adventures of a risk arbitrageur

Adventures of a Risk Arbitrageur

Trade # 1

Trade # 2

Trade # 3

From Nirma’s Annual Report of FY1997-98

Trade # 4

Trade # 5

Trade # 6

A Special situation is one in which a

particular development is counted upon to

yield a satisfactory profit even though the general market does not advance.

Buffett’s Case on Arcata

Corporation

28 Sept, 1981: KKR agrees to buy Arcata

printing and forest products business and a contingent claim.

10,700 acres of Arcata timberland acquired by govt. in 1978.

Arcata Timberland

$97.9 mil compensation over many installments deemed inadequate; plus co got 6% simple interest- claimed

more, compounded

Value of the stock = value of the business (less debt) + the value of

contingent claim

KKR offered Arcata’s shareholders $37 plus two-thirds of contingent claim if

materialized.

How did HE Analyse this

situation

How likely is it that KKR will go through with this

transaction?

Deal subject to “satisfactory financing”

Given KKR’s credentials, low probability of deal failure

What will happen if the deal with KKR fell through?

Other buyer likely to emerge

What is the Redwood Claim worth?

Somewhere between zero and “a whole lot.”

Why did Mr. Buffett not value this claim?

Started buying at $33.50. offer price was $37 plus two-thirds of the claim.

Started buying on 30 September. Payment expected by next January.

Heads I win a little, tails I win a lot

Not counting the value of contingent claim, expected return = 40% p.a.

annualized.

Financing glitches appear. (“Shit Happens”)

The stockholders’ meeting was postponed again, to April.

Such news usually treated by the arbitrageur community as

bad bad news.

Stock declines, Mr. Buffett buys more.

On March 12 KKR revises offer, first cutting it to $33.50, then

two days later raising it to $35.00.

March 15: Arcata Board Rejects KKR bid and accepts rival bid of $37.50 plus 50% of contingent

claim.

Stockholders approved deal, $37.50 paid on June 4.

BRK received $24.6 mil versus its cost of $229 mil.

average holding period close to 6 months.

Annualized return came to 15% return excluding any value for the

redwood claim.

What about the contingent claim?

The trial judge appointed two commissions:

One to look at the timber’s value

The other to consider the interest rate question.

January 1987: Timber valued at $275.7 mil compound

interest @14% p.a. awarded!

Wow!

August 1987 the judge upheld these awards

Total value of claim = $600 mil.

Government appealed. In 1988, claim settled for $519 million.

BRK received an additional $29.48 per share, or about $19.3 million.

Risk Arbitrage TeachesProbabilistic Thinking

Risk Arb: Pursuit of profits from an announced corporate

event such as sale of the company, merger,

recapitalization, reorganization, liquidation, self-tender, etc.

In most cases the arbitrageur expects to profit regardless of

the behavior of the stock market. The major risk he usually

faces instead is that the announced event won’t happen.

To evaluate arbitrage situations you must answer four questions:

1. How likely is it that the promised event will indeed

occur?

2. How long will your money be tied up?

3. What chance is there that something still better will transpire - a competing

takeover bid, for example?

4. What will happen if the event does not take place

because of anti-trust action, financing glitches, etc.?

Annexure to 3rd Edition of Security Analysis

Trade # 7

The commercial vehicle business of Eicher Motors Limited along with the

related components and design services businesses will be transferred to the joint venture company which is

a step-down unlisted subsidiary of EML on slump sale going concern

basis at a value of Rs202 crores

Volvo will contribute Rs 1,082 crores in cash and will also transfer its Indian truck distribution and

service network to the joint venture. In lieu of cash and the service and distribution network, Volvo will be allotted 45.6% equity shares in the joint venture.

EML will consequently hold the balance 54.4% equity and thus the joint venture will be a subsidiary

of EML and its financials will be consolidated with the financials of Eicher Motors.

