The original article was written by Jack Lyons.

Done well, risk arbitrage has the potential to generate enormous returns for a skilled investor. Done poorly, however, the strategy is more akin to picking up nickels in front of a steamroller.

Just how high are the returns we’re talking about?

Consider that it’s pretty common to make a 5% capital gain in less than a month. That 5% gain amounts to an annualized 60% return. But, this does not factor in compounding. If you could compound $1000 at 5% month over month for an entire year, that initial investment would net an $800 capital gain, for an 80% yearly return.

But those returns are not risk free – far from it. In this article, we’ll dig deeper into the strategy and explain the nuances that most lay investors may miss.

Risk Arbitrage Investing Defined: What’s The Meaning of Risk Arbitrage?

Seth Klarman is considered one of the best value investors of all time, and he’s well versed in the world of special situation investing. In his book Margin of Safety, Klarman introduces the meaning of risk arbitrage and discusses the philosophy behind the strategy:

“Risk arbitrage differs from the purchase of typical securities in that gain or loss depends much more on the successful completion of a business transaction than on fundamental developments at the underlying company. The principal determinant of investors’ return is the spread between the price paid by the investor and the amount to be received if the transaction is successfully completed. The downside risk if the transaction fails to be completed is usually that the security will return to its previous trading level, which is typically well below the takeover price.”

Now you should be clear about the risk arbitrage meaning. When you hear risk arbitrage or merger arbitrage, or even merger risk arbitrage, remember that they’re basically discussing the same thing.

Risk arbitrage investing is an extremely specialized form of value investing. The point of the strategy is that following the announcement of a merger or acquisition, the acquiree’s share price tends to immediately increase to a level within a few percentage points of the acquisition price.

“Risk arbitrage is a highly specialized area of value investing. Arbitrage … is a riskless transaction that generates profits from temporary pricing inefficiencies between markets. Risk arbitrage, however, involves investing in far-from-riskless takeover transactions. Spinoffs, liquidations, and corporate restructurings, which are sometimes referred to as long-term arbitrage, also fall into this category.”

As Klarman suggests, risk arbitrage investing can be thought of as a separate branch of value investing. While the majority of value investing strategies are based on long-term, buy-and-hold fundamentals, risk arbitrage investing does not depend on these basics. Because there is a predefined execution date for a merger, there is a natural catalyst already built into this strategy.

Of course, the inclusion of the word “risk” in the title “risk arbitrage investing” highlights the point that the opportunity to make money from the strategy is by no means guaranteed. As with any type of investment strategy, the risk of failure exists. This makes risk arbitrage investing distinct from a true arbitrage situation, whereby profit can be made with zero risk. Such opportunities rarely arise in investing, and risk arbitrage investing should not be mistaken for a strategy that provides guaranteed returns.

Risk Arbitrage Investing & “The Risk Arb Spread”

However — and key to this strategy — the price of the acquiree will rarely move up all the way to the full price to be paid by the acquirer for each share. This leaves a “spread” between the current price of the stock and the price to be paid by the acquirer, should the event take place. Usually, the price will move to somewhere between 90%-95% of the proposed deal price. This leaves the risk arbitrage investor with the opportunity to purchase the stock at this point and make the remaining 5%-10%. By being able to differentiate between an ultimately successful and unsuccessful future merger, a risk arb investor can potentially make excellent returns.

In addition to this, because the merger is unrelated to the day-to-day movements of the stock market, risk arbitrage investing is uncorrelated with stock market movements. This makes the strategy an excellent form of diversification within a portfolio.

The danger, as alluded to above, is that an announced deal fails to take place. In this scenario, when a deal is announced, an acquiree’s stock price often rises close to the deal price, as mentioned previously, say from $15 to $19 on a deal worth $20 per share. If the deal falls through, the price of the acquiree’s stock can drop back down to the preannouncement stock price. So, in the above example, a purchase at $19 with the hopes of collecting $1 can lead to a $4 loss. That can wipe out a significant portion of the risk arb gains made throughout the year.

Because of this, a key consideration – and in our view the chief consideration – when evaluating a merger deal is assessing the likelihood that a deal will go through. While you can never determine whether a deal will be successful with 100% certainty, you should be able to put rough odds on the outcomes beforehand, and those odds better significantly line up in your favour.

