Longreads + Open Thread

Covid, Apple, Ireland, Fanatics, Private Credit, Austin, Hedge Funds, Arbitrage



Merger Masters: Tales of Arbitrage: Risk arbitrage—betting on whether mergers will go through, and whether or not there will be a competing offer—is a fun discipline that's right at the intersection of trading and investing. If you think of "investing" as selecting assets that will passively generate returns with the appropriate amount of risk, and think of "trading" as getting a read on near-term supply and demand by understanding the psychology of market participants, then merger arbitrage has both. There's a small set of participants—the buyer, seller, competing bidders, regulators, other arbitrageurs—so arbitrage can be all about looking around the table for tells. But what's being traded is a real business, and the price at which it will be bought, or the odds that the deal will be blocked, are a function of real-world economics, not just high-stakes bluffing.

The book profiles several arbitrageurs who were active from roughly the sixties to the 2010s, and it's interesting to watch the evolution of both the arbitrage business and finance generally.

For example: the business looked extremely ethically dubious until about the 1990s. Not that there couldn't be honest arbs, but there was immense temptation to trade on illicit information. The Boesky case is infamous, of course—giving investment bankers literal suitcases full of cash is not exactly in line with most compliance policies. (Incidentally, a good practical reason not to get involved in this kind of thing is that someone who was willing to betray trust for cash is about equally willing to do so to avoid prison time—the banker in question was quite cooperative and got a two-month prison sentence). Just about everyone interviewed loathes Boesky, because he made arbitrage famous before becoming infamous. But there are older precedents! One of the interviewees says that a well-known approach was for two different companies to each have an investment banking division and a risk arbitrage desk—bank A would tip off bank B about pending deals, and vice-versa. That certainly makes things easier. But the practice still made investors plenty of money when they weren't breaking the rules.

Risk arbitrage is cyclical; mergers happen when stocks are up, so the arbs have more deals, and more competitive deals, when the market's doing well. Many of them have, in response, expanded into distressed debt—in year one, you make money from a company selling to private equity, and in year three, you make money buying the acquirer's bonds in the bankruptcy reorg. But there's another cycle at work: one thing many of the arbitrageurs say is that they prefer strategic acquirers to financial ones, and they like to bet on the completion of deals that genuinely make sense. But that heuristic creates a risk factor—the deals that make financial sense to Wall Street are exactly the ones that worry the FTC and DOJ! And, as The Diff has noted before, that creates a correlated risk—a portfolio betting that twenty different mergers succeed is also making the same political bet twenty times over (albeit in varying size). Meanwhile, trailing returns and total capacity will look best at market peaks, so the strategy's dollar-weighted returns will be worse than its time-weighted returns.

Risk arbitrage remains a viable strategy, and is still a great training ground for investing talent, with Goldman's arbitrage team as a standout performer ($). It's a quick education in probability and psychology, and an event-driven excuse to do deep dives on one industry after another—if this month's big deal is oil, last month's was a bank, and next months is a biotech company, any arb analyst paying attention to fundamentals is going to end up with a wide range of knowledge about different industries. But it's like so many other strategies in that it mean reverts, and it wouldn't mean-revert if it didn't look like a good idea to sophisticated investors with significant financial resources at exactly the worst possible time.

Open Thread

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