Berkshire Ruminations

Thursday, November 06, 2008

Merger Arbitrage Mania!

I haven’t heard a lot of discussion about this, so I thought I would put my thoughts down on this blog, because to me the phenomenon is pretty obvious. There is some serious value out there right now, and for the last two months the market has been more inefficient than I have ever witnessed in my lifetime. Many stocks, especially small caps, are selling at valuations FAR below their intrinsic value, even after accounting for the possibility of severe and prolonged recession. I am convinced the reason for this is not fundamental, it is institutional.

Hedge funds make up a huge portion of the market and the vast majority of them are levered, many highly levered. By “hedge fund” mean simply the plain-vanilla, independent equity long/short type (not the arcane structured-product investing kind like Bear Stearns’ that got us in to this mess in the first place). By “highly levered” I mean anything from 400% gross exposure (this would be 200% long and 200% short) to infinity.

These are the types of investors that buy up small value stocks. Well, when liquidity dries up brokers have to boost margin requirements. Couple this with falling stock prices and the resulting margin calls and what you have is a situation where everyone is selling. This is basic stuff. But compounding the problem is even more selling as the result of investor redemptions. All hedge funds have different redemption periods, but my guess is that as the year closes we will see even more hedge fund selling as investors dissatisfied with this year’s performance cash out.

I still think it is this delevering phenomenon that explains much of the disparity between price and value that we are currently seeing in the market. But where it seems most obvious is in the merger arbitrage arena. This is where I am focusing currently because a) the value of the stock is much less ambiguous and b) the delevering effect is likely especially pronounced among stocks heavily invested by hedge funds who must leverage up substantially to take advantage of what are typically small discounts.

The first case-in-point is a long-time favorite company of mine, Anheuser-Busch (BUD). InBev settled with BUD back in July to purchase the company for cash of $70/share by calendar-year end. The stock hovered around $68, representing a reasonable merger arb discount, until the market blew up in September. At this point the stock, like all others in the market, fluctuated wildly and momentarily got as low as $56. This $14 discount implied a 25% raw return, or 240% annualized! Investors immediately assumed this was because the deal was in limbo because of the state of the European credit markets. But InBev soon issued a press release reiterating that the cash offer was still a go and still expected to close by the end of the year.

I was lucky enough to load up on BUD around $58. Since I don’t mind owning it as a standalone company (in fact I had for many years anyway), my rationale was simple since the expected value of the purchase was enormously positive. That is, there was a high probability of the deal going through, resulting in a large gain, and only a small probability of it not going through, which would result in only a small loss.

The second case-in-point is an even bigger no-brainer. Remember back in September when Berkshire Hathaway announced that MidAmerican Energy would acquire Constellation Energy (CEG) for $5 billion or $26.50 per share? Did you know the stock is currently trading at $23.50? This doesn’t make any sense, but yet the cigar butt is right there in front of us. With this deal, although not expected to close until sometime in Q2 of 2009, there is absolutely no danger of the acquirer failing to find financing. We are talking about Warren Buffett and his war chest!

I believe that the only reason these situations are occurring is because of the deleveraging effect. It certainly does not seem to be a function of risk so far as I can tell. Highly levered hedge funds MUST sell off their BUD or CEG stakes simply to meet higher margin requirements or investor redemptions. This leaves the individual investor with some great opportunities. But these types of opportunities are unlikely to ever be repeated, which is why I am placing large bets on them.

A couple of other merger arb plays to consider: HPC and MVCO

Ashland Inc.’s acquisition of Hercules Inc. (HPC) is a deal that has been approved by all shareholder constituencies and is expected to close next week. I don’t know much about these companies but I can find no indication anywhere that the deal is in trouble. If it is, someone please let me know. The shareholders will get $18.60 plus 0.093 shares of the acquiring company. With Ashland currently around $20, this puts the value of HPC around $20.50. HPC stock is currently at $18.

Meadow Valley Corporation (MVCO) agreed to be acquired back in July for $11.25/share and the deal is still expected to close by the end of the year. With the stock currently under $8, we are looking at a 26% return in two months.

Another intriguing thing about these merger arbitrages is that even if our return is small, the market in general does not look good in the near term anyway. We could play the safest mergers and still come out ahead, since the standard discount out there right now seems to be in excess of 10% annualized.

FD: I am long BUD, CEG, HPC and MVCO