For Arbs, It's Not The '80s But Hey, It Ain't BadJeffrey M. Laderman
In just a few weeks, shareholders of Viacom Inc. and Paramount Communications Inc. will finally close one of the biggest and most contentious takeover battles in years. In the 1980s, such fights were richly rewarding to risk arbitrageurs, the savvy sorts who invest in companies once a buyer makes an offer.
But for all the hoopla over Paramount--a much-glamorized bidding war between Viacom and QVC Network Inc.--the deal has delivered the arbs little return and quite possibly losses. That's because many of them acquired Paramount at prices as high as 82. The deal is now worth less than 78.
EASY MONEY. Don't cry for the arbs, however. Business is better than it's been since the merger craze of the 1980s. The takeover boom of the past year has provided investment opportunities and has made it easier for arbs to raise money. Equally important in drawing new investors are the violent shakeouts in the stock and bond markets. "The beauty of arbitrage is that returns have little correlation with the stock or bond market," says Howard Roffman, managing director of Mesirow Advanced Strategies, which offers advice on alternatives to traditional stock and bond investing.
Arbs estimate that today there's somewhere between $3 billion and $4 billion invested in deals, down from as much as $18 billion a decade ago. As always, the money is mainly in private partnerships--where investors have to commit $1 million or so--and in securities firms' proprietary trading accounts. But there is one door to arbitrage that is open to investors of more modest means. The Merger Fund is the only mutual fund dedicated to merger arbitrage, and the minimum investment is $2,000.
Not everyone calls risk arbitrage by its name anymore. Some prefer "event-driven" investing, figuring risk arbitrage might dredge up unwanted connotations left over from the days of corporate raiders and insider traders.
There's no great mystery in what an arb does. When a takeover is announced, the arb buys the stock of the target company, which will usually sell at a few dollars below the offering price because of the risk that the deal may collapse. If the deal goes through, as most do, the arb may earn only a 5% return on the investment. But if it takes only, say, three months, that works out to a nifty 20% a year. "We perform a risk-transfer function," explains Guy P. Wyser-Pratte of Wyser-Pratte & Co., a third-generation arbitrageur. "We provide liquidity that allows shareholders to sell near the takeover price without incurring the risk that the deal falls through."
Arbitrage partnerships don't have to report their numbers to the public. But consultants who dig for numbers find impressive ones. International Advisory Group Inc., a Nashville firm that matches investors with money managers, reports that during the 1988-93 period, the average returns for arb partnerships ranged from 10.4% in 1990 to 49.2% in 1988 (chart). The arbs' average for the period was 23.7% vs. 14.8% for the Standard & Poor's 500-stock index. In the first quarter of 1994, the arbs were barely in the black, but they were still well ahead of the market.
Despite the good returns, even big-name arbs are running a lot less money now than they did 10 years ago. During the 1980s, Wyser-Pratte was responsible for as much as $1 billion, half of it on margin, when he ran Prudential Securities Inc.'s arbitrage operation. He went off on his own in 1991 when Prudential, like some other big firms, dropped the business. Today, he runs $250 million and is beating the bushes for more. So is George A. Kellner of Kellner, Dileo & Co., a $1 billion arb manager in the 1980s who runs just $140 million today.
While rising interest rates can wreak havoc on stocks and bonds, the returns to arbitrage are unaffected. That's because when arbs buy a takeover stock, they will generally pay a price that allows them to earn some multiple of short-term interest rates, such as two to four times the T-bill rate, or 2.5 times the prime rate. If interest rates go higher, the arbs bid less for the stocks. If rates fall, arbs will pay more and thus accept a lower return.
TAME SPENDING. Still, the takeover mavens have to work harder and smarter to earn the returns to which they have been accustomed. True, the "deal flow" is up substantially--$242 billion in announced transactions in 1993, a 61.7% increase over 1992, according to Securities Data Co. And 1994 deals so far are coming in at 1993's heady pace.
But the buyers of companies--even when they're in a bidding contest--are not spending wildly. It's a far cry from the 1980s, when making money in takeovers was a lay-up. "When a deal was announced, all you had to do was to take a large position in the stock, lever it up [borrow money to buy more], and wait for the bidding to begin," says Kellner somewhat wistfully.
Today's buyers are mainly other companies in the industry who know the value of what they're buying. They're willing to pay--but just so much. For instance, Martin Marietta Corp.'s $55-a-share offer for Grumman Corp. put the defense contractor into play and drew a $60 counteroffer from Northrop Corp. But Grumman stock ran up to $65, as some speculated that Martin Marietta would boost its offer. It didn't. Northrop eventually paid $62 a share for Grumman.
Today's deals also have less cash and more securities. That, in part, is what tripped up the arbs on Paramount. Viacom paid $107 a share for 51% of Paramount's stock, but is paying for the rest with a hodgepodge of difficult-to-price debentures which can, at the company's option, be converted into preferred stock. Says Kellner: "That package changed the dynamics of the arbitrage business."
COSTLY DELAYS. The Clintonites are also far more concerned with antitrust and regulatory issues posed by takeovers than recent GOP Administrations. Indeed, regulatory actions helped to sink the huge Bell Atlantic Corp.-Tele-Communications Inc. merger in February.
Even if the takeovers are ultimately approved, delays can be costly. Fred Green, portfolio manager of the Merger Fund, estimates that he'll earn a 23% annual rate of return if AT&T's acquisition of McCaw Cellular Communications Inc. is completed by September. But the return could drop to less than 12% if the deal drags on to yearend.
With more cost-conscious acquirers, more complicated payout structures, and a more difficult regulatory environment, even the arbs are lowering their expectations. Says consultant Mark S. Ostroff of Graystone Partners: "From here on out, we think the major arbitrage managers will earn steady 10%-to-20% annualized returns." That may not be 1980s-like results. But in today's shaky markets, such returns would be manna from heaven.