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Thursday, November 19, 2009

Return Free Risk - A Merger Arb Anecdote

Most people are familiar with the concept of risk free return.  Today I want to tell my personal anecdote about return free risk and how I should have seen the liquidity bubble forming back in 2006.  Don't be alarmed by the mention of arbitrage spreads, cost of capital, and short rebates - the concepts are simple.

When I was on the buy side of the business - working for an internal hedge fund at a major sell side firm - we ran a large merger arbitrage portfolio. Merger arb is simple in theory:  when a cash acquisition is announced (ie, ORCL buys JAVA for $9.50 per share), you buy the shares in the target company if the risk vs reward payout being priced by the market is favorable (in your opinion).  If and when the deal closes, you make the spread between where you bought the stock and the acquisition price.  If the acquisition is an offer for shares in the acquiring company instead of cash (ABC is buying XYZ, and giving XYZ shareholders 2 shares of ABC stock for every share of XYZ that they own), you buy shares of the target (XYZ)  and short 2 shares of the acquirer (ABC) for each XYZ share that you've bought.  If and when the deal closes, your long XYZ will be converted into an ABC position that will cover your short hedge, and you'll have captured the spread, and be left with no stock positions.

Now, there are other costs and considerations as well - dividends you will pay (on short positions) and receive (on long positions), and more importantly, the cost of carry.  The cost of carry is the opportunity cost on your money - the risk free rate that you could otherwise be earning, or your "cost" of borrowing money.  At my "fund,"  we had access to a large amount of capital courtesy of the bank's balance sheet.   The catch was, each dollar we used we paid for.  In other words, I could buy $100MM in stock, and they'd charge me for that money - say, 5% annualized.

Thus, when calculating the return on merger arb deals, I had to back out the cost of capital.  For cash deals, this meant basically subtracting 5% from the annualized return that the market was pricing in.  For stock deals, it's a little more complicated, but don't fret, it's not rocket science:  when you short stock, you usually earn a "rebate" on your short position.  This is a fancy way of saying that the proceeds from the short sale earn interest for you - although not quite as much interest as you have to pay on your long position.  Thus, in calculating my cost of carry I need to add the cost of buying the long position, and deduct the rebate that I earn on my short position.   In stock for stock deals where the company I'm shorting (the acquirer) is an easy to short, top rebate level stock, the impact on the cost of carry will be small - since the rebate on the short stock will be very close to the cost of funds for the long stock.

Anyway, fast forward to "ideas dinners" where a bunch of merger arb hedge funds get together and talk about their best ideas in the field.  We'd have 20 supposedly smart guys from different firms sitting around a table, and talking about arb spreads.  "the ABC-XYZ spread is 5% - it's a layup,"  one guy would say, and I'd raise my eyebrow.

"It's not 5%, it's 0%.  You have to adjust for the cost of your funds,"  I'd say.

"We don't pay for funds," he'd respond, as others in the room nodded.  See, most hedge funds just have a pool of client money that they're investing - they don't have to pay to borrow it from their firm.

Now my other eyebrow would go up, and I'd say "Are you guys serious?  Even if you don't actually get charged for the funds, you still need to deduct the risk free rate from your return profile."   I mean - this is finance 101.

Amazingly, most of these traditional hedge fund traders didn't look at it this way - they way they looked at it was that they had $100MM to invest, so if a deal returned 5%, they were making 5%.  Never mind the fact that US Treasuries returned 5% also - they were earning their 5% of RETURN FREE RISK.  ZERO excess return (above the risk free rate) with risk included!  Where do I sign up!  Of course, it's not entiely return free, as there were a number of merger deals in 2005 and 2006 that saw bumps or increases in the bid price to a higher price.

Shockingly,  in stock for stock deals, these same guys would add back in the rebate they earned on their short position to make their "return" look even higher - STILL without accounting for the cost of capital on the long side!   In a room full of twenty people, there were maybe 2 others in the same boat I was who approached me after the events to explain that they understood my point. 

I'd return from the events and explain to my boss that the Street was batshit crazy, and that they were absolutely mispricing the risk in these deals.  Every time a broker called us and said "Check out XYZ-ABC - it's 5% annualized,"  my boss would just mutter "don't educate them,"  and we'd say "thank you," and hang up the phone.  Obviously, you know how this story ends:  the merger arb world blew up in 2007, and guys who were recklessly putting on every spread at rates which didn't compensate them for the risk they were taking on got wiped out.

How does this relate to today?  If you read Bill Gross's monthly piece today, he talks about the Fed's efforts to reflate the market by keeping rates so low that investors are almost FORCED to plow their funds into riskier asset classes to avoid earning a near 0% return on their money - which is what the risk free rate is now paying.

