Warren Buffett is famous for his long-term investment strategy. In fact, his favorite holding period is forever.
But what many people don’t know is that Buffett often engaged in some very short-term investing, especially in his early partnership days.
He called this type of investing “workouts”.
Workouts, also sometimes called “special situations,” includes things such as merger arbitrage, spinoffs, carveouts, and reorganizations.
Here’s what Warren Buffett had to say about workouts from his 1964 letter:
“Workouts – These are securities with a timetable. They arise from corporate activity – sell outs, mergers, reorganizations, spinoffs etc. In this category we are not talking about rumors or “inside information” pertaining to such developments, but to publicly announced activities of this sort. We wait until we can read it in the paper. The risk pertains not primarily to general market behavior (although that is sometimes tied in to a degree), but instead to something upsetting the applecart so that the expected development does not materialize. Such killjoys could include anti-trust or other negative government action, stockholder disapproval, withholding of tax rulings, etc.”
“The gross profits in many workouts appear quite small. It’s a little like looking for parking meters with some time left on them. However, the predictability coupled with a short holding period produces quite decent average annual rates of return after allowance for the occasional substantial loss. This category produces more steady absolute profits from year to year than generals do. In years of market decline it should usually pile up a big edge for us; during bull market it will probably be a drag on performance. On the long term basis, I expect the workouts to achieve the same sort of margin over the Dow attained by generals.”
Special situations are a staple of Seth Klarman‘s investing strategy. And Benjamin Graham also invested in workouts, and these types of investments were a big reason why both Benjamin Graham and Warren Buffett were so successful in their early days.
Let’s zero in on merger arbitrage (also sometimes called risk arbitrage), which is an investment strategy that you can start using today.
What is a Merger?
Before we talk about merger arbitrage, let me quickly explain what a merger is.
Technically, a merger occurs when two companies combine into one new company (Company A + Company B = Company C). An acquisition occurs when one company buys another company (Company A + Company B = Company A including B). But don’t get hung up on the details here – merger arbitrage applies to both mergers and acquisitions.
Companies buy each other all the time. They do this to increase their scale, their profits, to improve their competitive positioning, or sometimes – in the case of bad corporate governance – just to feed the egos of executive management.
Note that these mergers can involve both public (i.e. listed on the NYSE, Nasdaq, or another stock exchange) or private companies. We can only use merger arbitrage when public companies are involved (you’ll see why below). Let’s continue.
The Merger/Acquisition Process
Here’s an example from Lélian Girard over at MergerArbitrages.com of what happens during a typical acquisition:
Public Company A makes an offer to acquire the shares of Public Company B for $65/share. Before the announcement, the shares of Company B were trading at $50/share. Upon the news release, Company B’s shares immediately shoot up to $60/share.
But wait!
Why didn’t Company B’s shares shoot up to $65/share? After all, Company A said they’d buy them for $65/share, not $60/share.
Well, the announcement of a merger and the actual closing of a merger are two different things.
As Lélian explains:
“When a merger is announced, it only means that two companies have come to an agreement to combine and have signed a legally binding contract (the merger agreement) to this effect. However, similarly to when you sign the paperwork to buy a house and leave a deposit, the house is not actually yours until the transaction closes and legal ownership documents are established. Until that’s the case, you can back out if you’re willing to lose your deposit (and upset your realtor). The same is true for a corporate transaction, except that even if the two companies do not change their minds, a few other things could go wrong and get in the way of a transaction.”
“For one, that both the companies’ executives and Boards want to pursue the transaction does not mean that the shareholders do; and after all, they’re the ones owning the businesses, so any transaction can be blocked by them if it doesn’t get enough votes in support of it (usually 50% of the shares outstanding). In addition, mergers can also fall apart if they are blocked by regulators due to antitrust (competition) concerns, or if one of the companies gets pulled in another transaction by a third-party.”
The spread between the agreed upon acquisition price and the price that the target’s stock shoots up to is the market’s assessment of the risk that the merger won’t actually close.
This is when merger arbitrage comes into play.
