Merger arbitrage specialists trade on the probability of merger deals happening (or falling through), seeking to extract a sliver of trading alpha from a supposedly efficient market. While Berkshire Hathaway (BRK.A, Financial)(BRK.B, Financial) is out buying companies, arbitrageurs make the high-stakes bets on whether those buyouts will succeed.
The high-intensity world of merger arbitrage attracts all sorts of interesting investment professionals, from a host of ersatz backgrounds. Roy Behren got his start in securities law enforcement, spending seven long years at the Securities and Exchange Commission's New York office, before bringing his sharpened legal and analytical skills to the private sector.
As a managing director of Westchester Capital Management, a merger specialist, Behren has been at center for many impressive arbitrage plays and has developed a number of principles that any would-be arbitrageur must take to heart.
Bet on home runs, not last-mile trades
Mergers happen all the time, but the opportunities for extracting trading alpha from such events do not. Behren is well aware of this fact and is especially eager to caution investors to avoid getting sucked into trades with limited upside:
“Nor will we play what we call ‘Last Mile Trades,’ which involve taking positions in deals that are almost certain to happen - ones with four or five days to closing that you can maybe make a nickel in. To us, the asymmetric optics of buying a position to make a nickel when - God forbid - something could go wrong and you’d lose $8.”
It may seem like a surer thing to only bet on deals that are near completion since that tends to de-risk the trade. Unfortunately, such “last-mile trades” still carry considerable downside risk. Even a seemingly sure deal can fall apart at the last minute. Picking up small wins on sure bets can work for a while, but the gains from such a strategy can often be erased by a single bad trade.
According to Behren, the seemingly de-risked late-stage trades offer little long-term alpha. Instead, the key to success is to find deals that offer significant rewards, given the inherent risks to merger and arbitrage uncertainty. In other words, coming to terms with the risks inherent to merger arbitrage is a crucial prerequisite for success.
Deals will fall apart from time to time, but the upside from home run trades will make up the difference in a way safe base hitting never could.
Squeeze out directional exposure for absolute return
The world does not stop when a merger is announced or when deal terms are being negotiated. Stock prices fluctuate and the market keeps moving. That can be a problem for mergers, and can impact an arbitrageur’s returns substantially if not dealt with appropriately. Behren’s strategy is to always squeeze out directional exposure:
“The important thing for us is to squeeze out any directional exposure. Our goal in managing the merger-arbitrage portfolio is to create a market-neutral vehicle to provide absolute return for our investors.”
That may sound a bit esoteric to the layman, and even to the traditional class of long-only investors (value-oriented or otherwise). Thankfully, Joseph G. Nicholas of the HFR Group has offered a straightforward explanation of how a market-neutral trade can be set up:
“Market-neutral investing refers to a group of investment strategies that seek to neutralize certain market risks by taking offsetting long and short positions in instruments with actual or theoretical relationships. These approaches seek to limit exposure to systemic changes in price caused by shifts in macroeconomic variables or market sentiment.”
Westchester Capital, like most merger arbitrage shops, employs these sorts of tools regularly in order to make their trades market-neutral and lock in the absolute return. Anyone who wants to get into the arbitrage game needs to understand them intimately. They are not necessarily always ideal for maximum returns on a given opportunity, but they do effectively crowd out risks not directly associated with the merger itself. It has become the industry's best practice for a reason.
Diversify and pay attention to position sizing
While betting on potential arbitrage home runs will increase an investor’s upside potential, it also exposes them to greater risk in the event disaster strikes. Behren’s approach to dealing with this issue is rather straightforward:
“Inevitably there will be broken deals. There will be fraud at a company, there may be a natural disaster - anything can happen...We deal with that by limiting our position sizes and properly diversifying.”
This is a universal principle that can and should be applied to every portfolio strategy. Investors should diversify their holdings across industries and asset classes in order to protect themselves from economic shocks, as well idiosyncratic risks unique to particular securities. Even the most dogmatic of value investors, who by and large have fewer-than-average stocks in their portfolios (thanks to their being carefully and deliberately chosen by the investor), usually accept that a certain level of diversification is good for overall financial health.
In many ways, this is Investing 101, yet it is a trap to which many investors fall prey. Inadequate risk mitigation through periodic resizing and thesis reappraisal can lead to portfolios facing inordinate levels of exposure to narrow, often idiosyncratic, risks. This is even truer of merger arbitrage opportunities, in which the downside risk can be as frightening as the upside benefit is enticing.
Investors would be wise to heed Behren’s call for caution, especially when it comes to playing around with merger arbitrage. One bad trade can annihilate a successful track record and one spectacular failure can sink a portfolio. Investors must approach such opportunities with extreme caution and be prepared for occasional losses. These are inevitable, even for the best in the business.
Verdict
Only the sharpest minds and sturdiest nerves can win in this particular game, and Behren is rightly counted among the best. He has witnessed first-hand what it takes to succeed in the merger arbitrage game.
Any investors who seriously want to pursue merger trade opportunities should heed Behren’s advice.
Disclosure: No positions.
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