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Risk Arbitrage – Back To The ’80s?

By: Hanif Mamdani

The term ʻrisk arbitrageʼ often evokes memories of infamous characters such as Ivan Boesky who dominated the merger arbitrage scene in the 1980s. Despite this connotation, it may be time to revisit the world of risk arbitrage given todayʼs robust environment for mergers and acquisitions and heightened interest among pension plans in market-neutral strategies.

Some background first.

In ancient Rome, merchants grew wealthy transporting silver to China, while hauling gold back to Rome. Amazingly, an ounce of gold was worth 12 ounces of silver in Rome, but only six in Asia. This discrepancy was a classic example of arbitrage.

Modern-day arbitrage is typically defi ned as the simultaneous buying and selling of securities in order to capture ʻrisklessʼ profits. However, with nearly 10,000 hedge funds scouring the globe with more than $1 trillion of liquidity, the prospect for finding riskless arbitrage opportunities seems remote today. While opportunities for riskless arbitrage may be scarce, risk arbitrage is a time-tested strategy that is worth revisiting in the current environment.

Merger Or Risk Arb – The Basics

Risk or merger arbitrage is defined as the exploitation of opportunities arising from mergers, acquisitions, and other corporate reorganizations. In its most basic form, ʻmerger arbʼ allows the capturing of a spread between a target companyʼs prevailing share price and the expected transaction price in a proposed merger.

To illustrate risk arbitrage in its most basic form, consider an example of an allcash takeover bid. Imagine an acquirer offering $50 per share for a target whose share price was $35 prior to the takeover announcement. The targetʼs shares will typically rise just short of the stated transaction price, allowing an investor to buy the targetʼs shares at, say, $47. At this point, the key variables that determine the success of this investment are:

• the time required to consummate the proposed deal
• the probability of the deal being completed
• the potential for another party to offer a higher price for the target In the event that no other bidder surfaces, the deal might be consummated in about six months. In this case, the arbitrageur will capture the $3 spread on his initial investment resulting in a 13 per cent annualized return. If the investor applies leverage to this strategy and borrows half the purchase price at an annual interest cost of five per cent, the annualized return would exceed 20 per cent. In the event that a superior bid emerges, the arbitrageur will generate even higher returns.

However, as is the case in approximately three per cent to fi ve per cent of all deals, the transaction may fall apart for a variety of reasons and the investor could lose 25 per cent to 50 per cent of his or her investment depending on the use of leverage. Hence, the ʻriskʼ in the term ʻrisk arbitrage.ʼ

In order to mitigate risk, good arbitrageurs will analyze every facet of a proposed deal including the commercial logic behind the transaction and management motivation/ incentives on each side.

The seasoned practitioner will also keep individual position sizes small (typically one per cent to three per cent of the capital base) and diversify over as many transactions as possible across a variety of industries in order to further manage risk. Some merger arbs will even purchase S&P 500 put options as a market hedge, knowing that deal risk rises during periods of equity market stress.

While our simple example illustrates the all-cash bid, stock-for-stock transactions result in many of the same issues outlined above. In this type of deal, the arbitrageur would match a long position in the target with a short position in the acquirerʼs shares, based on the proposed exchange ratio. When the merger closes, the long and the short positions would naturally cancel out.

Performance And Variability

According to the Henessee Mer-ger Arbitrage Index, the annual returns from this strategy were 10.3 per cent from 1993 to 2005 with an annual standard deviation of only 3.7 per cent. The correlation of this strategy to broad equity markets was less than 0.4 over this timeframe. While merger arbitrage as a strategy has produced several fallow periods for investors during the early 1990s and following some of the spectacular failed mergers in the 1998 to 2002 era, this strategy has produced decent risk adjusted returns over the long haul.

Thankfully, much of what we endured in the 1980s remains a distant memory. However, some things made popular in the decade may be worth revisiting. Given the recent resurgence in global M&A volume and growing interest in absolute return strategies, pension plans may want to consider dusting off a primer on risk arbitrage or, better yet, employing a multi-strategy manager with experience in this unique, timetested strategy.

Hanif Mamdani is vice-president – fixed income, director and member of the investment committee at Phillips, Hager & North Investment Management Ltd.

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