Arbitrage

The textbook definition of arbitrage reads something like, “the simultaneous purchase and sale of the same security in different markets to profit from unequal prices”, or ‘riskless profit’. Genuinely ‘riskless profits’ do not exist in my experience, but clean-cut market inefficiencies occur occasionally. This is ordinarily when the chance for profit at ‘measurably low’ risk presents itself.

An example occurred one summer when a well-known publicly traded company raised $210 million in subscription receipts to acquire assets of another company. Subscription receipts convert into common shares upon formal closing of an acquisition, but allow the issuing company to return money to investors if the acquisition does not close (by a predetermined date). Subscription receipts are normally listed on an exchange if it is a public issuer. In this example, even though there was a sizable break fee on the transaction and the seller was motivated (given large capital requirements on another asset), the subscription receipts opened for trading at a 7% discount to the common stock. The expected closing date for acquisition was less than two months after the subscription receipts were listed, which meant an opportunist could effectively lock in an >7% gain within two months if the acquisition closed. There was no guarantee that this deal would close, but it was highly probable, and, in the end, it did close. A 7% return in a couple months looks pretty good on an annualized basis; even better when accounting for risk.

Pseudo arbitrage opportunities can also come about when illiquid public companies get acquired by liquid companies in a share exchange deal. One day I came into a 6am morning meeting to learn that a relatively illiquid junior company was being acquired by a larger public company; with a preset share exchange ratio. The target company was largely illiquid because a very high net worth individual had a control position in the stock. This individual publicly disclosed they would be tendering their stock in support of the deal, so we knew it was pretty certain that the acquisition would close (i.e. in a month and a half). The takeout premium was greater than 40%, and yet, the target company opened for trading just ~22% higher than its previous day’s close. Shareholders had been so liquidity starved that they were happy to take advantage of the liquidity and lock-in a ~22% pop. This left a relatively very low risk ~18% layup in a month and a half for the rest of us.