What is Arbitrage?
Arbitrage is the practice of taking advantage of a price difference between two or more markets and striking a combination of matching deals that capitalize upon the imbalance, with the profit being the difference between the market prices.
For example, say you can buy an iPad in the U.S. for $500. However if you go to Japan, iPad’s are selling for $600 (ignore currency translations here). If shipping from the U.S. to Japan only costs $50, then you can buy an iPad in the U.S. for $500, pay $50 for shipping, and then sell it in Japan for $600. You would have paid $550 in total and received $600. Your profit is a risk-free $50!
If you were rational you would do this as much as you can – you would mortgage your house and sell your kids – and keep doing this arbitrage until the prices even out (because you’re buying so many iPads, you will increase the demand for iPads in the U.S. which would cause the price to increase from $500; and because you’re selling so many iPads, you would increased the supply of iPad’s in Japan which would cause the $600 to decrease).
Of course, this is just an academic example but you get the idea.
We can do the same thing with mergers.
So going back to our previous example, if we’ve done our analysis and we believe with very high probability that the acquisition will indeed close, then we can buy Company B’s shares for $60 right now, and then Company A will buy them from us for $65 when the acquisition closes. Our profit will be $5. The only risk is that the deal falls through and that Company B’s shares fall back to $50 (what they were trading at before the merger announcement). In that case, we would lose $10.
Types of Mergers
Acquisitions aren’t always paid for the same way. What I’m talking about here is called the “consideration,” which is what the buyers use to pay and what the sellers get paid with.
Here are the three possibilities, followed by an example of how each works, courtesy of MergerArbitrages.com:
Cash Deals
An acquiring company offers to buy the target’s shares from its shareholders for a cash consideration. If the transaction is approved by shareholders and regulators, the transaction closes, the target’s shares are de-listed and its shareholders receive the full purchase price in their brokerage account in cash. Note that the cash can be financed with debt, but if the acquiring company is paying with cash then it’s still a cash deal.
Public Company A makes an offer to acquire the shares of Public Company B for $65/share in cash. Before the announcement, the shares of Company B were trading at $50/share. Upon the news release, Company B’s shares immediately shoot up to $60/share.
Investors who believe the deal will close simply buy Company B’s shares at $60/share, and wait for the transaction to close to pocket the $5/share delta.
So, upon announcement of the merger:
- Purchase Company B share for $60 and wait for the merger to close.
- Now you own 1 share of Company B.
- Cash flow = -$60.
Once the merger closes:
- Company B’s shares are de-listed and Company A pays all Company B shareholders $65 per share.
- Now you don’t own any Company B shares (which no longer exist).
- Cash flow = +$65.
- Final profit = +$5.
All-Stock Deals
An acquiring company offers to buy the target’s shares from its shareholders in exchange of its own stock (this is done via an exchange of shares according to the exchange ratio negotiated by the companies and present in the merger agreement). If the transaction is approved by shareholders and regulators, the transaction closes, the target’s shares are de-listed and its shareholders receive the corresponding shares of the acquirer (or combined entity) in their brokerage account.
Public Company A makes an offer to acquire the shares of Public Company B, with shareholders receiving 0.50 share of Company A for each share of Company B they hold. Before the announcement, the shares of Company A were trading at $130/share (which values Company B at $65/share) and the shares of Company B were trading at $50/share. Upon the news release, Company B’s shares immediately shoot up to $60/share.
Investors who believe the deal will close can buy Company B’s shares at $60/share, and sell short 0.5 share of Company A for each share of Company B they’ve bought, pocketing $5 of merger spread per share of Company B.
Remember, when an investor short sells Company’s A shares (i.e. borrows shares of A he doesn’t own to sell them in the market), he receives the money for them upfront. Therefore, each share of Company B purchased is an outflow of $60, and the associated short sale of 0.5 share of Company A is an inflow of $65 ($130*0.5), netting the investor $5 in the process.
When the transaction closes, the investor will receive 0.5 share of Company A for each Company B’s share he owns, which will be used to cancel out the short selling of Company’s A shares.
