Merger arbitrage and special situation investing (or “workouts”) have been a secret weapon for Warren Buffett throughout his investing career and is one of the lesser-known areas of Buffett’s investment operations. In Berkshire’ Hathaway’s 1988 letter, Buffett stated “Starting in 1956, I applied Ben Graham’s arbitrage principles, first at Buffett Partnership and then Berkshire. Though I’ve not made an exact calculation, I have done enough work to know that the 1956-1988 returns averaged well over 20%.”
In this article, I will explain what factors make a transaction more likely to succeed and present case studies on four merger arbitrage scenarios. The article also highlights four merger arbitrage deals that I wrote about on Seeking Alpha that were completed successfully.
Note: Be sure to read Berkshire’s 1988 Annual Report for more information on arbitrage as well as Warren Buffett and the Art of Stock Arbitrage: Proven Strategies for Arbitrage and Other Special Investment Situations.
What is Arbitrage?
Arbitrage involves exploiting price differentials to make a profit with the absence of risk. For example, a stock trader may notice a small price differential between two stocks trading on different exchanges. If a stock is trading for $20 on one exchange and $20.10 on another, they could theoretically make a riskless profit of $0.10 per share. Most short-term arbitrage trading is done by high frequency trading algorithms that correct price inefficiencies in seconds. That being said, merger arbitrage trading can be profitable for investors willing to do the proper due diligence.
When news breaks of a merger, you will often see the target company’s stock rise close to the proposed acquisition price. For example, company “A” announces it has planned to buy company “B” for $30 per share. Before the announcement, company B’s stock was trading at $20. After the announcement, company B’s share price rises to $27. Due to the uncertainty of a successful deal consummation, company B’s stock does not immediately trade at the proposed acquisition price. In this example, the $3 dollar spread represents the opportunity for the investor. Assuming no leverage is used, the potential return would be 11.1% ($3 / $27). If this deal was expected to close in four months, the annualized return would be closer to 33% because the investor’s capital was only tied up for four months.
Hostile Takeovers
An activist investor may begin buying shares in an underperforming company with the goal to sell it or push for some other corporate change that will unlock value for shareholders. Often times, the board and existing management have no desire to sell the company. Activists will attempt to buy enough shares in the company to have meaningful influence in the voting process when the shareholders are voting on whether to sell or not. The board of directors and shareholders are more likely to approve a deal that is not a hostile takeover.
Strategic vs. Financial Buyer
Strategic buyers acquire companies to supplement their existing product offerings and gain market share in their industry. A good example is Meta’s purchase of Instagram in 2012 or Microsoft’s purchase of LinkedIn in 2016. Meta capitalized on an opportunity to acquire Instagram to gain market share in social media. Microsoft saw an opportunity to leverage LinkedIn’s valuable user base to make its dynamics 365 CRM software even better.
Financial buyers, on the other hand, are often private equity companies that use leverage to finance an acquisition. These firms typically acquire companies with the goal of selling their investment in order to maximize returns for investors.
Acquisitions that are dependent on the buyer being able to obtain financing may have a higher risk of not succeeding. This is not always the case, but investors should do their due diligence and read the filings to ensure the buyer has the financial resources to be able to successfully complete the transaction.
Why the Regulators Block Mergers
One of the biggest factors that often derail larger acquisition attempts is anti-trust litigation from regulators. Regulators may sue to block a proposed merger due to antitrust concerns. The three primary regulators are the FTC (Federal Trade Commission), FCC (Federal Communications Commission, and CFIUS (Committee on Foreign Investment in the United States). The FTC can block mergers that are deemed to be a threat to fair trade. The FCC will review large telecom transactions and CFIUS will review foreign companies making investments in the United States. For example, in May 2016, Staples and Office Depot walked away from their proposed merger after the FTC sued to block the merger. The combined Staples/Office Depot entity would have had a nearly 80% market share and regulators argued that the combined company could have had enough market power to unfairly raise prices on office supply items. More recently, Jet Blue called off its proposed merger with Spirit Airlines in 2024 after the FTC sued to block the merger due to antitrust concerns. The FTC argued that the combined entity would reduce competition and raise ticket prices. Typically, it is best to stay away from arbitrage opportunities in which the combined new company would have a large market share and there are regulatory/antitrust concerns. The best kind of merger arbitrage opportunities exist when there are no regulatory threats, and the board and shareholders are receptive to a proposed transaction.
Successful Merger Arbitrage Examples
Planar Systems – 16% Return in 3 Months
This is an excerpt of an article I wrote for SeekingAlpha.com on Sept. 9, 2015:
“On August 12 Planar Systems (NASDAQ: PLNR), a global leader in display and digital signage technology agreed to be acquired by Chinese based Leyard Optoelectronic Co., Ltd. for $6.58 per share.
Leyard's bid of $6.58 per share in cash represents a 16% spread from the current price of $5.68, which equates to a 50% annual return if the deal closes as expected by the end of 2015.”
The deal closed a little over two months later on November 27th, 2015 and investors realized a return of 16% in a little less than three months. This equates to a roughly 64% annualized return.
The shareholders were receptive to the deal and unanimously voted in favor of it. Moreover, there were no antitrust concerns to this proposed acquisition. The only regulatory hurdle was getting the ok from CFIUS. CFIUS had to approve the deal because Leyard was a Chinese company.
