Arbitrage as a safe interest alternative for savings?

[scorpioncapital]

What do people think of using cash on merger arbitrage to earn a reasonable return on cash balances that would otherwise be held in a savings account? If you do this would you spread it out over x number of opportunities and seek out say simple, industrial companies with reputable buyers and not go for the maximum return but reasonable returns in the 3 to 5% range till closing?

 

E.g. I saw Cleo Corp (CNL) is a utility being bought by a reputable Canadian/Australian investor group, closing in 1-3 months and spread is 3.5%. You may even get 1 dividend in October. The deal is cash. A bank account would pay perhaps 0.5% in a term deposit held for 1 year. Since it would be treated as a capital gain, you would also have a lower tax rate on the profit.

 

I saw Bill Gross mention the idea today when he suggested Precision Castparts getting 3% till closing was an alternative to getting interest on your cash in a bank account?

 

 

[DTEJD1997]

Interesting idea...but I am going to suggest that it is more difficult & riskier than simply putting it in a savings account.

 

The Precision Cast Parts deal is pretty safe...Buffet is fully able to commit, but there are things out of his control.  What if the regulators put the nix on it?  An environmental problem?  Stock market crash?  War? Terrorist attack, EMP burst?  All very small risks to be sure, but still they are there.

 

Other deal?  Not so sure.  What are you gaining vs. the risk you are taking on?  One deal blows up and you are out a lot of $$$$.  Much more than you would make on 3,5,10 deals going through OK probably.

 

Essentially, you've got to be right 99/100 times.  There is almost no margin for error.

 

You've also got another problem in that maybe the deal gets delayed for a month, or two, or six.

 

I am sure others more knowledgeable than I am can probably add to this...

[scorpioncapital]

Good point. In the example I use the deal was delayed for about 1.5 years. I recall Graham saying this operation works well as a basket.

[thepupil]

a portfolio of merger arbs is not cash, period. you are short tail risk, anything that involves shorting tail risk is not "cash". That doesn't mean it isn't a worthwhile activity, but it isn't cash.

 

it's an "uncorrelated and low beta" source of risk/reward.

 

Starting with the Shire/Abbvie break last October, which caught a lot of people off guard (chicago based board felt the heat  from the dems to not do deal even though it was legal, tax dodging and all that) and hurt a lot of event driven/merger arb guys, merger arb spreads have been unusually high. But deal breaks are high too.

 

I personally think the merger arb environment offers good risk/reward relative to other spread risks (credit, duration, etc.) but only to a non-taxable investor. But it isn't cash.

 

http://arbitragefunds.com/sites/ArbitrageFunds/files/pdf/Why_Merger_Arb_Now.pdf

 

At the end of 2014, deal spreads are annualizing at nearly 9%, according to UBS research. Accelerating market volatility and a few, high profile, terminated transactions expunged much of the speculation from the space......What makes merger arbitrage even more compelling today is the outlook for potential returns has improved significantly. Spreads on merger arbitrage deals have widened considerably since late October 2014, due in part to several high profile deal breaks and a rise in market volatility to normalized levels. At the same time, deal-making activity continues to make a strong resurgence.

 

You can think of your return on a portfolio of merger arbs over time (much like a portfolio of bonds, with defaults instead of breaks) as

 

annualized spread - (breaks/year * loss upon break)

 

note that this calculation can be a little funky, because over time your returns before losses from breaks will be the annualized spread but in the short term, your returns (and most notably your losses) will not be annualized. In other words, if you are long a merger with a 4% spread and it closes in 6 months (8% annualized) but it will return -30% on a break, the risk/reward ratio is 7.5/1 in the short term. But if you invested in a portfolio of 100 deals that had those characteristics in an infinite number of years, you'd make 8% - losses from breaks (a more palatable risk/reward of 3.75/1 but obviously this is still a negatively skewed endeavor), not 4% . <---hope this clumsily written paragraph made sense.

 

I'd have to be at work and get in touch with the guy who follows this more closely than i, but i believe gross merger arb spreads are in the mid single digits and annualized spreads are in the range of 10-12%. So even with a decently high deal break rate, you may end up earning a nice return over the risk free rate.

 

I would disagree with the above that you have to "be right 99/100 times".

