Discussing risk arbitrage in his book “You Can Be a Stock Market Genius: Uncover the Secret Hiding Places of Stock Market Profits,” Joel Greenblatt (Trades, Portfolio) titled chapter three “Don’t Try This at Home” and later compared the strategy to running around the house with scissors.
He was positive, though, about merger securities, the second topic in the chapter.
Starting with risk arbitrage, this involves buying stock in a company that is subject to a takeover or merger; most often, entry is made after the potential deal has been announced. We’ve all seen the announcements in which an acquiring company proposes to pay a premium for the shares of a takeover candidate.
A risk arbitrageur buys shares in the target at its current price and hopes to make a quick and substantial profit if the deal goes through. Nice work if you can get it, but the arbitrageur takes on two significant risks:
- The deal is broken off for some reason. When this happens, and it can happen for many reasons, the share price does not go up and, in some cases, disappointment about the break leads many investors to sell their shares, depressing the price below the price paid (the formerly “normal” price).
- Timing. It can take anywhere from one to 18 months for a merger deal to go through. When the time value of money is considered, the return may be low or even non-existent.
Another lesser problem with arbitrage is it requires close attention by the trader. Many things can happen that will scuttle or delay a deal, and a trader must stay on top of them constantly.
In April 1985, Greenblatt got involved in one of his first arbitrage deals, one which saw publisher and the owner of SeaWorld SEAS, Harcourt Brace Jovanovich, announce a friendly merger with Florida Cypress Gardens. Odds were reasonably high that the merger would go through.
After the proposal was announced, Cypress shares popped from $4.50 to $7.50, but there remained an 80-cent premium because the deal with Harcourt was worth $8.30. If the deal closed in three months, the return would work out to almost 50% on an annualized basis. If the deal failed, Greenblatt would have taken a loss of $3 as the stock price fell back to its original $4.50.
The author takes readers through all the myriad details of an arbitrage position in a merger deal, but bottom line, he expected the deal to go through and to make a profit.
A few weeks before the deal was scheduled to close, though, his optimism fell like a stone. Cypress Gardens’ main pavilion had literally dropped into a sinkhole. That would mean a significant decline in revenues, uncertainty about insurance coverage—and a potential delay or even cancellation of the merger.
Greenblatt was left looking at the potential of Cypress stock falling to $2.50 from $7.50, a very big risk in relation to the anticipated return of 80 cents. As it turned out, he lost about $1 on his $7.50 investment and was greatly relieved he hadn’t lost much more.
Merger securities
When one company buys another, the currency is normally cash or shares of the acquiring company. But in some circumstances, a company may also add some kind of bonds, preferred stocks, warrants or rights. When they are used, these “merger securities” tend to make up only a small portion of the deal. Why use them at all? Because the acquiring company can no longer tap into equity or debt markets enough to cover the full cost of the deal.
This was the type of security that won Greenblatt’s endorsement.
Most investors don’t know what to do with these securities, so they sell them as soon as they receive them. Institutional investors often sell them right away because these new securities are outside their official mandates (purely stock or bond portfolios, for example). As is the case with spinoff companies, such securities are often available at bargain prices.
One case study for merger securities was Super Rite Foods, a grocery chain being spun off from drugstore operator Rite Aid Corp. RAD in 1989. In what amounted to a leveraged buyout offer, the management group of Super Rite proposed paying $18 in cash and $5 in the form of a new preferred stock that paid dividends of 15% per year. This would turn Super Rite into a private company.
The deal sailed into rough waters when other investors and groups also expressed interest in buying the grocery chain. That led to an auction in which the management group prevailed, but now its offer had ballooned to $25.25 in cash, $2 in the new preferred shares yielding 15% and warrants to buy into the new private company.
Greenblatt took notice of the warrants. Once again, the herd and institutions sold off their warrants and preferreds at discount prices. Had they done their homework and read the proxy, they would have learned that a new customer would add millions per year in new revenue.
The outcome of it all? Two years after the deal closed, Super Rite went public. Warrants that were available at $6 after the original deal were worth more than $40. Preferred shares that had been available for 50% to 60% of face value after the original deal rose to 100% of face value (and their holders had received 15% per year for two years).
Greenblatt summed up his experience with risk arbitrage by noting, “Too many things have to go right too often.” Most deals do close, but one bad deal can do serious damage. As for merger securities, he gives them a thumbs up, but warns it is very important to do your homework, to read and understand the information in the documents that come with the deal.
Disclosure: I do not own shares in any company listed, and do not expect to buy any in the next 72 hours.
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