Active Investors are fundamentally buyers of risk. They do so through various forms of research. Risk is available across a spectrum of time-horizons, from secular disruption through long-term buy-hold decisions, to the shortest of event-driven risks often involving corporate transformation. In Kate Welling’s new book Merger Masters, she interviews some of history’s greatest investors at the short end of the spectrum. Arbs as they are colloquially known, capture profits by buying into announced mergers between companies. They profit through a form of time-arbitrage that can be a result of a rapidly changing investor-base with different perceptions of risk. Or as Martin Gruss put it, they “[underwrite] the risk in corporate deals in exchange for a rate of return.”
Welling outlines the extraordinary discipline and risk management that these investors perform to generate uncorrelated returns in a highly skewed risk/reward niche. Skew is the name of the game in merger arb because a deal break can wipe away the profit of dozens of successful deals. It takes an attuned eye and a balance of legal / corporate expertise (with a pinch of cynicism) to succeed in the space. The book is wonderfully arranged through interviews with fund managers and CEOs. The later was particularly interesting, as the buy-side can get caught up in the media narrative around these situations without ever having the inside view.
For the purpose of this post, I’ll highlight four managers who were interviewed in the book that frame the evolution of merger arb over the last 5+ decades. I strongly recommend the book as an enjoyable read on the beach for the financial nerds. I’ve taken the liberty of compiling these four managers through the lens of an Innovation S-Curve, which categorizes four stages of an industry’s innovation:
Guy Wyser-Pratte: The arb’s return on investment is a direct function of the demand for that particular investment.
Pratte’s interview is the opener, as he in some ways is a godfather of the modernized practice. Welling notes a Fortune magazine cover in 1977 citing Wyser-Pratte, Richard Rosenthal, Richard Rubin, and the now infamous Ivan Boesky as the ‘four horseman of arbitrage.’
Wyser-Pratte was by no means the first merger arbitrageur, but he will be known for his role in the evolution through the transparency his writings brought to the investment style. Wyser-Pratte published a treatise on the practice in the form of a graduate school dissertation. This document was read across the street, bringing transparency and talent to arbitrage. This ushered in an era where insider information was eschewed, arbs were given a better name, and specialization could flourish.
At the time, the lack of competition in merger arbs allowed for wide spreads to be captured by thoughtful practitioners. This was before legal acumen, complex or automated option-strategies, and shareholder activism were common tools. To provide a reference point, think of the institutionalization of today’s early-stage niches of investing (e.g., crypto, cannabis, vaping). They are marked by questionable legality, confusion between skilled and “right place right time” practitioners, and an uncertain evolution. With all of that comes abnormal dispersion of outcomes and fat initial margins. By providing guidelines and structure, Wyser-Pratte was able to entice a generation of bright minds to join the merger arb community, ultimately accelerating the maturity of the space. He deserves significant plaudits for his role in pushing progress forward.
Martin Gruss: all boats – yachts and rowboats – go down together in a severe market decline. And if you’re highly leveraged, you’ll be carried out.
Similar to Wyser-Pratte, Martin Gruss got into the business through his father that ran a successful investment banking business turned oil business. Prior to the specialization of active management (let along hedge fund strategies), the incubation of investment strategies often resided on prop desks, and Martin Gruss was groomed to take over his father’s business after a stint at another investment bank (Kuhn, Loeb & Co).
Gruss’ firm in still a fixture in the multi-strategy community, and this staying power stems from his focus on the risk management elements of running a business rather than a trading operation. That focus on risk management was necessary given the expansion of the practice and the evolving marketplace. This evolution required new tools. He discusses how leverage was a powerful tool in arb situations, and how that leverage forced a disciplined approach towards risk management. Activism was another tool that Gruss used in its arsenal, being able to look at deals differently than a passive element. By being able to catalyze actions, he understood that value could be unlocked.
The lasting power of such a firm is predicated on understanding various forms of risk:
- idiosyncratic risk: as he details in several situations where understanding the dealmaking intimately was integral to making it out alive;
- regulatory risk: during the period where Boesky’s footprint of insider trading was impacting markets as well as market participant behavior; and
- cyclical risks: he highlights the environment during the LBO and ‘greenmail’ boom of the 80s, versus the ensuing busts of 1987 and 2000.
