Editor's note: With this column, we introduce David Brail, the president and portfolio manager of Palestra Capital LLC, a Manhattan-based hedge fund that focuses on risk arbitrage. Before founding Palestra, he was director of research at Dickstein Partners for eight years. He has served on the board of directors of Amerihost Properties and on the creditors' committees for Interco, First Republic Bank and Gaylord Container, among others. As always, tell us what you think.
More than any other Wall Street occupation, the risk arbitrager has become, in the public's eye, the ultimate expression of high-rolling, amoral criminality. And who can blame them?
, reportedly the basis for the
character in the Oscar-winning movie
, and the
winners whose formulas led
Long Term Capital Management
to its rise -- and ultimate fall -- make investment bankers look like accountants by comparison! And even the fact that both former
cut their teeth as arbitragers hasn't helped.
But let's be honest: Gordon Gekko was no arbitrager. First of all, no arb dresses that well. Second, what we do is not nearly as exciting.
And yet understanding the dynamics of risk arbitrage can help an investor anticipate the forces that set share prices in the aftermath of a takeover announcement. Even if you have no intention of becoming an arbitrage investor, almost everyone at one point or another will own a stock that is the target of a tender offer. Being conversant in risk arbitrage -- how the players handicap the deals and the concepts they use in the process -- can help you understand how they game is played. It may even give you a leg up in these circumstances.
The Rules of the Game
Risk arbitrage, as it is generally practiced today, involves making investments in
takeover deals. Success or failure depends on an arbitrager's assessment as to whether, and when, a pending merger will actually close. If the deal does close on time and on the terms originally announced, the position will be profitable. Should a transaction be delayed, renegotiated or abandoned, the investment will likely be a loser.
Since the upside we are playing for is usually modest, it takes many more winners than losers to grind out an acceptable return. On the other hand, merger agreements are binding legal documents: Deals are not undertaken lightly, and the historical closing rate of mergers is very high. Given these factors, many arbitragers use leverage to some degree to improve returns even though, as
of LTCM can tell you, leverage cuts both ways.
The easiest way to see arbitrage in action is to watch the first-day trading in a company that has just announced a deal.
announced it will purchase
. The terms specify a fixed share exchange ratio of 0.45 (0.45 share of Microsoft for every Visio share), meaning it will not vary, regardless of where Microsoft trades between now and the merger's close.
To the typical Visio shareholder, the ultimate value of the merger will depend on where Microsoft's stock price trades once the merger closes. But arbs look at the deal very differently: They want to know what return on their capital they can earn for bearing the risk that the deal will close on time.
At noon on that Wednesday, for instance, Visio was trading at 40 3/8 with Microsoft at 93 7/16. At that single point in time, the merger was worth 0.45 multiplied by 93 7/16, or $42.04 per Visio share. The difference between this value and Visio's share price is "the spread," or $1.67, and it reflects the market's determination of the risk of the transaction.
To lock in this spread, an arb would buy Visio shares, and sell short 0.45 share of Microsoft for each share of Visio purchased. This way, an arb doesn't care whether Microsoft's and Visio's share prices are going higher or lower, only the relationship between those prices. That spread has since narrowed to $1.63, incidentally, even though Microsoft shares have climbed nearly 3 since.
An arb's research will focus on how long the deal should take to consummate and what obstacles it might encounter. My thinking in this case is that the merger should close in 90 to 120 days, standard length for a stock-for-stock merger that requires a proxy filing, government antitrust approval and a vote of the target's shareholders.
It's All in the Odds
The original $1.67 spread would annualize to around a 16% return
the merger closed in 3 1/2 months. (I am simplifying the calculation a bit here.) This is a slightly lower rate of return than most currently outstanding merger spreads, but then again, Microsoft is a higher-quality buyer than an arb usually encounters.
An arbitrage portfolio is loaded with mundane deals like this, each with its own implied return. Monitoring pending deals, checking off milestones as they are achieved, responding to unforeseen developments and replacing recently completed deals with newly announced deals is the bulk of an arb's work.
So where does the excitement come? With hostile deals, where the outcome is uncertain, developments happen unexpectedly, and the risks -- and returns -- are greater. Of course, these make up a small portion of the merger universe.
What an arb doesn't do is predict the next takeover target -- that is, the province of traders and speculators. Arbs also don't go out and buy or threaten to buy entire companies -- the occupation of the fictional Mr. Gekko. They usually aren't in the business of evaluating the investment merits of the combined company -- only the transaction merits. Of course, the lines sometimes blur.
The general press never seems to get this right, crediting the arbitrage community with enormous but fictitious profits every time a deal is announced at a big premium over the last trade for a company not previously in play. Of course, that just helps build the mystique. And in an otherwise not-always-exciting investment discipline, a little mystique is not such a bad thing.
David Brail is the president and portfolio manager of Palestra Capital, a Manhattan-based hedge fund that focuses on risk arbitrage. Prior to founding Palestra, he was director of research at hedge fund Dickstein Partners for eight years. At the time of publication, neither Brail nor Palestra held positions in any securities mentioned in this column, 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