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An investor’s guide to risk arbitrage as a strategy

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Picking up nickels in front of a steam roller

Risk arbitrage as a strategy is basically the act of picking up nickels in front of a steamroller. When a deal successfully closes, you get a nickel. When a deal breaks, you lose a buck. This asymmetric risk-to-reward ratio is what makes risk arbitrage a difficult strategy to make a buck in. While deal breaks are rare (typically, 5% of deals break for some reason or another), they can have an outsized effect on the portfolio. An effective risk arbitrage team will usually have a younger number cruncher who calculates the comparables, keeps track of the various stages in the process, and handles some of the more difficult options—related stuff like hedging deals with collars and cash or stock elections. There’s usually an older member of the team who has “seen a lot of movies” and knows where the pitfalls are. This person is usually the portfolio manager, who makes decisions on position size and needs to have a 10,000-foot view of the portfolio. Below is an illustration of the risk-to-reward outlook  of a typical merger arbitrage deal

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The key to success in merger arbitrage is to miss the mines. It takes experience to know when something doesn’t smell right and to stay away. In investing, there are no called strikes. If an arbitrage situation doesn’t feel right, avoid it until you find out why. The second key to success in merger arbitrage is knowing what positions you need to get big in. Every quarter, there’s a deal that simply has a better risk-to-reward ratio than the others, and it needs to be a big position.

Long-Term Capital Management used to do no work on mergers. It looked at them from the top down and invested in them equally, knowing that while some would break, it would still have a return on capital. That approach is a guarantee for capital punishment.

Current deals

Right now, the biggest deals on Wall Street are between Time Warner (TWC) and Comcast (CMCSA) and between DirectTV (DTV) and AT&T (T). Investors who want to invest in M&A deals via an ETF should look at the IndexIQ ETF (MNA).

For access to premium risk arbitrage content, please email singh@marketrealist.com.

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