It’s little wonder than Gruss was able to mentor legendary disciples, such as John Paulson. They too have expanded into activism, and even beyond into different legs of the corporate capital structure. Gruss transformed his business by institutionalizing its risk, and groomed a tree of talent with expertise around the maturing field of arbitrage investing.
John Paulson – You’ve got to be 100 percent focused because there are a lot of deals, and the way you get or find things is by 100 percent focus and constant digging
Best known for his legendary trade against domestic RMBS, John Paulson was historically known as an expert in merger arb. Paulson always had an eye on working in arbitrage which ultimately shaped his career choices. As he recounted, he needed M&A experience from the banking side, which required a high-pedigree MBA. He did both and began his ascent, ultimately landing a job with Martin Gruss. Paulson recounts how his tenure there saw the explosion of partnership (or LP) capital which changed the nature of the business.
This external capital meant you “had one hundred times more capital from outside people” than your own. This is a far cry from the dynamics in the early days of Gruss, Rubin, or Wyser-Pratte. This gave rise to a very profitable business model, which also brought significant competition to the forefront. Practitioners such as Paulson really needed to sharpen their edge, as the pool of available alpha (all else equal) was shrinking due to heightened competition.
While the early arbs cited 2000 – 2500 basis point spreads (annualized), Paulson notes how the world changed (partially due to a changing interest rate environment). “A 400-to-600 basis point premium to the risk free rate is a reasonable expectation for unlevered, long-term average returns in risk arbitrage…to add value above that…you can add 200 to 400 basis points of return.”
The relentless focus on understanding the minutia behind deals, the corporate governance underlying them, the rationale behind the deal, the probability adjusted distribution of potential outcomes, and the ability to insert expertise into the dealmaking process were all hallmarks of Paulson. His generation of arbs represented the Pareto function of competition x expertise per unit alpha.
Jamie Zimmerman: The great advantage of risk arbitrage as a discipline is evident in looking at how many of today’s multi-strategy hedge funds started out as arb funds (paraphrase)
Zimmerman, who along with several other multi-strategy investors interviewed in the book (such as Peter Schoenfeld, Jamie Dinan, and Clint Carlson) represent the mutation of risk-arbitrage from a standalone strategy to a complement within a multi-strategy approach. Each of these interviewers lamented the heightened competition and the cyclicality of attractiveness in pure arbitrage, as a function of the interest rate environment, competition, and technology.
I found this quote to be quite fascinating. Zimmerman cites risk arb as a “risk management system,” or a training designation for the multi-strat investor. The arb is trained to be a pessimist, because a blind acceptance toward every deal would be prone to an assymetric downside for a miss. These are key ingredients toward multi-strategy investing, where a cadre of strategies can provide a superior risk-adjusted return if the skewness of outcomes can be soberly assessed and balanced across uncorrelated assets. As a result, merger-arb can be more valuable within a lineup of alternative strategies, versus a stand-alone. It also allows a portfolio manager to eschew deals if the environment isn’t favorable, while keeping an ace in the sleeve should it ripen.
Zimmerman, as well as Paul Singer, also cite the role of distressed investing in becoming a “full stack” multi-strat. With the enhanced table-stakes required for successful arbitrage investing came overlap into other fields. This natural evolution from merger-arb to multi-strat seamlessly integrates the legal expertise required to forensically examine deals toward the restructuring expertise required for successful distressed investors.
A few of the interviews touch upon the role of quantitative investing strategies in merger arb, starting with Jeff Tarrant. Clint Carlson noted how expertise was automated through superior options-pricing models made ubiquitous, and Roy Behrens cited a stint at a well-known quant firm who looked to plant a flag into the space. Ultimately what the book and the practice shows is the difficulty of using statistical inference / quantitative models in assessing fat-tailed risks, which is at the heart of generating abnormal returns versus a passive merger-arb indexation strategy. It remains to be seen how advancements in natural-language processing (key for legal & news flow interpretation) and machine learning (key for pattern recognition) could be applied to merger arb. Until then, there is much to be learned from the masters of human judgment. The layperson can start by reading this book.