Upon announcement of the merger:
- Purchase Company B share for $60, sell short 0.5 share of Company A for $65.
- Now you own 1 share of Company B and you owe 0.5 share of Company A because you sold it short.
- Cash flow = +$5.
Once the merger closes:
- Company B’s shares are de-listed and Company A gives all Company B shareholders 0.5 Company A stock for each Company B share. So you get 0.5 share Company A stock and your Company B stock gets cancelled.
- You now can return the Company A stock to the original owner because you had sold it short. Now you don’t own any Company A shares or any Company B shares (which no longer exist).
- Cash flow = $0.
- Final profit = +$5.
- Note that it doesn’t matter what price Company A’s shares are when the merger closes! Company A’s stock can double or drop by 50%. It doesn’t matter because you don’t need to buy or sell Company A stock once the merger closes – you just have to return the stock back to the original owner.
Cash / Stock Mix
Lastly, an acquiring company offers to buy the target’s shares from its shareholders in exchange of its own stock and a cash consideration. If the transaction is approved by shareholders and regulators, the transaction closes, the target’s shares are de-listed and its shareholders receive the corresponding shares of the acquirer (or combined entity) and the cash portion in their brokerage account.
Public Company A makes an offer to acquire the shares of Public Company B, with shareholders receiving 0.30 share of Company A and $26 for each share of Company B they hold. Before the announcement, the shares of Company A were trading at $130/share (which values Company B at $65/share) and the shares of Company B were trading at $50/share. Upon the news release, Company B’s shares immediately shoot up to $60/share.
Similarly to the previous example, investors who believe the transaction will close will need to short sell shares of Company A in the same proportion of the exchange ratio (0.30 share of Company A per share of Company B purchased).
Because of the cash component, the investor won’t pocket the spread right away, but upon closing. The logic is a mix of the two previous examples.
Upon announcement of the merger:
- Purchase Company B share for $60, sell short 0.3 share of Company A for $39.
- Now you own 1 share of Company B and you owe 0.3 shares of Company A because you sold it short.
- Cash flow = -$21.
Once the merger closes:
- Company B’s shares are de-listed and Company A gives all Company B shareholders 0.3 Company A stock plus $26 for each Company B share. So you get 0.3 share Company A stock, $26, and your Company B stock gets cancelled.
- You now can return the Company A stock to the original owner because you had sold it short. Now you don’t own any Company A shares or any Company B shares (which no longer exist).
- Cash flow = +$26.
- Final profit = +$5.
- Note again that it doesn’t matter what price Company A’s shares are when the merger closes.
Taking Advantage of Merger Arbitrage in Your Portfolio
Now that we know what merger arbitrage is, let’s take a closer look once more at what Warren Buffett wrote about the topic back in 1969:
We are not talking about rumors or “inside information” pertaining to such developments, but to publicly announced activities of this sort. We wait until we can read it in the paper.
This is investing – not speculation. This means you shouldn’t be investing in the stock of a company because you think it would be “a good acquisition target” for a larger company.
For example, merger arbitrage would not mean investing in Twitter stock because you think Google or Facebook should buy it. You would only invest once Google or Facebook had signed a legal contract saying that they will definitely buy the Twitter for a predetermined price, just as long as the below doesn’t happen….
The risk pertains not primarily to general market behavior (although that is sometimes tied in to a degree), but instead to something upsetting the applecart so that the expected development does not materialize. Such killjoys could include anti-trust or other negative government action, stockholder disapproval, withholding of tax rulings, etc.
The risk with merger arbitrage doesn’t really have to do with changes in stock prices (we’ve already seen in our examples that stock prices can move and have no effect on the ultimate profit of a merger arbitrage.
The risk comes from things like anti-trust issues (e.g. the government doesn’t approve the merger because it thinks the combined company would be a too powerful monopoly), the target’s shareholders don’t approve the merger, or that the merger becomes delayed or postponed. Warren says that general market behavior is only “tied in to a degree,” because a market crash could cause companies to walk away from a merger, even if it was already agreed upon.
