BCE: Risky Arbitrage

John Paulson's, the founder of Paulson & Co. (huge subprime bets) started his career as a investment banker and then worked as a risk arbitrager with Gruss Partners. He learned a very important lesson here that I'd like to reiterate: "Watch the downside, the upside will take care of itself". He also wrote a paper titled, "The 'Risk' in Risk Arbitrage", and its a must read! A caveat here is in order, risk arbitrage is very risky and should not be tried at home (as Joel Greenblatt would put it). The BCE buyout deal has been a non-stop soap opera for anyone who's watching. Today it was announced that the deal might be in jeopardy and the stock dropped 40% from around $37 to $24; the buyout price is $42.75/share. Arbitrage spreads in general have been very very wide over the last 3-6 months and for a good reason as deals have imploded left and right. While I am not going to talk specifically about the BCE deal, but will talk about arbitrage at the tail end of the buyout boom (and its common sense!).

But first, all this reminds me of something I read in the 1988 Berkshire Hathaway shareholder letter (which is also a must read for risk arbitrage). In that letter Warren Buffett explains arbitrage and his approach with relevant examples. Here's a synopsis: "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.?"

He goes on to explain a couple of transactions and but in the end the thing that I remember is, "Even if we had a lot of cash we probably would do little in arbitrage in 1989. Some extraordinary excesses have developed in the takeover field." He goes on further to talk about how he 'doesn't know' and 'no one knows', "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. But we do 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."

And this is the essence of it. Simply, do not engage in arbitrage at the tail end of the buyout boom. The ratio of collapsed deals to total deals has been very high this past year. It usually is when the buyout boom takes a form of its own, and the market values everything at private market valuations, exactly as WB said. It was high in 1988 and it was high in 2007 (read: Blackstone IPO). Michael Price once said that the folks who do risk arbitrage are the same ones that do distressed debt when the cycle turns, and this rings true today when a lot of hedge funds are unloading the risk arbitrage staff and beefing up their distressed debt teams (but just a little too late). If an investor as a rule refuses to participates in risk arbitrage during these times, a lot of pain and suffering can be avoided. When you are picking pennies (or dollars) in front of a road roller you really want to have the odds on your side.