150 THE WARREN BUFFETT WAY
ARBITRAGE
Arbitrage, in its simplest form, involves purchasing a security in one
market and simultaneously selling the same security in another market.
The object is to prof it from price discrepancies. For example, if stock in
a company was quoted as $20 per share in the London market and $20.01
in the Tokyo market, an arbitrageur could prof it from simultaneously
purchasing shares of the company in London and selling the same shares
in Tokyo. In this case, there is no capital risk. The arbitrageur is merely
prof iting from the ineff iciencies that occur between markets. Because
this transaction involves no risk, it is appropriately called riskless arbi-
trage. Risk arbitrage, on the other hand, is the sale or purchase of a secu-
rity in hopes of prof iting from some announced value.
The most common type of risk arbitrage involves the purchase of a
stock at a discount to some future value. This future value is usually
based on a corporate merger, liquidation, tender offer, or reorganization.
The risk an arbitrageur confronts is that the future announced price of
the stock may not be realized.
To evaluate risk arbitrage opportunities, explains Buffett, you must
answer four basic questions. “How likely is it that the promised event
will indeed occur? How long will your money be tied up? What chance
is there that something better will transpire—a competing takeover
bid, for example? What will happen if the event does not take place be-
cause of antitrust action, f inancing glitches, etc.?”^7
Confronted with more cash than investable ideas, Buffett has often
turned to arbitrage as a useful way to employ his extra cash. The Arkata
Corporation transaction in 1981, where he bought over 600,000 shares
as the company was going through a leveraged buyout, was a good ex-
ample. However, whereas most arbitrageurs might participate in f ifty or
more deals annually, Buffett sought out only a few, f inancially large
transactions. He limited his participation to deals that were announced
and friendly, and he refused to speculate about potential takeovers or the
prospects for greenmail.
Although he never calculated his arbitrage performance over the
years, Buffett estimated that Berkshire has averaged an annual return of
about 25 percent pretax. Because arbitrage is often a substitute for
short-term Treasury bills, Buffett’s appetite for deals f luctuated with
Berkshire’s cash level.