From a Reader:

I’ve mentioned this before but I’m an avid reader of the blog. I’m currently going through your old posts one by one and learning a lot. Yours is one of 2 or 3 other blogs that I am reading the archives… thanks for spending so much time sharing.

My question is about arbitrage (tenders and merger arb). I’ve been reading through Buffett’s old letters and in the late 1980’s he had quite an impressive run with his arbitrage investments (I think in 1987 he made around 80% on his arb investments).

Both he and Graham seem to have had long time success for decades using merger arb and other arbitrage techniques. I’m wondering if you ever employ any of these strategies in your portfolio? It seems like a specialized area, but also seems like an area that would add uncorrelated returns to the portfolio, and serve as a great substitute for cash when markets begin to become overvalued.

Would love to hear your thoughts on merger arb if you have time…

I did small deal merger arb for two years 1998-1999 and took some losses in the process.  On the whole I made money, but:

• Merger arbitrage is a lot like credit analysis.  Analyze why the deal might not go through.  Your upside is capped, but your downside is unlimited.
• Only work with binding commitments.  Do not speculate on “letters of intent.”
• Do not speculate on mergers that the media cooks up.
• Merger arbitrage is an “over-fished” area of the market.  The regular gains from it have been competed down to low yields.

When Buffett was doing merger arbitrage, few were doing it. That’s why he did so well then, though it was a small part of his strategy from an asset standpoint.

You are picking up nickels in front of a steamroller when you do this, so  don’t deceive yourself into thinking this is a low-risk venture.  This is a mature area of investing, with a lot of clever competitors.

One final note: this is not as uncorrelated as you think.  Merger arb is highly correlated to the credit cycle, because most mergers require credit to fund the purchase.  Also, many funds that do merger arbitrage consider fixed income investments as an alternative.

So be wary here… there is no free lunch.