 

Ignoring that whole annualizing thing, let's look at a 6 month period. Let's say you invest across 33 deals equal weighted they have gross spreads of 4% and close in 6 months, loss of 30% on break. Each deal offers 12 bps of upside to the portfolio and 91 bps of downside. So at 4 breaks 29 wins, you lose 364 bps and make 348 bps and start to lose more after that. So you have to be right 9/10. I believe the historical merger break rate is around 10% but don't quote me. So in my contrived scenario, to really lose big you have to have a high break rate and big losses (some deals break without big losses and you always have the upside optionality of increased bids and stuff).

 

it's not cash. And it isn't that great after losses from inevitable breaks and from taxes. I'd stick with CD's, I-bonds, and actual cash for the savings account type of money.

[jawn619]

a portfolio of merger arbs is not cash, period. you are short tail risk, anything that involves shorting tail risk is not "cash". That doesn't mean it isn't a worthwhile activity, but it isn't cash.

 

it's an "uncorrelated and low beta" source of risk/reward.

 

Starting with the Shire/Abbvie break last October, which caught a lot of people off guard (chicago based board felt the heat  from the dems to not do deal even though it was legal, tax dodging and all that) and hurt a lot of event driven/merger arb guys, merger arb spreads have been unusually high. But deal breaks are high too.

 

I personally think the merger arb environment offers good risk/reward relative to other spread risks (credit, duration, etc.) but only to a non-taxable investor. But it isn't cash.

 

http://arbitragefunds.com/sites/ArbitrageFunds/files/pdf/Why_Merger_Arb_Now.pdf

 

At the end of 2014, deal spreads are annualizing at nearly 9%, according to UBS research. Accelerating market volatility and a few, high profile, terminated transactions expunged much of the speculation from the space......What makes merger arbitrage even more compelling today is the outlook for potential returns has improved significantly. Spreads on merger arbitrage deals have widened considerably since late October 2014, due in part to several high profile deal breaks and a rise in market volatility to normalized levels. At the same time, deal-making activity continues to make a strong resurgence.

 

You can think of your return on a portfolio of merger arbs over time (much like a portfolio of bonds, with defaults instead of breaks) as

 

annualized spread - (breaks/year * loss upon break)

 

note that this calculation can be a little funky, because over time your returns before losses from breaks will be the annualized spread but in the short term, your returns (and most notably your losses) will not be annualized. In other words, if you are long a merger with a 4% spread and it closes in 6 months (8% annualized) but it will return -30% on a break, the risk/reward ratio is 7.5/1 in the short term. But if you invested in a portfolio of 100 deals that had those characteristics in an infinite number of years, you'd make 8% - losses from breaks, not 4%. <---hope this clumsily written paragraph made sense.

 

I'd have to be at work and get in touch with the guy who follows this more closely than i, but i believe gross merger arb spreads are in the mid single digits and annualized spreads are in the range of 10-12%. So even with a decently high deal break rate, you may end up earning a nice return over the risk free rate.

 

I would disagree with the above that you have to "be right 99/100 times".

 

Ignoring that whole annualizing thing, let's look at a 6 month period. Let's say you invest across 33 deals equal weighted they have gross spreads of 4% and close in 6 months, loss of 30% on break. Each deal offers 12 bps of upside to the portfolio and 91 bps of downside. So at 4 breaks 29 wins, you lose 364 bps and make 348 bps and start to lose more after that. So you have to be right 9/10. I believe the historical merger break rate is around 10% but don't quote me. So in my contrived scenario, to really lose big you have to have a high break rate and big losses (some deals break without big losses and you always have the upside optionality of increased bids and stuff).

 

it's not cash. And it isn't that great after losses from inevitable breaks and from taxes. I'd stick with CD's, I-bonds, and actual cash for the savings account type of money.

 

+1

[Okta]

If you find a company which is still undervalued at the bid, invest and earn the spread.

 

You don't need to go long when the bid is double the undisturbed price. For example Precision castpart's undisturbed price was not way lower than current price.

 

As the deal risk is not fully correlated to the market, you can add a good risk adjusted return. Don't leverage.

[scorpioncapital]

To some degree it seems the reputation of the buyer is the key and the regulators. If Berkshire makes 1 public deal per year, I'd expect it to close and that he believes the odds of a regulatory issue are low. Perhaps Berkshire acquisitions can be used as an interest rate on bank cash. Are there any other buyers of this calibre in the market?

