Over the last 10 years, the democratization of information flow has steadily eroded the edge institutions have over individuals. This premise is, of course, the guiding principle of
. Individual investors now have at their disposal virtually all the same tools as the professionals.
One of those institutional tools used to be the ability to access
Securities and Exchange Commission
documents before individuals knew what was happening. But with the availability on the Internet of free, searchable
databases, the field is now truly level
(here's how it used to be done). Every document is universally available as soon as it's filed. Risk arbitrage provides one of the most powerful examples: While the professional arbitrageur still retains some important edges, document-retrieval speed is no longer one of them.
Consider a case from last week. Friday morning,
Policy Management Systems
filed its preliminary merger proxy statement at about 11:30 a.m. Policy Management had agreed on March 31 to be bought by
Welsh Carson Anderson and Stowe
, a New York-based LBO firm, for $13.50 in cash.
The market responded to this deal with quite a bit of skepticism: Upon the announcement, Policy Management had traded up to only $12, implying a $1.50 spread over the four months or so it would take to close the merger. On an annualized basis, this worked out to better than 35%, a return large enough to signal that arbs were not comfortable with the deal. During the volatility of April, Policy Management shares traded as low as $10, promising an astounding 125% annualized return if the deal were to close on time.
Some of the reasons the spread was that wide included:
- LBOs in general are trading at very wide spreads due to the perceived difficulty of arranging financing in the junk bond market;
- Welsh Carson broke one deal in 1999 (Centennial HealthCare (CTEN) ) and recut the price of another deal (Centennial Cellular (CYCL) ), and
- Policy Management's fundamentals are poor -- the company was recently in technical default of its bank covenants, and had recently announced a large earnings shortfall.
In other words, this was a very high-risk deal from an arbitrage point of view. My firm chose not to partake of the deal for just these reasons.
But if you read the Preliminary Merger Proxy on Friday morning, you would have stumbled across some very juicy narrative in the section titled: "Background." Namely, Policy Management had several suitors emerge both before and
the deal with Welsh Carson was announced. Also, Policy Management's directors had taken steps to ensure that nothing in the Welsh-Carson deal would impede a higher bidder. Although Policy Management's board didn't auction the company back in March, it has set up a process likely to maximize value should a better bid emerge.
And if you had read that proxy, you would have had plenty of time to reflect on what you had learned. While the stock did indeed start to trade up late Friday morning, you still could have bought it at a small discount to the deal price over the balance of the day. The news services did not pick up the story, despite Policy Management putting out a 2:55 p.m. press release announcing the filing. Right after the close, you would have been rewarded, as Policy Management disclosed that it had just received a letter from
Electronic Data Systems
offering to acquire Policy Management for between $18 to $20 a share in a cash tender offer.
The shares opened Monday morning at 18 3/4. My firm bought stock Monday, but I sure wish we had bought it Friday instead: We didn't see that preliminary proxy. Policy Management was simply not a deal we were following closely. With 200 or more large mergers currently pending, no firm can adequately follow every deal. We choose to perform triage and follow very closely the 50 or so most promising transactions. I'm sure other shops take a similar approach. Sometimes we come across a gold nugget like this one, but this wasn't one of those times. Someone did, however, and there were high-fives exchanged somewhere when those EDS headlines ran Friday evening.
How do you find one of these nuggets? The easiest way is to set up email updates on a portfolio of companies you are interested in at any of the EDGAR sites. I like
Freeedgar, but there's
10-K Wizard, each with its own bells and whistles. (Note, filings on the SEC's
own EDGAR site tend to appear later than on the commercial sites.) Most of these services will send you an alert whenever one of your companies makes a filing with the SEC.
What to Look for
In the course of evaluating a merger spread, the real work comes in analyzing the deal-specific filings -- the merger agreement, the merger proxy and the tender-offer documents. It's in these filings that crucial disclosures relating to financing arrangements, conditions to closing, walk-away rights, collar mechanisms, pricing periods and the background of the negotiations that led to the deal come to light.
When I pull up a new filing, I always go immediately to the most important sections. Here they are:
- For a merger agreement (usually filed on form 8-K, except when it's included in the tender-offer documents), it's the provisions titled: Conditions, or Consideration, or Termination
- In a tender offer or merger proxy (usually filed as an SEC Form 14A, but sometimes as a Form S-1 or S-4), it's the background section, which contains the history of the negotiations that led to the deal.
With a little practice, you'll quickly get a sense of what language is the same in every document, and what is relevant.
The widespread and cost-free availability of real-time SEC filings is the single-biggest shift in edge I've seen on Wall Street. Not enough people take advantage of this extraordinary tool. If individual investors reduced their time spent in chat rooms and reading largely worthless sell-side research (Disagree? Shoot me an
email) by a third and instead devoted that time to reading the company's actual filings, I believe it would show up quickly in their returns. And if we're talking about companies involved in deals, it's even more true.
All it takes is finding one little nugget not yet in the market.
David Brail is the president and portfolio manager of Palestra Capital, a Manhattan-based hedge fund that focuses on risk arbitrage, and has been an investor in risk arbitrage and bankruptcy securities since 1987. At the time of publication, Palestra Capital was long PMS shares, although holdings can change at any time. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. Brail appreciates your feedback at