He considers that arbitrage is sometimes more promising in terms of greater returns than Treasury bills. In fact, during 1988 he made unusually large profits from arbitrage.
Of course, the activity level requires some discussion about arbitrage.
At some point in time, arbitrage was applied only to simultaneous purchase and sale of securities or foreign exchange in two different markets. The goal at that moment was to exploit insignificant price differentials that might exist, supposedly, in the trading of stock in guilders, pounds and dollars.
There are those who call this operation scalping. However, practitioners decided that the French term would fit better.
Since WWI, arbitrage, or also called “risk-arbitrage,” has expanded to include the search of profits from a corporate event such as the sale of the company, a merger, recapitalization, reorganization, liquidation, self-tender, etc.
Mostly, the arbitrageur tries to obtain profit without considering the stock market’s conduct. There is a major risk: the announced event will not take place.
Most arbitrage-related operations involve friendly and unfriendly takeovers. Arbitrageurs have profited substantially from out-of-control acquisition fever, with nearly nonexistent anti-trust challenges and with bids moving upwards.
In Wall Street they use an old proverb regarding arbitrage which has been reworded:
“Give a man a fish and you feed him for a day. Teach him how to arbitrage and you feed him forever.”
Arbitrage situations can be evaluated by answering four questions:
(1) How likely is it that the promised event will indeed occur?
(2) How long will your money be tied up?
(3) What chance is there that something still better will transpire — a competing takeover bid, for example?
(4) What will happen if the event does not take place because of anti-trust action, financing glitches, etc.?
Buffett has a particular arbitrage experience that is worth describing. More than particular, erratic.
In 1981, Arcata’s BOD agreed to sell the company to Kohlberg Kravis Roberts & Co. (NYSE:KKR), a major leveraged-buyout firm.
Arcata's activities were mainly focused on the printing and forest products businesses. They had one thing anyway. In 1978 the government of the United States took title to almost 10,700 acres of Arcata timber to expand the Redwood National Park.
In exchange for the acres, the U.S. government paid Arcata $97.9 million in several installments. For Arcata this amount was inadequate. They not only contested the amount but they also disputed the interest rate applicable to the period between taking the property and the final payment.
Legislation at that time stipulated 6% of simple interest. Arcata’s directors were extremely disappointed because they wanted a much higher and compounded rate.
The purchase of a company having a large-sized and speculative claim in litigation is somewhat difficult.
To solve this problem, KKR offered $37.00 per Arcata share plus two-thirds of any additional amounts paid by the government for the lands.
Buffett needed to appraise the arbitrage opportunity and for such purpose, he and his team asked themselves whether KKKR would complete the transaction, as its offer was contingent upon obtaining “satisfactory financing.”
This type of clause is always a danger for the seller. However, Buffett was not concerned about the situation because KKR records on closing were good.
There was something else that Buffett and his team had to analyze: What would happen if the KKR deal failed? Arcata’s managers were determined to find another interested party. Indeed, Arcata had been offered for some time.
Finally, Buffett needed to know what the claim would be worth. The team evaluated the claim.
Buffett started to buy Arcata stock. The purchase price was around $33.50. In eight weeks, Buffett and his team had bought 400,000 shares, or 5% of the company.
The initial announcement said that the $37.00 would be paid in January 1982. If everything had gone perfectly, Buffett would have achieved an annual rate of return of about 40% — not counting the redwood claim.
Unfortunately not everything went as expected. In December, Arcata announced that the closing would be delayed. But, a definite agreement was entered into in January.
With this piece of news, Buffett decided to buy more shares, thus totaling 655,000 or 7% of the company.
Buffett’s intention to pay although the closing had been postponed was risky.
In February the lenders decided to give a second look to financing terms upon a severe depression in the housing industry and its impact on Arcata's outlook. The stockholders' meeting was postponed again, to April.
Arcata’s spokesman announced that the fate of the acquisition was in danger.
When arbitrageurs hear such reassurances, their minds flash to the old saying: "He lied like a finance minister on the eve of devaluation."
The final message of this story is that merger arbitrage is risky. Even Warren Buffett lost money on it and one should exersize lots of caution in analyzing potential merger closings.