again, this uncertainty (especially with the huge boom in LBOs over the last few years) is what presents the potential for high return. Right now, I would rather pick a safer deal with lower return (like BCE) than a higher potential one (like PENN).