Saturday, August 9, 2014

Review of Risk Arbitrage by Guy Wyser-Pratte

I've had Risk Arbitrage by Guy Wyser-Pratte in a pile to review for some time, and this week's merger crackups have created a great discussion opportunity.

"Merger arbitrage" or "risk arbitrage" means that when a company announces a takeover of another company, you buy shares in the company to be acquired ("target"). After the news is already out. If you want to get fancy, you hedge (sort of) by selling short the shares of the acquirer, in a quantity equal to the number of shares that your shares of the target would receive, if the deal closed. The profit, or spread, is the difference between the price you pay for the target shares and the actual consideration to be paid when the deal closes.

This is not a true arbitrage, hence the qualifiers "risk" or "merger" to describe the strategy. Rather, it is a bet that one hopes is uncorrelated with the market; a bet on whether or not the deal will close (or, sometimes, that the consideration will be increased.)

Apparently, it used to be the case that many institutional investors would sell their shares of a target when a takeover deal was announced. Combined with a relatively small amount of capital at work in risk arbitrage, it meant that the spread was big enough for real money to be made if the deal closed. This was when merger arbitrage worked, and - not coincidentally - you couldn't buy a book explaining how to do it then.

Notice that when Rupert Murdoch offered $85 per share for Time Warner last month, the share price of TWX traded up to $88 before settling in right around $85. People - "arbs" - were betting not only that the deal would close but that Rupert would have to bid against himself.

But the Time Warner execs don't want to get sacked to create synergy, so they blocked the deal. In the aftermath, the stock has fallen back to $73. Someone who bought to try to make $2 has instead lost $10. (The other deal that fell apart on Tuesday was Sprint's purchase of T Mobile US, which also dropped significantly.)

Too many investors betting on deals to close compresses spreads, which means that more leverage needs to be (and does) get used to achieve the same rate of return. At the top of a social mood cycle, you'd expect risk arbs to have bid the deal spreads to zero or negative.

Something else amusing. The biggest withdrawn takeover deals in history occurred in: 1999, 2000, 2007, 2008, and 2014. A gigantic takeover deal - $100 billion - is an expression of huge confidence. What does it mean when the deal is withdrawn before it can close?

Mining company BHP Billiton bid for competitor Rio Tinto in fall 2007, right as the markets were peaking. The merger was called off in November 2008, after the CRB index had fallen 35 percent.

There's nothing to risk arbitrage, in terms of clever strategy. You have to have an edge in knowing whether or not the deal is going to close, or else you are just gambling that the social mood up-cycle that you are in will continue. And who needs another investment strategy that is positively correlated to social mood? The whole point of risk arbitrage was that these are uncorrelated returns. 

There's also nothing to it in terms of returns, because it's too crowded. Notice there are several dozen hedge funds in the Barclay Hedge Merger Arbitrage Index. (I can't wait to see the August 2014 return.)


1 comment:

CP said...

Notice that TWX is still below $88.