To engage in arbitrage, you must estimate the odds of
the merger going through, and what the possible outcomes will be if it
does not. Once a deal was announced, Rubin would undergo rapid,
intensive research, examining all available public information. He would
weigh each factor, and create an expected value table for the deal.
An expected value table works like this. Take the example of Company A and B from above. If
the deal goes through, there is $1 in potential profit, and maybe we
think there’s a 90% chance this will happen. In the 10% chance the
merger falls apart, it will probably decline $4 to its price before the
announcement. The final equation is: 90% x $1 – 10% x $4 = $0.50. So our
expected return is fifty cents on a $19 investment, or 2.6%. If the
deal took two months to close, the actual annualized return
would be 36%. But using our expected profit, annualized return is only
17%. Rubin normally accepted deals only if expected annualized return was 20% or more.
Bob Rubin’s most important lesson was this: you
should use probabilistic decision making when confronting any problem.
Success comes by evaluating all the information available to judge the
odds of various outcomes and the possible gains or losses for each.
•
Look at incentives. Incentives
aren’t given enough credit in most arbitrage situations. Yet they are
very powerful motivators and can have a huge impact on the final
outcome. Look for monetary incentives on both sides of the transaction.
Usually there will be a “break-up” fee to discourage the buyer from
walking away. What do executives in both companies get out of the deal?
Will there be synergies or huge cost savings that make the merger
beneficial? Do major shareholders have enough incentive to approve the
deal?
•
Know who’s involved. In May of last year, Rupert Murdoch made a surprise bid for Dow Jones & Co., publisher of The Wall Street Journal.
The $60 per share offer was a huge 67% premium to Dow Jones’ prior
closing price. In the weeks after the bid, hostility from the Bancroft
family (the controlling shareholders) caused the market to price Dow at a
10% discount to the offer. It seemed reasonable, considering the amount
that Dow would drop if the deal fell through (30 to 40%).
Warren Buffett knows Rupert Murdoch. Not as in “he knows him as a friend,” but as in he knows who he is, as a businessman. The market was weary, but Buffett knew there was a very
good chance the deal would get done. Between the announcement and the
end of June, Buffett purchased 2.8 million shares of Dow Jones—another
one of his classic arbitrage investments.
Knowing the background and personalities of those
involved can help immensely. The Tribune takeover was a prime example of
this. No matter what happened in the final stages, Sam Zell was the
kind of guy who wouldn’t have let Tribune slip past him. He had the
intelligence, resources, and determination to see the deal through to
the very end. This aspect isn’t always present in every arbitrage
situation, but when it is, it’s often overlooked by the market.
•
Look for a margin of safety. What
will happen if the deal gets cancelled? You don’t want to end up holding
an overvalued or distressed security. Look for any “back-doors” if the
initial thesis doesn’t play out. If the Tribune deal fell through, there
were multiple bidders who may have stepped in to buy the company or its
assets.
Find out if it’s a good deal in the first place. When
you think the takeover target is more valuable than the price being
offered, it’s beneficial for a few reasons. First, if the deal falls
through, you’ll still end up holding an undervalued security. Second,
there’s a better chance of someone coming in with a higher bid. Either
way, your possible losses are minimal.
•
Wait for the no-brainers. Most funds
and institutions that are dedicated to arbitrage treat it like an
actuarial business. They participate in dozens of investments at a time,
hoping any losses in one will be made up for with gains in the others.
With the risk that merger arbitrage imposes, this isn’t a terrible way
of thinking. But it ensures only mediocre performance. Warren Buffett’s
strategy in his partnership and early Berkshire days was a more
concentrated approach. He would be in at most a handful of situations at
any one time.
The advantage Buffett had (and we have) is that he
wasn’t constantly forced to make new arbitrage investments. If the
buyout market cooled off, he could wait on the sidelines for better
opportunities. This is in contrast to the dedicated arbitrage funds who
are forced to remain active and analyze every possible deal. The best
thing to do is wait for the no-brainer buyouts where (forgetting the
market) the target company is obviously mispriced. That was the case
with our investment in Tribune Company.
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