Friday, 21 December 2012

Warren Buffett on Arbitrage


     Berkshire’s arbitrage activities differ from those of many arbitrageurs.  First, we participate in only a few, and usually very large, transactions each year.  Most practitioners buy into a great many deals perhaps 50 or more per year.  With that many irons in the fire, they must spend most of their time monitoring both the progress of deals and the market movements of the related stocks.  This is not how Charlie nor I wish to spend our lives.  Because we diversify so little, one particularly profitable or unprofitable transaction will affect our yearly result from arbitrage far more than it will the typical arbitrage operation.  So far, Berkshire has not had a really bad experience.  But we will - and when it happens, we’ll report the gory details to you.

     The other way we differ from some arbitrage operations is that we participate only in transactions that have been publicly announced.  We do not trade on rumors or try to guess takeover candidates.  We just read the newspapers, think about a few of the big propositions, and go by our own sense of probabilities.

     Some offbeat opportunities occasionally arise in the arbitrage field.  I participated in one of these when I was 24 and working in New York for Graham-Newman Corp. Rockwood & Co., a Brooklyn based chocolate products company of limited profitability, had adopted LIFO inventory valuation in 1941 when cocoa was selling for 50 cents per pound.  In 1954, a temporary shortage of cocoa caused the price to soar to over 60 cents.  Consequently Rockwood wished to unload its valuable inventory - quickly, before the price dropped.  But if the cocoa had simply been sold off, the company would have owed close to a 50% tax on the proceeds.

     The 1954 Tax Code came to the rescue.  It contained an arcane provision that eliminated the tax otherwise due on LIFO profits if inventory was distributed to shareholders as part of a plan reducing the scope of a corporation’s business.  Rockwood decided to terminate one of its businesses, the sale of cocoa butter, and said 13 million pounds of its cocoa bean inventory was attributable to that activity.  Accordingly, the company offered to repurchase its stock in exchange for the cocoa beans it no longer needed, paying 80 pounds of beans for each share.

     For several weeks I busily bought shares, sold beans, and made periodic stops at Schroeder Trust to exchange stock certificates for warehouse receipts.  The profits were good and my only expense was subway tokens.

     The architect of Rockwood’s restructuring was an unknown brilliant Chicagoan, Jay Pritzker, then 32.  If you’re familiar with Jay’s subsequent record, you won’t be surprised to hear the action worked out rather well for Rockwood’s continuing shareholders also.  From shortly before the tender until shortly after it, Rockwood stock appreciated from 15 to 100, even though the company was experiencing large operating losses.  In recent years, most arbitrage operations have involved takeovers, friendly and unfriendly.  With acquisition fever rampant and anti-trust challenges almost non-existent, and with bids often ratcheting upward, arbitrageurs have prospered mightily.  In Wall Street the old proverb has been reworded: “Give a man a fish and you feed him for a day.  Teach him how to arbitrage and you feed him forever.”

     To evaluate arbitrage situations you must answer four questions: 
(1) How likely is it that the promised event will indeed occur?  
(2) How long will your money be tied up?  
(3) What chance is there that something still better will transpire - a competing takeover bid, for example?  and 
(4) What will happen if the event does not take place because of anti-trust action, financing glitches, etc.?

     Arcata Corp., one of our more serendipitous arbitrage experiences, illustrates the twists and turns of the business.  On September 28, 1981 the directors of Arcata agreed in principle to sell the company to Kohlberg, Kravis, Roberts & Co. (KKR), then and now a major leveraged-buy out firm.  Arcata was in the printing and forest products businesses and had one other thing going for it: In 1978 the U.S. Government had taken title to 10,700 acres of Arcata timber, primarily old-growth redwood, to expand Redwood National Park.  The government had paid $97.9 million, in several installments, for this acreage, a sum Arcata was contesting as grossly inadequate.  The parties also disputed the interest rate that should apply to the period between the taking of the property and final payment for it.  The enabling legislation stipulated 6% simple interest; Arcata argued for a much higher and compounded rate.  Buying a company with a highly-speculative, large-sized claim in litigation creates a negotiating problem.  To solve this problem, KKR offered $37.00 per Arcata share plus two-thirds of any additional amounts paid by the government for the redwood lands.

     Appraising this arbitrage opportunity, we had to ask ourselves whether KKR would consummate the transaction since, among other things, its offer was contingent upon its obtaining “satisfactory financing.”  A clause of this kind is always dangerous for the seller: It offers an easy exit for a suitor whose ardor fades between proposal and marriage.  However, we were not particularly worried about this possibility because KKR’s past record for closing had been good.  We also had to ask ourselves what would happen if the KKR deal did fall through, and here we also felt reasonably comfortable: Arcata’s management were clearly determined to sell.  If KKR went away, Arcata would likely find another buyer, though the price might be lower.