Below is a formula to calculate the merger arbitrage return for this deal:
(Acquisition price = $6.58 / purchase price = $5.68) -1 = 0.1584 or 16% x (12 months/3 month holding period = 4) = 16% x 4 = ~64% annualized return.
Metalico – 7% Return in 3 days
This is an excerpt of an article I wrote in Sept. 2015:
“Metalico (AMEX: MEA) is a scrap metal processor with operations in New York, New Jersey, Ohio, Pennsylvania, West Virginia, and Mississippi. On June 16, 2015 the company announced its intentions to be acquired by Total Merchant, for $0.60 per share. Total Merchant is an investment vehicle controlled by Chung Sheng Huang who is the Chairman of the of Ye Chiu Group, one of the world's leading recyclers and producers of aluminum and a prominent Asian scrap metal recycler with operating facilities in China and Malaysia.
In the end, Total Merchant agreed to terms to acquire Metalico for $87 million including outstanding debt. This leaves $0.60 per share left for the equity holders.”
Metalico stock was trading around $0.56 just days before the Metalico shareholders voted in favor of the merger on Sept. 11, 2015. Investors who were able to buy shares at that price realized about a 7% return in just days.
Key Point #1 – Large Shareholders were in Favor of the Deal
The CEO Carlos Aguero owned roughly 7% of the stock and had said he would vote in favor of the deal. Some of Metalico's large institutional holders include BlackRock, Vanguard and The Oppenheimer Funds. These institutions are very likely to vote in favor of the transaction because they are often passive index investors and have no reason to vote against an acquisition offer.
Key Point #2 – No Financing Risk
“Total Merchant's chairman Mr. Huang stressed in his letter of introduction to Metalico's board of directors that his offer is not subject to Chinese regulatory approval or to any financing contingency.”
Key Point #3 – The biggest risk (and why there was still a 7% spread just days prior to the merger) was uncertainty of how a large shareholder would vote
“Mr. Weitsman's intentions remain to be seen in the shareholder vote because he owns a substantial stake of roughly 9.25% of Metalico stock. There remains the possibility that Mr. Weitsman still thinks he can mount a successful hostile takeover of the company and vote a dissenting opinion. That is likely the biggest risk and only potential holdup in this deal. The holders of a majority of Metalico's 73,690,436 outstanding shares of common stock constitute a quorum at the special meeting.”
Ultimately, the deal was approved, and investors realized an adequate profit in a relatively short time.
Shanda Games – 9% Return in 2 months
This is an excerpt of an article I wrote on Sept. 14, 2015:
“Chinese online game developer Shanda Games (NASDAQ: GAME) has announced definitive plans to go private. The company will be acquired by its parent company, Capitalhold Limited, which owns roughly 75% of Shanda's stock.
Shanda's shareholders will receive $7.10 per share in cash upon the deal closing. Shareholders will receive more like $7.05 because there is a $.05 cancellation fee associated with holding the American Depositary Shares (ADS). Even with the cancellation fee, there remains an 8.63% spread based on Shanda's closing price of $6.49 as of market close on September 11th.
Key Point #1 - The deal was not contingent on financing.
Key Point #2 - The buying group had majority voting power, so the approval was very likely.
“The buying consortium that includes Capital hold and Mr. Zhang's investment partnerships owns 75% of Shanda's stock and 90.7% of the total voting power of the outstanding ordinary shares. A two-thirds majority is needed to approve the deal and the buying group has already said it will vote in favor of the merger. Moreover, the buyers will owe Shanda a termination fee of $115 million if the deal is not consummated. The termination fee equates to 25% of the total deal consideration. To summarize, the buying group has the majority voting power to approve the deal and it has already said it will approve it. The shareholder vote is a formality at this point. This deal will close once the "official vote" takes place.”
The merger was completed about two months later on Nov. 19, 2015. Shareholders received $7.10 per share, good for a roughly 9% return in two months.
Jinpan International – 15% Return in 2 ½ Months
I wrote this note for investors on February 2nd, 2016 recommending Jinpan stock:
FNOF E&M Investment Limited has agreed to acquire Jinpan International Limited (NASDAQ: JST) for $6.00 per share in cash. Jinpan is a company that "designs, manufactures, and markets electrical control and distribution equipment used in demanding industrial applications, utility projects, renewable energy installations, and infrastructure projects." The deal is expected to close in the first half of 2016.
Key Point #1 - board had unanimously approved the merger
“The board of directors has unanimously approved the deal and has recommended that shareholders do the same.”
Key Point #2 – major shareholders were in favor of the deal
“The deal is contingent on a majority shareholder vote. CEO Zhiyuan Li and President Yuqing Jing (combined represent about 23.45% of total voting power of Jinpan stock) have agreed to vote in favor of the deal. It is likely that they will represent most of the shareholders (both in person and via proxy) at the general meeting when the vote will take place. If the deal is completed, Jinpan will become a private company and the current shares will be cancelled from the NASDAQ. If the deal is approved according to the announced terms, shareholders of record on the deal closing date will see each share they own swapped for $6 in cash…”
Jinpan International closed the deal a little over two months later in April 2016. Investors who bought Jinpan shares in early February 2016 and held to close date realized profits of about 15% in 2 ½ months.
On these four arbitrage opportunities, all were completed successfully, and the average return was about 11.75% returns in about 2 months.