[rb]

Are there any other buyers of this calibre in the market?

No.

[Guest MarkS]

I'm with thepupil on this issue.I remember looking at pending deals during the credit crises of 2008. It was butt ugly - a lot of tail risk.

Thanks

Mark

[VersaillesinNY]

The “Risk” in Risk Arbitrage by John Paulson

 

http://iamgroup.ca/doc_bin/The%20Risk%20in%20Risk%20Arbitrage.pdf

 

Risk arbitrage is not about making money, it’s about

not losing money

The_Risk_in_Risk_Arbitrage.pdf

[boilermaker75]

I occasionally do risk arbitrage plays. I always do it by writing puts on the company being acquired. That way I set the date when the trade closes. I usually want an all-cash deal for the acquisition. The put premium has to be good and I have to have confidence there is small chance of anything happening before the put I sold expires.

[jawn619]

no

[Gamecock-YT]

Was it greenblatt that said it's like picking up pennies in front of a steamroller?

[boilermaker75]

In his partnership days Buffett made much use of risk arbitrage, which he referred to as workouts, as did Ben Graham.

[rb]

In his partnership days Buffett made much use of risk arbitrage, which he referred to as workouts, as did Ben Graham.

Workouts continued at Berkshire for a long time until Berkshire got too big for them to matter.

[scorpioncapital]

Is there someone out there with a longer term experience in merger arbitrage that has ever experienced a company to sell an asset in a country that denied it anti-trust clearance or that it took too long and that one country held up the merger even if it was approved in the other jurisdictions? In other words, do countries have claims on anti-trust clearance for only the assets of the company within that country?

 

 

[compounding]

In his partnership days Buffett made much use of risk arbitrage, which he referred to as workouts, as did Ben Graham.

 

And if your name is Warren Buffett circa 1964 it's probably a good idea to do some risk arbitrage.

 

Not sure what relevance it has for John Doe in 2015.

 

If you want to think about this I think you need to approach it the way thepupil is; like an investment like any other. Which btw includes the fact that there are competing investors also looking to find good risk-adjusted returns.

[Hielko]

In his partnership days Buffett made much use of risk arbitrage, which he referred to as workouts, as did Ben Graham.

 

And if your name is Warren Buffett circa 1964 it's probably a good idea to do some risk arbitrage.

 

Not sure what relevance it has for John Doe in 2015.

 

If you want to think about this I think you need to approach it the way thepupil is; like an investment like any other. Which btw includes the fact that there are competing investors also looking to find good risk-adjusted returns.

And that wasn't the case in 1964?

[compounding]

In his partnership days Buffett made much use of risk arbitrage, which he referred to as workouts, as did Ben Graham.

 

And if your name is Warren Buffett circa 1964 it's probably a good idea to do some risk arbitrage.

 

Not sure what relevance it has for John Doe in 2015.

 

If you want to think about this I think you need to approach it the way thepupil is; like an investment like any other. Which btw includes the fact that there are competing investors also looking to find good risk-adjusted returns.

And that wasn't the case in 1964?

 

Of course there was. Your point?

[randomep]

 

 

Anybody participating in the Anthem/Cigna or Humana/Aetna mergers? or have something intelligent to say about them?

[dabuff]

The last no-brainer M&A investment I can remember personally was DTV - you could easily get the stock at an undervalued price with the upside of the acquisition.

[boilermaker75]

The last no-brainer M&A investment I can remember personally was DTV - you could easily get the stock at an undervalued price with the upside of the acquisition.

 

That was the last one I did also. I would write short-term puts, and covered calls whenever I was put to. End of July 2014 I wrote my first put and midi-April 2015 I wrote my last covered call.

[Jurgis]

What do you guys think about CVC?

[boilermaker75]

What do you guys think about CVC?

 

I haven't looked at any merger plays since DTV. A quick glance at the CVC options indicate no activity. So the way I would play a merger arbitrage will not work with CVC at this point.

[bcvaluation]

How about the PFE/AGN merger?  Has anyone given it any consideration?  My gut-shot feeling is that there is a good deal of headwind against the chances of it going through.  Tax-inversions are politically unpopular.  Anti-trust is also a big concern.