Warren Buffett's favorite bet, event-driven arbitrage

two merger arbs worth keeping an eye on

On Saturday, Warren Buffett passed away. It was very sad. No wait, that’s not right. He announced his retirement as CEO of Berkshire effective the end of the year. This took many by surprise, and based on the tweets of remembrance if you didn’t see the initial announcement you’d have thought he passed away.

Buffett is most known for his control of Berkshire Hathaway and using the cash float of the insurance business to buy and sell public equities and treasuries. His famous saying “never bet against America” and the fact that people view him as a cuddly grandpa like figure who’s relaxing in Omaha while sipping on a coke and eating McDonald’s, instead of the ruthless shark he is, shows that he was a master of PR.

While his post 2010 investments will be solely remembered for his huge Apple bet and bank warrants, his early years should be studied. As he took a small sum of money and turned it into a huge sum of money using only his wits (and some whispers of information from his dad’s political connections) very quickly.

For those hungry to replicate similar levels of explosive growth his early years should be studied. He and Ben Graham both used merger arbitrage, or “workouts" to juice gains. They were called workouts because the investing was the easy part, the workout was the study needed to figure out how to minimize downside risk while maximizing profits.

Buffett would figure out how the best way to minimize losses, then go long the merger arb, often with huge leverage. A win for him would pay out huge against the expected loss. This investment style has become so popular that pod shops in all the big hedge funds exist to try to replicate these types of low risk huge returns. Often over crowding the position and if the merger arb blows up, as with what happened with Capri or spirit airlines, the realize huge losses.

This has created a lot of risk for individual investors to try to follow the arb as well. The upside is often quickly eaten away by huge funds, making the downside risk greater than the upside reward. Barring a case where you like the underlying company even if the deal falls through, there hasn’t been many arbs worth looking at over the last 18 months. UNTIL the arb blows up. Given the market instability of the past month there are three arbs that still haven’t closed to their pre-April 2nd level.