Many people associate Berkshire Hathaway (BRK.B) Chairman and legendary investor Warren Buffett with value investing, but fewer people know that merger arbitrage, or "workouts" as he sometimes calls them, is one of his long-time investing strategies. Merger arbitrage involves purchasing the stock of an acquisition target for less than the offered price. Investors profit as the stock rises toward the acquisition price as the closing date nears. Although the price movements may be small, annualized returns can be substantial because the investments are for a limited time, often weeks or months.
Buffett has discussed his arbitrage investments over the years in letters to his investors (e.g., here and here). I highly recommend all of Buffett's letters to Berkshire shareholders. Buffett is clever and funny, which makes them enjoyable, and it is impossible to overstate the value of his clarity of thought. Buffett's investment bible, Graham's The Intelligent Investor, also has a section discussing Workouts in Chapter 15. Buffett's questions for evaluating arbitrage in his 1988 letters are still relevant today:
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.?
This article discusses a merger arbitrage opportunity in leading Chinese pork processor Zhongpin Inc. (HOGS). I invested in HOGS years ago as a play on the rising Chinese middle class; pork is the most consumed meat in China, and Zhongpin is one of the biggest pork processors. Moreover, the Chinese government is requiring the pork processing segment to modernize, which benefits Zhongpin's modern cold chain logistics model. I began "trading the range" on the long side of HOGS shortly after I began investing in the company, because the stock was range bound and I was willing to hold the stock long-term if necessary.
On March 27, 2012, the company announced that it had received a nonbinding "going private" proposal at $13.50 per share from Zhongpin Chairman and CEO Xianfu Zhu. The company formed a Special Committee to evaluate the bid, and remained largely remained silent until November 26, 2012, when Zhongpin announced that it had entered into a definitive merger agreement with Zhu and a group of insiders that own 26% of the outstanding stock. According to the November announcement, the deal has been approved by the board, the buyout group has arranged financing ($85 million equity investment by China Wealth Growth Fund I, L.P. and a $320 million loan from China Development Bank Corp.), and the deal is slated to close in Q1'13.
The deal had a "go shop" provision that was originally set to expire on January 25, but was just extended by the Special Committee to February 8.
HOGS closed on Friday at $12.85. This represents a 5% discount to the $13.50 offered price. If the deal closes at the end of Q1, the annualized ROR is just over 20%. If it closes by the end of Q2, the annualized ROR is still greater than 10%. I think that the deal is likely to close in Q1 or perhaps early Q2. The buyout team is upper management; they are unlikely to learn information during diligence that would kill the deal. Moreover, counsel for the special committee (Akin Gump), the company (O'Melveny & Meyers) and the insiders (Skadden) are white shoe U.S. law firms. They are very sophisticated (and expensive) deal counsel, which indicates that all sides are serious about the deal and, in my opinion increases the chances of the deal closing within a reasonable time. This analysis does not take into account a potential bidding war, which would increase the upside, because 26% of the stock plus top management is already in the bag for the current proposal.
The potential downside of this trade includes possible delays in closing the deal, which would reduce rate of return, or in the deal falling through completely. If the deal falls apart, the stock would almost certainly drop, meaning that you either lose money on the trade or convert to a long term investor. I think that the deal will close and in any event I am comfortable being an investor, as I view Zhongpin as a solid company that has a good valuation and significant growth potential (I am aware of the many reasons people distrust Chinese companies, but I think there are many markers here that provide some comfort).
Based on the above, I like this play and am long HOGS.