Merger Arbitrage And Value Investing by John Szramiak was originally published on Vintage Value Investing

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Warren Buffett is famous for his long-term investment strategy. In fact, his favorite holding period is forever.

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Mergers
Image source: The Blue Diamond Gallery

But what many people don’t know is that Buffett often engaged in some very short-term investing, especially in his early partnership days.

He called this type of investing “workouts”.

Workouts, also sometimes called “special situations,”  includes things such as merger arbitrage, spinoffs, carveouts, and reorganizations.

Here’s what Warren Buffett had to say about workouts from his 1964 letter.

Workouts – These are securities with a timetable. They arise from corporate activity – sell outs, mergers, reorganizations, spinoffs etc. In this category we are not talking about rumors or “inside information” pertaining to such developments, but to publicly announced activities of this sort. We wait until we can read it in the paper. The risk pertains not primarily to general market behavior (although that is sometimes tied in to a degree), but instead to something upsetting the applecart so that the expected development does not materialize. Such killjoys could include anti-trust or other negative government action, stockholder disapproval, withholding of tax rulings, etc.

The gross profits in many workouts appear quite small. It’s a little like looking for parking meters with some time left on them. However, the predictability coupled with a short holding period produces quite decent average annual rates of return after allowance for the occasional substantial loss. This category produces more steady absolute profits from year to year than generals do. In years of market decline it should usually pile up a big edge for us; during bull market it will probably be a drag on performance. On the long term basis, I expect the workouts to achieve the same sort of margin over the Dow attained by generals.

Special situations are a staple of Seth Klarman‘s investing strategy. And Benjamin Graham also invested in workouts, and these types of investments were a big reason why both Benjamin Graham and Warren Buffett were so successful in their early days.

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Let’s zero in on merger arbitrage (also sometimes called risk arbitrage), which is an investment strategy that you can start using today.

What is a Merger?

Before we talk about merger arbitrage, let me quickly explain what a merger is.

Technically, a merger occurs when two companies combine into one new company (Company A + Company B = Company C). An acquisition occurs when one company buys another company (Company A + Company B = Company A including B). But don’t get hung up on the details here – merger arbitrage applies to both mergers and acquisitions.

Companies buy each other all the time. They do this to increase their scale, their profits, to improve their competitive positioning, or sometimes – in the case of bad corporate governance – just to feed the egos of executive management.

Note that these mergers can involve both public (i.e. listed on the NYSE, Nasdaq, or another stock exchange) or private companies. We can only use merger arbitrage when public companies are involved (you’ll see why below). Let’s continue.

The Merger/Acquisition Process

Here’s an example from Lélian Girard over at MergerArbitrages.com of what happens during a typical acquisition:

Public Company A makes an offer to acquire the shares of Public Company B for $65/share. Before the announcement, the shares of Company B were trading at $50/share. Upon the news release, Company B’s shares immediately shoot up to $60/share.

But wait!

Why didn’t Company B’s shares shoot up to $65/share? After all, Company A said they’d buy them for $65/share, not $60/share.

Well, the announcement of a merger and the actual closing of a merger are two different things.

As Lélian explains:

When a merger is announced, it only means that two companies have come to an agreement to combine and have signed a legally binding contract (the merger agreement) to this effect. However, similarly to when you sign the paperwork to buy a house and leave a deposit, the house is not actually yours until the transaction closes and legal ownership documents are established. Until that’s the case, you can back out if you’re willing to lose your deposit (and upset your realtor). The same is true for a corporate transaction, except that even if the two companies do not change their minds, a few other things could go wrong and get in the way of a transaction.

For one, that both the companies’ executives and Boards want to pursue the transaction does not mean that the shareholders do; and after all, they’re the ones owning the businesses, so any transaction can be blocked by them if it doesn’t get enough votes in support of it (usually 50% of the shares outstanding). In addition, mergers can also fall apart if they are blocked by regulators due to antitrust (competition) concerns, or if one of the companies gets pulled in another transaction by a third-party.

The spread between the agreed upon acquisition price and the price that the target’s stock shoots up to is the market’s assessment of the risk that the merger won’t actually close.

This is when merger arbitrage comes into play.

What is Arbitrage?

Arbitrage is the practice of taking advantage of a price difference between two or more markets and striking a combination of matching deals that capitalize upon the imbalance, with the profit being the difference between the market prices.

For example, say you can buy an iPad in the U.S. for $500. However if you go to Japan, iPad’s are selling for $600 (ignore currency translations here). If shipping from the U.S. to Japan only costs $50, then you can buy an iPad in the U.S. for $500, pay $50 for shipping, and then sell it in Japan for $600. You would have paid $550 in total and received $600. Your profit is a risk-free $50!

If you were rational you would do this as much as you can – you would mortgage your house and sell your kids – and keep doing this arbitrage until the prices even out (because you’re buying so many iPads, you will increase the demand for iPads in the U.S. which would cause the price to increase from $500; and because you’re selling so many iPads, you would increased the supply of iPad’s in Japan which would cause the $600 to decrease).

Of course, this is just an academic example but you get the idea.

We can do the same thing with mergers.

So going back to our previous example, if we’ve done our analysis and we believe with very high probability that the acquisition will indeed close, then we can buy Company B’s shares for $60 right now, and then Company A will buy them from us for $65 when the acquisition closes. Our profit will be $5. The only risk is that the deal falls through and that Company B’s shares fall back to $50 (what they were trading at before the merger announcement). In that case, we would lose $10.

Types of Mergers

Acquisitions aren’t always paid for the same way. What I’m talking about here is called the “consideration,” which

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