Merger Arbitrage is Like Credit Analysis

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Merger Arbitrage is Like Credit Analysis

Merger Arbitrage is Like Credit Analysis

From a Reader:

I’ve mentioned this before but I’m an avid reader of the blog. I’m currently going through your old posts one by one and learning a lot. Yours is one of 2 or 3 other blogs that I am reading the archives… thanks for spending so much time sharing.

David Einhorn: This NJ Deli With One Location And Little Revenue Is Trading At $100M+ Valuation

david einhorn, reading, valuewalk, internet, investment research, Greenlight Capital, hedge funds, Greenlight Masters, famous hedge fund owners, big value investors, websites, books, reading financials, investment analysis, shortselling, investment conferences, shorting, short biasIn his first-quarter letter to investors of Greenlight Capital, David Einhorn lashed out at regulators. He claimed that the market is "fractured and possibly in the process of breaking completely." Q1 2021 hedge fund letters, conferences and more Einhorn claimed that many market participants and policymakers have effectively succeeded in "defunding the regulators." He pointed Read More


My question is about arbitrage (tenders and merger arb). I’ve been reading through Buffett’s old letters and in the late 1980’s he had quite an impressive run with his arbitrage investments (I think in 1987 he made around 80% on his arb investments).

Both he and Graham seem to have had long time success for decades using merger arb and other arbitrage techniques. I’m wondering if you ever employ any of these strategies in your portfolio? It seems like a specialized area, but also seems like an area that would add uncorrelated returns to the portfolio, and serve as a great substitute for cash when markets begin to become overvalued.

Would love to hear your thoughts on merger arb if you have time…

I did small deal merger arb for two years 1998-1999 and took some losses in the process.  On the whole I made money, but:

  • Merger arbitrage is a lot like credit analysis. Analyze why the deal might not go through.  Your upside is capped, but your downside is unlimited.

  • Only work with binding commitments.  Do not speculate on “letters of intent.”
  • Do not speculate on mergers that the media cooks up.
  • Merger arbitrage is an “over-fished” area of the market.  The regular gains from it have been competed down to low yields.

When Warren Buffett was doing merger arbitrage, few were doing it. That’s why he did so well then, though it was a small part of his strategy from an asset standpoint.

You are picking up nickels in front of a steamroller when you do this, so  don’t deceive yourself into thinking this is a low-risk venture.  This is a mature area of investing, with a lot of clever competitors.

One final note: this is not as uncorrelated as you think. Merger Arbitrage is highly correlated to the credit cycle, because most mergers require credit to fund the purchase.  Also, many funds that do merger arbitrage consider fixed income investments as an alternative.

So be wary here… there is no free lunch.

By David Merkel, CFA of Aleph blog

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David J. Merkel, CFA, FSA — 2010-present, I am working on setting up my own equity asset management shop, tentatively called Aleph Investments. It is possible that I might do a joint venture with someone else if we can do more together than separately. From 2008-2010, I was the Chief Economist and Director of Research of Finacorp Securities. I did a many things for Finacorp, mainly research and analysis on a wide variety of fixed income and equity securities, and trading strategies. Until 2007, I was a senior investment analyst at Hovde Capital, responsible for analysis and valuation of investment opportunities for the FIP funds, particularly of companies in the insurance industry. I also managed the internal profit sharing and charitable endowment monies of the firm. From 2003-2007, I was a leading commentator at the investment website RealMoney.com. Back in 2003, after several years of correspondence, James Cramer invited me to write for the site, and I wrote for RealMoney on equity and bond portfolio management, macroeconomics, derivatives, quantitative strategies, insurance issues, corporate governance, etc. My specialty is looking at the interlinkages in the markets in order to understand individual markets better. I no longer contribute to RealMoney; I scaled it back because my work duties have gotten larger, and I began this blog to develop a distinct voice with a wider distribution. After three-plus year of operation, I believe I have achieved that. Prior to joining Hovde in 2003, I managed corporate bonds for Dwight Asset Management. In 1998, I joined the Mount Washington Investment Group as the Mortgage Bond and Asset Liability manager after working with Provident Mutual, AIG and Pacific Standard Life. My background as a life actuary has given me a different perspective on investing. How do you earn money without taking undue risk? How do you convey ideas about investing while showing a proper level of uncertainty on the likelihood of success? How do the various markets fit together, telling us us a broader story than any single piece? These are the themes that I will deal with in this blog. I hold bachelor’s and master’s degrees from Johns Hopkins University. In my spare time, I take care of our eight children with my wonderful wife Ruth.

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