     Finally, we had to ask ourselves what the redwood claim might be worth.  Your Chairman, who can’t tell an elm from an oak, had no trouble with that one: He coolly evaluated the claim at somewhere between zero and a whole lot.  We started buying Arcata stock, then around $33.50, on September 30 and in eight weeks purchased about 400,000 shares, or 5% of the company.  The initial announcement said that the $37.00 would be paid in January, 1982.  Therefore, if everything had gone perfectly, we would have achieved an annual rate of return of about 40% - not counting the redwood claim, which would have been frosting.

     All did not go perfectly.  In December it was announced that the closing would be delayed a bit.  Nevertheless, a definitive agreement was signed on January 4.  Encouraged, we raised our stake, buying at around $38.00 per share and increasing our holdings to 655,000 shares, or over 7% of the company.  Our willingness to pay up - even though the closing had been postponed - reflected our leaning toward “a whole lot” rather than “zero” for the redwoods.

     Then, on February 25 the lenders said they were taking a “second look” at financing terms “ in view of the severely depressed housing industry and its impact on Arcata’s outlook.”  The stockholders’ meeting was postponed again, to April.  An Arcata spokesman said he “did not think the fate of the acquisition itself was imperiled.”  When arbitrageurs hear such reassurances, their minds flash to the old saying: “He lied like a finance minister on the eve of devaluation.”

     On March 12 KKR said its earlier deal wouldn’t work, first cutting its offer to $33.50, then two days later raising it to $35.00.  On March 15, however, the directors turned this bid down and accepted another group’s offer of $37.50 plus one-half of any redwood recovery.  The shareholders okayed the deal, and the $37.50 was paid on June 4.  We received $24.6 million versus our cost of $22.9 million; our average holding period was close to six months.  Considering the trouble this transaction encountered, our 15% annual rate of return excluding any value for the redwood claim - was more than satisfactory.  But the best was yet to come.  The trial judge appointed two commissions, one to look at the timber’s value, the other to consider the interest rate questions.  In January 1987, the first commission said the redwoods were worth $275.7 million and the second commission recommended a compounded, blended rate of return working out to about 14%.

     In August 1987 the judge upheld these conclusions, which meant a net amount of about $600 million would be due Arcata.  The government then appealed.  In 1988, though, before this appeal was heard, the claim was settled for $519 million.  Consequently, we received an additional $29.48 per share, or about $19.3 million, and another $800,000 in 1989.   

      At year end 1988, our only major arbitrage position was 3,342,000 shares of RJR Nabisco with a cost of $281.8 million and a market value of $304.5 million.  In January we increased our holdings to roughly four million shares and in February we eliminated our position.  About three million shares were accepted when we tendered our holdings to KKR, which acquired RJR, and the returned shares were promptly sold in the market.  Our pre-tax profit was a better-than-expected $64 million.

     Earlier, another familiar face turned up in the RJR bidding contest: Jay Pritzker, who was part of a First Boston group that made a tax-oriented offer.  To quote Yogi Berra; “It was deja vu all over again.” During most of the time when we normally would have been purchasers of RJR, our activities in the stock were restricted because of Salomon’s participation in a bidding group.  Customarily, Charlie and I, though we are directors of Salomon, are walled off from information about its merger and acquisition work.  We have asked that it be that way: The information would do us no good and could, in fact, occasionally inhibit Berkshire’s arbitrage operations.

     However, the unusually large commitment that Salomon proposed to make in the RJR deal required that all directors be fully informed and involved.  Therefore, Berkshire’s purchases of RJR were made at only two times: first, in the few days immediately following management’s announcement of buyout plans, before Salomon became involved; and considerably later, after the RJR board made its decision in favor of KKR.  Because we could not buy at other times, our directorships cost Berkshire significant money.

     Considering Berkshire’s good results in 1988, you might expect us to pile into arbitrage during 1989.  Instead, we expect to be on the sidelines.

     We have no idea how long the excesses will last, nor do we know what will change the attitudes of government, lender and buyer that fuel them.  We know that the less the prudence with which others conduct their affairs, the greater the prudence with which we should conduct our own affairs.  We have no desire to arbitrage transactions that reflect the unbridled - and, in our view, often unwarranted - optimism of both buyers and lenders. 

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