Insights: Finance

Published in: December 1, 1999

Published November/December 1999

FINANCE Worth the Risk Profiting from risk arbitrage and "the third wave of takeovers"TM by Mario Gabelli We are in the midst of the third great wave of mergers and acquisitions since the Second World War. The first wave swelled in the 1960s, with conglomerators such as LTV's Jimmy Ling, Gulf & Western's Charles Bluhdorn and ITT's Harold Geneen merging companies in nonrelated industries. They did so in an attempt to produce more consistent earnings growth through the ups and downs of the business cycle. The second major wave of takeovers began in the 1980s, when financial engineers--including leveraged buyout firms such as Kohlberg, Kravis & Roberts and corporate raiders like T. Boone Pickens--used junk debt to gobble up undervalued companies and then dismember them for a profit. This second wave broke as financially unrealistic deals like the proposed leveraged buyout (LBO) of United Airlines fell apart, the junk bond market collapsed, and the House of Drexel disintegrated under the weight of a government criminal investigation.   The third great wave of mergers and acquisitions is being driven by consolidators--companies in a wide range of industries buying competitors to extend their franchises, trim costs and increase profitability. We trace the beginning of this wave to March 14, 1994, when much-admired General Electric chairman Jack Welch launched a hostile bid to buy Kemper Insurance--signaling that deals were once again respectable. This Third Wave will continue to gain momentum as companies worldwide jockey for market position and profits in the increasingly competitive global economy.   There are two ways investors can take advantage of merger and acquisition activity. The first is buying public shares of likely takeover candidates before the deal is announced. Gabelli Asset Management's ability to identify industries ripe for consolidation and our focus on undervalued companies has resulted in a long list of portfolio holdings being taken over at substantial premiums to our purchase prices. The second (and much less known) method is through risk arbitrage. It would take a book to unveil and make simple all the complexities of risk arbitrage--in fact, my colleague Regina Pitaro is writing one. In this article, I'll provide the basics, and more importantly, the reasons why I believe risk arbitrage is such a compelling investment strategy.   Simply stated, risk arbitrage is investing in a merger or acquisition target after the deal has been announced and pocketing the spread between the trading price of the target company following the announcement and the deal price upon closing. This spread is usually narrow--offering a somewhat modest nominal total return. However, since deals generally close in much less than a year's time, this modest total return translates into a much more attractive annualized return.   Following is an example of a very basic risk arbitrage investment. On March 22, 1999, the NYSE-listed First Data Corp. announced it would pay $25.50 in cash for each of the remaining publicly owned shares of Paymentech Inc. (52.5 percent of the company would be owned by Bank One, which has a merchant processing alliance with First Data). The deal was expected to close within four months. Following the announcement, we were able to purchase Paymentech shares for $24.02 (the trading price of $24 per share on the day the deal was announced plus 2 cents per share in commissions). The spread between our purchase price and the value of the stock upon closing was 6.2 percent. The deal closed on July 27, generating an annualized return of 18.5 percent.   This particular arbitrage worked out very well for us. We were able to buy Paymentech shares at a good discount to the final transaction price and the deal closed on schedule. Not all arb investments produce such an attractive annualized return. But, arbitrage portfolios have posted annualized returns in the low to mid teens during the 1990s.   The great advantage of risk arbitrage is that it is largely a market neutral strategy--deals get done in good markets and bad--that can deliver consistent returns even in volatile markets. Because a conservatively managed risk arbitrage portfolio produces consistent gains, the financial magic of compounding works strongly in its favor. Let me offer two examples of the power of compounding returns.   Once upon a time, there was a king in a faraway land. To repay the local sage for saving his daughter's life, the king offered the sage any reward he wished. The sage asked for what appeared to be a modest stipend--one grain of rice--the amount to be doubled each day for 31 days. The sage would receive one grain of rice that day, two the next, four the next, and so on. The king thought nothing of giving away a few grains of rice on a daily basis. But, it was only a matter of weeks before the king's granaries were empty and the sage had become the richest man in the land. After only one month, the king was paying the sage more than 1 billion grains of rice a day. In 31 days, one grain became one billion through the magic of compounding.   The purchase of Manhattan Island from the Indians for just $24 worth of beads is generally considered one of the greatest investments in history. The estimated value of all the real estate in Manhattan today is $10 trillion. Amazingly, this equates to an annualized compounded return of just 7.4 percent in the 375 years since the deal was done.   Of course, arbitrage investments don't compound at 100 percent daily, and most investors' time horizons are much shorter than the 375 years it took to make the purchase of Manhattan look like such a great deal. But, consider the following hypothetical scenario: Alice and Bob both invest $1 million of their 401k money in the year 2000. Alice puts her money in a risk arbitrage fund that returns 12 percent each year for the next 10 years. Bob puts his money in an aggressive equity fund that gains 20 percent in eight of the 10 years, but is down 20 percent in year one and year six. In 2010, Alice has $3.1 million compared to Bob's $2.7 million, despite Bob's returns being almost double Alice's returns in eight of the 10 years.   Are we shortchanging Bob in this scenario? After all, the stock market has had only one down year in the past 10, and over that period, the S&P 500 has posted an average annual gain of 20 percent. True enough. But, the long-term average annualized return from stocks is just over 11 percent, and I suggest that over the next 10 years, equities returns will more closely resemble the historic norms. I would also opine that these returns will be accompanied by considerable volatility--yes, major corrections and perhaps a full-scale bear market. Are Alice's arb fund returns realistic? Remember, risk arbitrage returns are affected by deal flow, not the direction of the stock market. If deal flow continues to be as robust as we anticipate over the next 10 years, arb funds have the potential to deliver consistent annual returns in the low to mid teens. So, this hypothetical scenario may prove remarkably accurate.   At this juncture, you may be wonder-ing, where is the risk in risk arbitrage? The biggest risk in risk arbitrage is that announced deals will not be consummated and that the stock of the company to be acquired will sink following a bust-up of the deal. In virtually every individual risk arbitrage investment, upside potential is dwarfed by downside risk. One old-time pundit said it best: "Arbitrage is the only business we know where you risk dollars to make nickels." The second biggest risk is that the deal may take much longer to close than anticipated, turning an attractive annualized gain into a much more modest return.   Deals break for a variety of reasons, and a busted deal generally means a big loss. However, during this third great wave of mergers and acquisitions, 96.5 percent of all announced deals have been consummated. That puts the odds in the arbritrageur's favor, particularly if he or she knows how to analyze a deal in a manner that helps avoid most, if not all, of the inevitable potholes. An adequately diversified arbitrage portfolio is a must. A diversified arb portfolio can withstand the large loss from a broken deal and still generate a positive return. Regarding the timing issue, deals do get stretched out, but provided one is not investing with leverage or having to bear the cost of a short position in a stock swap deal, this generally results in a more modest gain rather than a loss. Due to the complexities of most deals and because broad diversification is absolutely essential, in my opinion, risk arbitrage is best left to organizations with research and trading expertise and sufficient assets to support a fully diversified arb portfolio.   But, just because you can't do it at home doesn't mean that investors shouldn't take advantage of this relatively low-risk strategy to create wealth through the magic of compounding returns. There are numerous arbitrage partnerships open to individual investors. Tremont Advisers Inc. (tremontadvisers.com), a firm we have a sizable stake in, provides a list of arb partnerships and rankings.   So, when the next deal is announced, remember it is still not too late to buy and earn an attractive return on your investment.   Mario Gabelli is the founder and chairman of Gabelli Funds Inc., a Rye, New York-based financial services company. He appears regularly on CNN and CNBC.