Risk arbitrage explained | Microsoft - Activision acquisition case

Summary

In this video, Nir explores the concept of risk arbitrage using Microsoft’s acquisition of Activision Blizzard as a case study. While the price difference between Activision’s current stock price and Microsoft’s buyout offer may seem like a guaranteed profit, Nir highlights the significant risks involved. These include time risk, where the acquisition could take longer than expected, and deal failure risk, where the deal might collapse entirely. Nir advises that risk arbitrage is a dangerous game for individual investors, as it requires resources, expertise, and leverage typically only available to institutional investors, making it unsuitable for most retail investors.

Takeaways

• 😀 Risk arbitrage is an investment strategy where investors buy stocks at a discount, betting that a merger or acquisition will complete successfully.
• 😀 The Microsoft-Activision deal is an example of risk arbitrage, where Activision shares are priced at $79, but Microsoft has agreed to purchase them for $95 per share.
• 😀 The first key risk in risk arbitrage is the time risk: it could take years for the deal to close, during which your money is tied up.
• 😀 The second key risk is that the deal may fall through entirely, which happens more often than expected in mergers and acquisitions.
• 😀 If a merger falls apart, the stock price of the acquired company (Activision) could drop significantly, potentially causing losses for investors.
• 😀 A 10% annual return from risk arbitrage is underwhelming compared to the typical performance of the S&P 500, which often outperforms this.
• 😀 Risk arbitrage requires substantial resources, and large institutional investors with access to data and analysts have an edge over individual investors.
• 😀 Even experienced investors face risks when using leverage in risk arbitrage, as the potential for both gains and losses is amplified.
• 😀 The collapse of Long-Term Capital Management (LTCM) serves as a cautionary tale, demonstrating how even expert investors can fail due to over-leverage in risk arbitrage.
• 😀 In general, unless you have the resources of a large fund, risk arbitrage is not a suitable strategy for individual investors due to its complexity and high risk.

Q & A

What is risk arbitrage and how does it relate to the Microsoft-Activision acquisition?

Risk arbitrage is an investment strategy that involves buying shares of a company that is being acquired at a discount, with the expectation that the acquisition will close and the stock price will rise to the offered price. In the case of Microsoft acquiring Activision, the stock is trading at $79 per share, while Microsoft offered $95 per share, creating a potential arbitrage opportunity.

Why does the stock price of Activision remain lower than Microsoft's offer of $95?

The stock price is lower than Microsoft's offer due to risks associated with the acquisition. These include time risk (the deal may take longer than expected to close) and the possibility that the acquisition may fall through entirely, which would lead to a significant loss for investors.

What is time risk in the context of mergers and acquisitions?

Time risk refers to the uncertainty surrounding the timeline of an acquisition. In the case of Microsoft's purchase of Activision, the deal may take longer than expected to close, potentially locking up an investor's money for years without realizing any return during that period.

What happens if the acquisition deal fails?

If the acquisition deal fails, the stock price of the acquired company (Activision) is likely to fall back to its pre-announcement price, resulting in a potential loss for investors. For example, Activision’s price could drop to around $64 per share, leading to an 18% loss if the deal falls through.

How does risk arbitrage compare to the performance of the S&P 500?

Risk arbitrage, with its typical 10% annual return, underperforms the S&P 500, which has historically delivered higher returns, such as 26% in one year and 19% in another. This makes risk arbitrage less attractive, especially considering the significant risks involved.

What are the potential consequences for individual investors engaging in risk arbitrage?

Individual investors lack the resources of large funds and are likely to be at a disadvantage. They may be too slow to respond to market changes, leading to missed opportunities or increased losses. Additionally, leveraging a position to make risk arbitrage worthwhile increases the overall risk of the investment.

What role do large funds play in risk arbitrage?

Large funds have significant resources, including analysts and data access, which help them anticipate market movements and make informed decisions. These funds typically leverage their positions to gain higher returns and have the expertise to manage the risks involved in risk arbitrage, which individual investors may lack.

Why is leveraging a position in risk arbitrage risky?

Leveraging increases the potential for both gains and losses. In the case of risk arbitrage, leverage can amplify the impact of market changes or deal uncertainties, making it an even riskier strategy. If the deal falls through, highly leveraged positions can lead to significant financial losses.

Can you provide an example of a failure in risk arbitrage from history?

One notable example is the collapse of Long-Term Capital Management (LTCM) in the 1990s. Despite employing Nobel Prize-winning economists and managing billions of dollars, LTCM's use of high leverage in risk arbitrage led to catastrophic losses when a few of their bets went wrong.

What is the general recommendation for individual investors regarding risk arbitrage?

Individual investors should generally avoid risk arbitrage unless they have access to significant resources and expertise. Without the ability to leverage large amounts of data, analysis, and experience, individual investors are more likely to face substantial risks with limited potential rewards.