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John Engle
John Engle
Articles (332) 

Martin Gruss on the Art of Risk Arbitrage

A lifetime in the trenches has offered up some valuable insights

June 10, 2019

Founded by Joseph Gruss in the 1940s, Gruss Capital Management looms large in the world of risk arbitrage. The asset manager was an early pioneer of the investment technique and has remained an influential player for several decades. Many arbitrage greats, such as John Paulson (Trades, Portfolio), got their start at Gruss.

Gruss' son, Martin, was literally born into the world of risk arbitrage and proved a worthy successor when he eventually took the reins at the firm. Over the course of a lifetime in the field, the younger Gruss has developed a deep well of knowledge and insight, some of which he shared with the authors of the recently published "Merger Masters: Tales of Risk Arbitrage." His advice is essential reading for anyone interested in exploring the arbitrage game.

Focus on low-risk deals with free upside

Discipline was a key lesson Gruss learned early on, one he carried throughout his investing career. One of the methods he employed in sorting through potential arbitrage opportunities was to look for a very particular kind of situation:

“Focus on finding a free call. If you were risking a really small sum of money but there was a chance for the bid to be increased, we liked to load up.”

A free call option can emerge when a deal has two key characteristics. First, it is almost certain to go through at some price. Second, the offer price is likely to be raised before the deal closes. Thus, there is some mitigation of downside risk in the form of deal certainty, while the upside comes from the potential increase in buyout price. These opportunities are exceptional because they allow an arbitrageur to remain fundamentally risk-averse even when significantly leveraged.

Watch out for macro troubles

Risk arbitrage is a strategy that demands extremely narrow focus. As we mentioned in a recent discussion of Roy Behren’s guide to merger arbitrage, arbitrageurs usually endeavor to squeeze out directional risk. While this downside risk protection can work during stable markets, it becomes more challenging when the broader market turns negative. Gruss contends that keeping a close eye on the macro situation is absolutely critical:

“There were times we would not like where it looked like the market was going and so we’d get out. Which is important, because all boats - yachts and rowboats - go down together in a severe market decline. And if you’re highly leveraged, you’ll be carried out.”

Gruss has practiced watch he preaches. By paying attention to signs of trouble in the broader market and economy, he was able to carry his firm through the last three market downturns - 1987, 2000 and 2008 - largely unscathed. If you want to employ a risk arbitrage strategy, especially if you do it with significant leverage, take the necessary time to sense where the market is moving and stay away from deals - even enticing ones - when things get even slightly dicey at the macro level.

Be aware of the human element in every deal

In our world of algorithmic trades and computerized liquidity, it is often easy to forget that the market is ultimately a human-centric pursuit. Animal spirits still run hot and cold, pulling stocks – and whole markets – hither and thither. According to Gruss, this market psychology runs to the very heart of merger arbitrage:

“There’s no such thing as a ‘sure thing’ and deals can break for a whole host of reasons - which can’t be foreseen. What’s more, my experiences also taught me that the insiders very often don’t know how it will turn out. Deals get done by human beings, and human beings can be fickle. Attitudes can turn on a dime. So much so that maybe a degree in psychology would be good preparation for risk arbitrage.”

Perhaps Gruss overstates things a bit when he suggests a formal education in psychology is the best preparation for success in the field, but he is certainly not wrong that an understanding of – and appreciation for – the vicissitudes of human emotion and irrationality are every bit as important as a knowledge of structured finance.

Ultimately, mergers are complex, psychologically fraught affairs. Arbitrageurs ignore them at their peril.

Disclosure: No positions.

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About the author:

John Engle
John Engle is president of Almington Capital - Merchant Bankers. John specializes in value and special situation strategies. He holds a bachelor's degree in economics from Trinity College Dublin and an MBA from the University of Oxford.

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