The gross profits in many workouts appear quite small… However, the predictability coupled with a short holding period produces quite decent average annual rates of return after allowance for the occasional substantial loss.
The absolute return from merger arbitrage doesn’t look like much. For example in our all-cash consideration example, a $5 profit on an initial investment of $60 equals an 8.33% absolute return. But if it only takes a 3 months for the acquisition to close, that $5 profit translates into an annualized return of 37.74%!
If you do these throughout the year, you can see just how attractive a strategy merger arbitrage really is. You could even employ this strategy instead of holding cash because it’s essentially a pretty liquid investment.
This category produces more steady absolute profits from year to year than generals do. In years of market decline it should usually pile up a big edge for us; during bull market it will probably be a drag on performance. On the long term basis, I expect the workouts to achieve the same sort of margin over the Dow attained by generals.
Merger arbitrage can produce a steady stream of profits for you. In bull markets, it could be a drag on performance. But in market declines, it’s a hedge against declining stock prices.
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The Benjamin Graham Risk Arbitrage Equation
In the above section, I said that the $5 profit translates into an annualized return of 37.74%.
This is a great return, but there is also of course the risk that the merger won’t close.
This is why Benjamin Graham came up with the following equation, which he included in his book Security Analysis (one of the best books on investing of all time and often considered the value investor’s bible). His equation takes into account the probability that the merger won’t close:
Indicated annual return = [GC – L(100% – C)] / YP
Where:
G be the expected gain in the event of success;
L be the expected loss in the event of failure;
C be the expected chance of success, expressed as a percentage;
Y be the expected time of holding, in years;
P be the current price of the security.
So in our cash deal example (assuming we think the deal has a 90% chance of closing and that it will close in 3 months:
Indicated annual return = [($5*90% – ($60 – $50)(100% – 90%)] / (.25*$60) = 23.33%
Of course, if the merger does close then you’re realized return will still be 37.74%, as I said earlier. But Ben Graham’s formula is a good way to assess different merger arbitrage opportunities before you invest in them, especially when they have different probabilities of success.
Your Turn
Do you use merger arbitrage in your portfolio? Has it been successful?
If you want to learn more about merger arbitrage, be sure to check out MergerArbitrages.com or any of the books below.
Security Analysis
BY BENJAMIN GRAHAM AND DAVID DODD; FOREWORD BY WARREN BUFFETT
First published in 1934, Security Analysis is one of the most influential financial books ever written. Selling more than one million copies through six editions, it has provided generations of investors with the timeless value investing philosophy and techniques of Benjamin Graham and David L. Dodd.
Merger Arbitrage: How to Profit from Global Event-Driven Arbitrage
BY THOMAS KIRCHNER
Merger Arbitrage: How to Profit from Event-Driven Arbitrage is the definitive guide to the ins and outs of the burgeoning merger arbitrage hedge fund strategy, with real-world examples that illustrate how mergers work and how to take advantage of them. Thomas Kirchner discusses the factors that drove him to invest solely in merger arbitrage and other event-driven strategies, and details the methods used to incorporate merger arbitrage into traditional investment strategies.
The Essays of Warren Buffett: Lessons for Corporate America
BY WARREN E. BUFFETT, EDITED BY LAWRENCE A. CUNNINGHAM
Buffett, the Bard of Omaha, is a genuine American folk hero, if folk heroes are allowed to build fortunes worth upward of $15 billion. He’s great at homespun metaphor, but behind those catchy phrases is a reservoir of financial acumen that’s generally considered the best of his generation.
Margin of Safety: Risk-Averse Value Investing Strategies for the Thoughtful Investor
BY SETH KLARMAN
Taking its title from Benjamin Graham’s often-repeated admonition to invest always with a margin of safety, Klarman’s ‘Margin of Safety’ explains the philosophy of value investing, and perhaps more importantly, the logic behind it, demonstrating why it succeeds while other approaches fail. The blueprint that Klarman offers, if carefully followed, offers the investor the strong possibility of investment success with limited risk