Volvo will also buy 8.1% equity stake in Eicher Motors Limited from the promoters of Eicher Motors

Limited at a consideration of 157 crores which equates to Rs.691 per share. Now taking into account

it’s direct and indirect holding, Volvo’s economic ownership of the joint venture will be 50%.

The joint venture will have exclusive distribution rights in India for all present and future Volvo truck

products. All future Volvo group truck projects in India will be routed through this joint venture

subject of course to agreement on the terms and conditions.

EML and promoters have also entered into a separate non-compete agreement with the joint

venture for not getting into trucks and buses business in India. Volvo shall pay a non-compete consideration of Rs.39.4 crores each to Eicher

Motors and to the promoters.

Post-closing Eicher Motors will receive a consideration of 202 crores from the joint venture and it will be debt-free. In addition there will be the 39.4 crores of non-compete fees which will come in. So both put together this will be around 240 crores.

“Eicher Goodearth (promoter of EML) intends to propose to the EML board to consider a buyback of

shares from the public shareholders in the same proportion as the promoters have sold to Volvo. So

the promoters have sold 8.1% out of 58.2% stake and that equates to around 13% of the promoter holding. So we are recommending to the EML Board to do the

same to the public shareholders and at the same price of Rs.691.”

Buy 100 shares at 225Tender 13 shares at 691

Effective cost of 87 shares = 13,517 or Rs 155 per share.

Capital Structure Arbitrage

Exploiting relative valuation gaps between different securities which

form part of the same capital structure.

Network 18 PCCPS

Market neutral returns of 23% in 3 months

1 pccps = 1 stock + 1 warrant + 1 preferred

1/2 stock

=

Buy Spot Sell in Futures Create cheaply!

Trade # 8

http://fundooprofessor.wordpress.com/2011/03/01/ben-graham-framework-36/

Example Capital Structure Arb:

ISPAT INDUSTRIES

http://fundooprofessor.wordpress.com/2011/02/19/bfbv-examination-question/

http://fundooprofessor.files.wordpress.com/2011/02/ispat_pa_22122010.pdf

Subsequent Developments

24 Feb 2012

3 Sept 2012

13 Sept 2012

EXAMPLE CONVERTIBLES ARB

TATA STEELCCPS

Trade # 9

26.8 x 6 = 160.80 which is 12% cheaper than Tisco Stock

Current Discount is 12%

Rs 2 per share dividendon Rs 26 dividend yield (tax free) = 7.7%

Update as on 29 October 2012

EXAMPLE CONVERTIBLES ARBTATA MOTORS DVR

Slides from a presentation made on 13 october, 2011

Trade # 10

DVR enjoys 1/10th the

voting right of Equity but gets

5% extra dividend rights.

Discount of 46%

Post Split Equity shares = 269 cr shares @ 186 ≅ Rs 50,000 cr.Post Split DVR = 48 cr DVRs @ Rs 101 ≅ Rs 4,800 cr. (Almost $1

billion)

Discount of Rs 85 per DVR x 48 cr DVRs = Rs 4,100 cr.

http://breport.myiris.com/ICICISL/TATENGLC_20110530.pdf

Why No Mention of “DVR”?

Price is before stock split

Why don’t they switch?

Why the discount?

28% discountIs corporate governance at

Pantaloons better than at the house

of Tatas?

Month Promoter Stake in DVRJun 2011 9%Mar 2011 19%Dec 2010 19%Sept 2010 36%Jun 2010 36%Mar 2010 53%Dec 2009 57%Sep 2009 80%Jun 2009 84%Mar 2009 84%Dec 2008 84%

Is there a technical reason for the

discount?

1,500 Class B = 1 Class A (Economic Rights)10,000 Class B = 1 Class A (Voting Rights)

74x1,500 =111,000No Discount in Class B

Why do Tata Motors Futures

trade at a discount to

spot?

Update as of 29 Oct 2012

1500:1

Thank You