Graham's formula can be used to evaluate the potential return on the risk arbitrage operation in the Acme and Smith merger. The expected gain in the event of success is $1.00 (the spread between the $24.00 quoted price on the open market and the $25 Acme tender offer). If the merger fails to occur, the Smith stock may fall to its pre-tender offer of $15 per share (in many cases, history has proven otherwise; once a company is “in play” as a takeover target, its stock may remain inflated in anticipation of another acquirer materializing. We shall disregard this possibility for the sake of conservatism). Hence, the expected loss in points in the event of failure is $9. Assume there are no antitrust concerns, so the likelihood of consummation is 95%. Also assume the investor expects to hold his shares for one month (1/12 or 8.33% of a year) until the transaction is complete. The current price of the security is $15 per share. Plugging these into Graham’s formula, the investor gets the following:
Indicated annual return = [1 x .95 – 9 (1.00 - .95)] ÷ .0833 x 24
Indicated annual return = [.95 – .45] ÷ 2
Indicated annual return = 25%
In other words, had the investor been able to earn the same return on his capital for the entire year as he did during the holding period of this investment, he would have earned twenty five percent. In a world where the historic annual return on long-term equities has hovered around twelve percent, this is mouth watering.
Liquidations
From time to time, corporations will liquidate their operations in whole or part. As the liquidation unfolds, the funds are paid out to the shareholders. An investor that feels he can reasonbly estimate the eventual proceeds from the liquidation process can evaluated the potential arbitrage operation with Graham’s formula just as easily as opportunities arising from acquisitions and mergers. There is empirical evidence suggesting that these types of risk arbitrage operations are particularly profitable. According to Christopher Ma, William Dukes and R. Daniel Pace in
Why Rock the Boat? The Case of Voluntary Liquidation (The Journal of Investing, Summer 1997, p. 71), “A 1997 study of voluntary liquidations between 1961 and 1985 found that the average annual return for investment in securities from the date of their liquidation announcement until their final liquidating distribution was 44.4%. On average, the liquidation securities substantially outperformed the general market, shareholders recouped their initial investment within one year and the liquidation process was completed in just over two years.”
Capstone
On the whole, risk arbitrage can been a source of steady and dependable profits over long periods of time. Market conditions, however, will make these operations more or less scarce and more or less attractive. It is the responsibility of the investor to exercise sound judgment and decide at what time and in what amount he is willing to engage in these types of operations. Many institutional investors set aside a portion of their portfolio (ten or twenty percent, for example) that is dedicated to arbitrage commitments, special opportunities, liquidations and other specialized investing practices.
