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When Arbitrage Is Not Really Arbitrage… And When It Is

|Includes:GRFS, Kinder Morgan, Inc. (KMI)

What is arbitrage? To find out, do not watch the movie by that name in which there is absolutely no arbitrage whatsoever. In 107 minutes of runtime and at a cost of over $13 million dollars, the topic didn't even come up.

To start with, the definition is:

The simultaneous purchase and sale of an asset in order to profit from a difference in the price. It is a trade that profits by exploiting price differences of identical or similar financial instruments, on different markets or in different forms. Arbitrage exists as a result of market inefficiencies; it provides a mechanism to ensure prices do not deviate substantially from fair value for long periods of time.

But in common usage, "arbitrage" is typically conflated with "merger arbitrage" and is more advertising that description. Merger arbitrage is defined as:

A hedge fund strategy in which the stocks of two merging companies are simultaneously bought and sold to create a riskless profit. A merger arbitrageur looks at the risk that the merger deal will not close on time, or at all. Because of this slight uncertainty, the target company's stock will typically sell at a discount to the price that the combined company will have when the merger is closed. This discrepancy is the arbitrageur's profit.

The problem is that merger arbitrage typically misses the most salient fact of arbitrage - the market inefficiency. Usually, merger arbitrage is a gamble on the time value and risk weighting of a deal without any particular reference to why that spread is mispriced. True arbitrage is riskless and the work goes into finding these few opportunities. Here is one fertile hunting ground: the periphery of merger arbitrage mandates. Most narrowly mandated funds dedicated to merger arbitrage have explicit rules around what they can own, so the opportunities that lie just beyond their reach can be mispriced.

One tactic is to look for broken deal arbitrage, which can emerge when a deal breaks, especially when it breaks unexpectedly. Merger arbitrage sellers press the "ask" side of the market downwards before conventional fundamental buyers are able to redo their analysis and respond with a "bid" side of the market. In such situations, it is common for shares to dip below the pre-deal price and below their fundamental value. One key question is whether broken deals resulted from a problem with the buyer or the seller. It is not always clear, but when the problem is with the buyer, it can be particularly conducive to scooping up stock beneath its deal value and beneath its standalone value. When credit markets are open, one can even encourage "self-help" transactions. The target of a failed deal borrows and issues a special dividend in a leveraged recapitalization that allows the public shareholder to act as the private equity would have done.

For another example, merger arbitrage firms often struggle with arithmetically hedging out mergers when there are merger securities other than existing, publicly traded equity that is easy to short. Two of our favorite investment opportunities have been just such cases: the Grifols SA acquisition of Talecris (NASDAQ:TLCR) and the Kinder Morgan (NYSE:KMI) acquisition of El Paso (EP). In brief, Grifols did not yet trade in the US at the time of this deal and the deal consideration was partially paid in stock. So, this was a particular inconvenience to dedicated merger arbitrage funds. Our solution was an unhedged position in TLCR. We had a high level of confidence in the deal's completion and a high level of confidence in the fundamental value of the Grifols stock, which we would own following the deal's consummation. We captured a wide spread of over $5 per share and collected our shares. Here is the final outcome: the spread was kept artificially wide because of investors who wanted to - or, as per their mandate, were required to - avoid taking a directional view on Grifols (NASDAQ:GRFS)… and in so doing, avoided owning the stock as a result of the deal. What happened to that stock? As it turns out, it went up another 231%.

There were two features of KMI buying EP that made this an arbitrage worthy of the name arbitrage. First, KMI was an expensive stock to borrow, which kept the spread artificially wide. Secondly, EP shareholders were getting paid in part in a KMI warrant. These two features had a peculiar interaction that opened up an opportunity which we exploited and it was created by the behavior of our counterparties based on narrow mandates as opposed to anything that the merging companies were doing. Since it wasn't economic to short KMI against EP, many merger arbitrage funds shorted the when-issued warrant. Because of the when-issued mechanism, shorting this warrant was easy and liquid. But therein lay the opportunity. Because they were doing what came easily instead of what was price-sensitive, this trade crushed the price of the warrants. So, while we were already EP holders, we also bought a significant number of the warrants at a price that was a fraction of the value that any warrant model would assign them. To lay off some of the directional risk of KMI, which we basically liked, we wrote a modest number of calls on the equity. In this case, the deal closed and we captured over $3 of spread beneath the merger consideration. Once the deal closed, the equity settled at a price low enough that our calls expired worthless. The warrants? We paid under a dollar for the warrants based on our average of the warrants that we bought in the when issued market and the warrants that we bought via our EP position. Today they trade for over three times that amount.

In closing, here is a brief thought about when merger arbitrage is and isn't true arbitrage. If a merger arbitrage fund absolutely feels the need to lay off deal risk through shorting a buyer's stock and would not otherwise participate, this is probably not true arbitrage, this is instead speculating on time and risk weighted deal outcomes. Only when such hedging is unnecessary, when one is in the rare instance of buying a security at a discount to its value in a deal or without a deal can the name "arbitrage" properly apply. Popular hedge fund strategies first emerged because conventional active money management was self-defeating. Over time, those popular hedge fund strategies themselves became self-defeating. Such is the way of markets. Now, to find a durable advantage we are left probing the spaces between the narrow mandates and agency problems rife within the hedge fund world itself.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

Additional disclosure: Chris DeMuth Jr is a portfolio manager at Rangeley Capital, a partnership that invests with a margin of safety by buying securities at deep discounts to their intrinsic value and unlocking that value through corporate events. In order to maximize total returns for our partners, we reserve the right to make investment decisions regarding any security without further notification except where such notification is required by law.

Stocks: KMI, GRFS