Some Examples Of Risk Arbitrage Investing

A simple example of a potential risk arbitrage investing opportunity is as follows:

  • Company B has a share price of $5.
  • Company A announces that A & B have agreed on a merger whereby A will buy B for $10 per share.
  • Company B’s share price immediately jumps on the news to $9 per share — the price does not move all the way to $10, as the market perceives there is a small risk that the merger won’t ultimately take place.
  • At this point, Mr. Arb, a risk arbitrage enthusiast, purchases the share at $9, in the hope that he can sell it for $10 once Company B pays up for the shares.

The above is a simplified example of how a risk arbitrage opportunity might arise. However, why take my word for it when one of the masters of value investing is on hand to provide his own example?:

“The December 1987 takeover of Becor Western Inc. by B-E Holdings Inc. fits this description. In June 1987 Becor sold its aerospace business for $109.3 million cash. This left the company with $185 million in cash (over $11 per share) and only $30 million in debt. The company also operated an unprofitable but asset-rich mining machinery business under the Bucyrus-Erie name.The offer by B-E Holdings to buy Becor Western was the last in a series of offers by several suitors. The terms of this proposed merger called for Becor holders to receive either $17 per share in cash or a package of the following:$3 principal amount of 12.5 percent one-year senior notes in B-E Holdings;$10 principal amount of 12.5 percent fifteen-year senior debentures in B-E Holdings;0.2 shares preferred stock in B-E Holdings, liquidation preference $25; and0.6 warrants to buy common stock in B-E Holdings at $.01 per share.A maximum of 57.5 percent of Becor shares was eligible to receive the cash consideration. Assuming that all stockholders elected to receive cash for as many shares as possible, each would receive per share of Becor owned:$9.775 cash$1.275 principal amount one-year notes$4.25 principal amount fifteen-year debentures .085 shares preferred stock.255 warrants……The shares were a real bargain at $10……As it turned out, the merger consideration was worth about $14.25 at market prices. Becor shares had declined in the wake of a broad market rout to a level below underlying value, creating an opportunity for value investors.”

While the company in the example provided by Klarman was significantly undervalued by other methods of valuation, this will often not be the case when researching companies as part of a risk arbitrage investing strategy. Risk arbitrage investing can — and should — be thought of as a stand-alone strategy. While, of course, it is advantageous for a stock to be desirable from more than one perspective — for example, a company is subject to an impending takeover, while also being a net net — the two strategies are very different and need not be considered together.

Risk Arbitrage Opportunities Can Vary In Nature

With this example, Klarman identified a merger arbitrage opportunity with a very wide spread. Often, this can be the case when the market believes that there is very little chance of the merger going ahead. However, and what seems to have been the case in this stage, a general depression in stock prices at the time had also caused a decrease in Becor Western Inc.’s share price. Of course, when a company is in the midst of being acquired, it would seem irrational to think that market movements should affect its share price. However, as we well know, the market is not always a rational machine, and when it provides us with free money, we should accept it.

To sign off on his discussion of risk arbitrage investing, Klarman reminds us why it is that merger arbitrage investing — like all other winning value investing strategies — works:

“It is important to recognize that risk-arbitrage investing is not a sudden market fad like home-shopping companies or closed-end country funds. Over the long run, this area remains attractive because it affords legitimate opportunities for investors to do well. Opportunity exists in part because the complexity of the required analysis limits the number of capable participants. Further, risk arbitrage investments, which offer returns that generally are unrelated to the performance of the overall market, are incompatible with the goals of relative-performance-oriented investors. Since the great majority of investors avoid risk arbitrage investing, there is a significant likelihood that attractive returns will be attainable for the handful who are able and willing to persevere.”

As Klarman says, the tendency for investors to avoid what they don’t understand leaves an opportunity for value investors who do their homework. While risk arbitrage investing is not the most straightforward of strategies, it is by no means impossible to master. And, as Klarman points out, the fact that investors often do not engage in the strategy makes opportunities in the area timeless. The fact that many investors choose not to engage with the strategy, like with many other types of value strategies, means that money is being left on the table by the market. This alone makes the strategy at least worth investigating.

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