Areas of Opportunities for Value Investors: Investing in Risk Arbitrage

Risk arbitrage is a highly specialized area of value investing.

Arbitrage, as noted earlier, is a riskless transaction that generates profits from temporary pricing inefficiencies between markets. 

• Risk arbitrage, however, involves investing in far-from-riskless takeover transactions. 
• Spinoffs, liquidations, and corporate restructurings, which are sometimes referred to as long-term arbitrage, also fall into this category. 

Risk arbitrage differs from the purchase of typical securities in that gain or loss depends much more on the successful completion of a business transaction than on fundamental developments at the underlying company.

• The principal determinant of investors' return is the spread between the price paid by the investor and the amount to be received if the transaction is successfully completed. 
• The downside risk if the transaction fails to be completed is usually that the security will return to its previous trading level, which is typically well below the takeover price. 

The quick pace and high stakes of takeover investing have attracted many individual investors and speculators as well as professional risk arbitrageurs. 

• It is my view that those arbitrageurs with the largest portfolios possess an advantage that smaller investors cannot easily overcome. 
• Due to the size of their holdings, the largest arbitrageurs can afford to employ the best lawyers, consultants, and other advisors to acquire information with a breadth, depth, and timeliness unavailable to other investors. 
• As we have learned from recent criminal indictments, some have even enjoyed access to inside information, although their informational edge was great even without circumventing the law. 

The informational advantage of the largest risk arbitrageurs is not so compelling in situations such as long-term liquidations, spinoffs, and large friendly tender offers.

• In the largest friendly corporate takeovers, for example, the professional risk arbitrage community depletes its purchasing power relatively quickly, leaving an unusually attractive spread for other investors. 
• A careful and selective smaller investor may be able to profitably exploit such an opportunity. 

At times of high investor uncertainty, risk-arbitrage-related securities may become unusually attractive. 



Example:

The December 1987 takeover of Becor Western Inc. by B-E Holdings, Inc., fit this description.

• In June 1987 Becor sold its aerospace business for $109.3 million cash. This left the company with $185 million in cash (over $11 per share) and only $30 million in debt. The company also operated an unprofitable but asset-rich mining machinery business under the Bucyrus-Erie name. The offer by B-E Holdings to buy Becor Western was the last in a series of offers by several suitors. The terms of this proposed merger called for Becor holders to receive either $17 per share in cash or a package of the following: $3 principal amount of 12.5 percent one-year senior notes in B-EHoldings; $10 principal amount of 12.5 percent fifteen-year senior debentures in B-EHoldings; 0.2 shares preferred stock in B-E Holdings, liquidation preference $25; and 0.6 warrants to buy common stock in B-E Holdings at $.01 per share. A maximum of 57.5 percent of Becor shares were eligible to receive the cash consideration. Assuming that all stockholders elected to receive cash for as many shares as possible, each would receive per share of Becor owned: $9.775 cash $1.275 principal amount one-year notes $4.25 principal amount fifteen-year debentures .085 shares preferred stock .255 warrants The cash option was almost certain to be worth more than the package of securities. Thus the total value of the consideration to holders who elected cash was greater than for those who did not. Nevertheless, a small proportion of Becor holders failed to choose the cash alternative, increasing the value to be received by the vast majority of holders who did. 

What made Becor particularly attractive to investors was that in the aftermath of the 1987 stock market crash, the shares fell in price to below $10. 

• Investors could thus purchase Becor stock for less than the underlying cash on the company's books, and for an amount approximately equal to the cash that would be distributed upon consummation of the merger, which was expected either in December 1987 or January 1988. 
• The shares were a real bargain at $10, whether or not the merger occurred. The total value of the merger consideration was certainly greater than the $10 stock price-the cash component alone was nearly $10. Moreover, there was nearly enough cash on the books of B-E Holdings pro forma for the merger to retire the one-year notes. These appeared to be worth close to par value. Based on the market price of comparable securities, the fifteen-year debentures seemed likely to trade at a minimum of 50 percent of face value and perhaps significantly higher. The preferred stock was more difficult to evaluate, but 25 percent of its liquidation preference seemed conservative compared with other preferred issues. The warrants were virtually impossible to value. Even assuming they would trade at negligible prices, however, the total value of the merger consideration appeared to be at least $14 per share.
• Better still, the downside risk to investors was minimal. The book value of Becor was $12 per share, nearly all of it in cash. There were several sizable holders of Becor stock, a fact that increased the likelihood that underlying value would be realized in some fashion. Even if the merger were rejected by shareholders, a corporate liquidation appeared likely to yield similar value. 
• At prices of $12 or below, investors faced little downside risk and the prospect of an appreciable and prompt return. As it turned out, the merger consideration was worth about $14.25 at market prices. 
• Becor shares had declined in the wake of a broad market rout to a level below underlying value, creating an opportunity for value investors.