If investment bankers have become famous for their role in initiating, advising and financing takeovers, risk arbitrageurs have become infamous for their bets on the outcomes of these takeovers. Which is a bit of a bum rap. Their generally poor reputation is based not only on the reality of government investigations and convictions, but also on what's in a name. Arbitrageur sounds mysterious and foreign; the shortened version, arb, sounds like something you don't want to brush up against. At the same time, managements portray them as selfish, shortsighted, and soulless traffickers in corporate ownership to the highest bidder.
Risk arbitrageurs play the odds, buying positions in companies that have received takeover offers. If, for example, Company A announces an offer for Company B at $50, B might trade up immediately to $48. An arb must determine if it is worth buying the stock for the last 2 points. Let's say that there's a 95 percent chance of the deal being completed within three months, and a 5 percent chance that the deal falls through and the stock drops $40. The expected gain is $1.50/share (.95 x $2 profit minus .05 x $8 loss). On a percentage basis, the expected annual return is 12.5% ($1.50 x 4 quarters $48 cost).
The trick is to have enough such deals in which to invest so that the odds work themselves out. This is similar to owning a casino: although you might lose to any given player, you will win a predictable percentage of the thousands of bets placed. As one casino owner put it, "What I love is the risk; some nights we make money, and other nights we make more money."
The challenge to a risk arbitrageur is much greater than this, however. Arbs don't have thousands of deals on which to spread the risk, and the odds of success are never clear. They must thoroughly research the valuation of the target company, the resources of the potential acquirer, the strategic fit of the two companies, the legal issues, the personalities of both managements, the possibility of a poison pill, a white knight or greenmail*, and the chances of a higher bid.
In addition to the weak science of valuation, they also rely on the weaker art of "reading the tape," trying to detect the strategies of all sides through the patterns of stock purchases and sales. Theirs is a business of small wins and large losses, none larger than those of October 1989, when the arbitrage community lost hundreds of millions in a few weeks. But, over time, risk arbitrage has been a very profitable profession and will probably continue to be in the future.
Some players prefer to anticipate deals rather than react to them. Interestingly enough, the best at this game are the aggressively unflashy value investors. They buy companies selling at a fraction of their underlying value, and then wait and wait for that value to be recognized by the market. Occasionally, that value is recognized sooner than expected in the form of a takeover bid. Unfortunately, a few conspicuously non-value players have preferred to pay for illegal inside information and have contributed to the negative perception of risk arbitrageurs.
Another contributing factor to the poor reputation of risk arbitrageurs has been the criticism that greedy arbs replace concerned shareholders in determining the future of a target company. But think about it for a minute: Who did the arbs buy the stock from in the first place, if not these shareholders?
* Greenmail occurs when a company buys out the shares of a potential acquiror at an above-market price; in return, the seller drops its takeover bid the remaining shareholders, however, are left to watch the price of their shares plummet.