"The Fed is trying to reflate the U.S. economy. The process of reflation involves lowering short-term rates to such a painful level that investors are forced or enticed to term out their short-term cash into higher-risk bonds or stocks. Once your cash has recapitalized and revitalized corporate America and homeowners, well, then the Fed will start to be concerned about inflation – not until."

If you're wondering why the stock market (not to mention the government bond market, oil market, gold market,  corporate bond market, junk bond market) seems to be rising without logic, it's because of all this liquidity that is MANDATING the devouring of risk assets.  In my opinion, this can only end one way... badly.

-KD

13 comments:

Chris said...

Kid...good post. My question then becomes, "Which positions to short, and how much money do we set aside to short them?" Oh, and of course I should add "How much of that should I set aside for a celebratory trip to the Rhino?"

Kid Dynamite said...

@Chris - whatever you do, don't take this blog as any sort of trading advice. I've been short and very wrong since May.

the problem is, it can take YEARS for these bubbles to pop... witness 2001-2008...

Taylor said...

It's amazing some of these people didn't see / understand your point. I'm just a simple CFP in south Georgia and I agree - it's econ 101.

Anonymous said...

As a follow-up to your anecdote, the real issue is about the hurdle rate that hedge funds do or do not have. Most European hedge funds do not have a hurdle rate; most American funds do. The hurdle rate is the rate you must beat BEFORE you can charge performance fees. In your excellent example, the manager would make 5% from the trade but earn 0 fees because LIBOR was also 5%.

getyourselfconnected said...

KD,
Whenever I think of arb trading I think of LTCM. Thanks for the insider look, very interesting. Still, to me it seems too much time is tried deploying massive amounts of money to play a small angle for a few bucks. Better to try and make quality bucks than fast ones, but I understand that is not how the Street is built.

Anonymous said...

I believe some of the purchases that look like they are chasing yield, are in fact people just trying to own non-fiat assets (be it oil, gold, manufacturing facilities, even intellectual property that is protected) - as there is no longer a "risk free" 0% rate of return... since the possibility of hyper-inflation of the USD is now material (if still quite small).

If the DXY keeps heading in the same direction it has been, borrowing costs in USD are actually quite negative, and so are savings rates.

Great story about the hedge funds.

-peterpeter

LightnRod said...

That is exactly what is happening. It is another bubble that the Fed is creating.

I have been watching the markets climb since March. The economy is not supporting the market really. It is the Fed, the liquidity. Amazing. I should have been paying attention to the Fed and liquidity instead of the economy.

The markets can continue to go up much futher. Should have been long the market, however the time will come, and the party will be over at some point in time. It will end badly.

This is not a good way to guide the economy. It is not supportable on a long term basis. Actually, it is wrong.

It is unbelievable...the "smart" people don't learn, and the public takes it.

Hammer Player a.k.a Hoyazo said...

Great, great point about the whole reflation bubble. I myself have bought more in stocks over the past year than I otherwise would normally have done, because wtf am I making putting that money into the bank these days?

I guess the thinking is that we can reflate the economy in this fake way for now, until real demand comes in to pick up the slack. Scary.

David Merkel said...

Yo, KD. Good post. I view it a little differently. I think of merger arb as similar to investing in junk bonds. I look at deals, and ask how likely it is for the deal not to go through. Every deal has at least 1% odds of not going through; many have more.

Then I look at the price pop from the deal, and that gives me my potential loss severity. If a deal doesn't offer more yield than my expected loss rate plus the yield on short-term Treasuries, it doesn't make sense to do the arb.

Kid Dynamite said...

of course, David - the EV is calculated as the profit if the deal goes through, times the probability of the deal going through, minus the loss if the deal breaks, times the probability of the deal breaking.

the point of this post is, you then annualize that number and subtract the carry costs - so that you can normalize deals.

GS751 said...

thats amazing you would get call's from brokers saying "its 5% annualized"

Tjemme said...

I must be missing your point. In your hedge fund example, you suggest that the hedge funds (incorrectly) ignore the presence of a risk-free rate. But in your final point, you suggest that investors are (incorrectly) overreacting to the risk-free rate. These two concerns seem to be conflicting?

Kid Dynamite said...

@TJemme - the problem is that right now there is no risk free rate! it's ZERO.. this phenomenon encourages the other class of investor - those who DO evaluate risk free alternatives, to have to seek out risk.

another way of saying it is "if you liked that deal return with a 5% risk free rate, you must LOVE it with a 0% risk free rate"