Risk Arbitrage For The TimidPhillip L. Zweig
Back in the rough-and-tumble 1980s, risk arbitrage--betting on the outcome of takeover deals--was a game played mostly by high-rolling wealthy individuals. It was considered much too risky for so-called "prudent" investors.
Now, some cautious investors, such as pension funds and endowments, are coming to the conclusion that risk arbitrage can produce fat returns with less risk than traditional stock investments. With merger-and-acquisition activity showing no signs of abating, such institutions as General Electric Co.'s $28-billion pension trust are beginning to jump in. Budge Collins, chairman and chief executive of Collins Associates, a firm in Newport Beach, Calif., that manages money for pension funds, endowments, and wealthy individuals, says that the approximately 10 arbitrageurs he deals with say they have received a total of about $1 billion in new money over the past year, most of it from corporate employee pension funds.
FRISKY RETURNS. Risk arbitrage, says Heide L. Lankeit, a senior research analyst at Tacoma (Wash.) pension consultant Frank Russell, "is a good diversifier. It's producing attractive returns now and we expect attractive returns over the next two to three years." Lankeit tracks the annual returns of 55 "event-driven" investment managers, whose holdings include distressed securities as well as risk arbitrage. Over the past three- and five-year periods, the returns were 16.6% and 13.6% respectively. That compares with S&P returns of 6.3% for the same three-year period and 8.7% for five years.
In part because risk arbitrageurs are still seen as promoters of hostile takeovers, most pension funds that have invested in risk arbitrage prefer to remain in the closet. Yet company sources say that such companies as Eastman Kodak Co. and Kennecott Corp. are players. A spokesperson for General Electric says that the conglomerate's pension trust fund had "fairly recently" invested one-quarter of 1% of its fund, or roughly $70 million, with outside risk arbitrage managers.
To be sure, pension-fund consultants and arbitrageurs say that many more pension and endowment funds are currently kicking the tires than writing checks. But they think that more pension and endowment funds will eventually come to regard risk arbitrage as a relatively mainstream investment option, certainly one that promises less risk than venture capital, commercial real estate, distressed securities, and junk bonds.
RAIDER-FRIENDLY. Risk arbitrage is certainly less risky--if somewhat less profitable--than it was in the 1980s, when many deals, often launched by raiders with questionable financing, fell apart. Since 1991, the cancellation rate on announced deals has averaged about 3.5%, half the level for the 11 years ending in 1990, according to Merrill Lynch & Co.'s Mergerstat Review. Today, bank financing is readily available and most large public deals are being launched for strategic rather than purely financial reasons. "There are blue-chip buyers and blue-chip sellers," says Peter M. Schoenfeld, vice-chairman and head of the risk-arbitrage unit at Wertheim Schroder & Co., a Wall Street firm.
Playing the arb game, though, could raise some tricky issues for institutions. More money in the hands of arbs, says Alan R. Bromberg, a securities law professor at Southern Methodist University, will itself help "create a more congenial environment for takeovers." But, he adds, it could also enable more raiders to play in the takeover game and create "conflicts of interest for pension trustees," particularly if the company is a raider or a target.
Some of the new arb money has found its way to Wertheim Schroder, which claims to be one of the few large Wall Street firms that invests other people's money in these transactions. According to Schoenfeld, Wertheim's risk arbitrage limited partnership fund has grown by about 50% in the past year, to about $180 million. Virtually all of the $60 million in new money has come from three corporate employee pension funds, college and foundation endowments, and even small investments from a few public pension funds, including one big-city firefighters' union fund. Since the fund was started in 1980, Wertheim says it has generated a 23.3% gross compound annual return to investors after expenses--and a net return of 19% after the firm takes its hefty share of the profits. In 1988, the fund earned a gross return of nearly 114%. Defying last year's bear market, it generated a 12.6% gross return. The fund is also investing in overseas deals, including transactions in which neither the acquirer nor the target is a U.S. company.
Risk arbitrage, of course, is no slam- dunk. "Risk arb hasn't always worked," explains Budge Collins. "If in 1987 and 1990 you say you invested in risk arbitrage, it looks like you took stupid pills." When the hits come, they can be brutal. Wertheim's fund dropped by nearly 17% in 1987 and 28.7% in 1990, thanks to the collapse of bids to buy out UAL Corp., parent of United Airlines. Risk arbitrage investors are betting that the skies will be a lot friendlier in the future.
PLAYING THE M&A GAME
-- Higher long-term returns than traditional investing
-- Less volatility than S&P 500 stock returns
-- Index not closely correlated with stock market
-- More liquid than other alternative investments such as venture capital
-- Susceptible to sharp losses if big deal blows up
-- Declines in a single year can be much worse than rest of market
-- Management fees often higher than for more conventional funds