John Paulson: How Investors Can Benefit From Risk Arbitrage Done Correctly
The Acquirer's Multiple2021-05-14T03:46:15-04:00
We’ve just finished re-reading The Alpha Masters: Unlocking the Genius of the World’s Top Hedge Funds, written by Maneet Ahuja. There’s a great passage in the book in which legendary risk arbitrageur John Paulson explains how investors can benefit by doing risk arbitrage correctly. Here’s an excerpt from the book:
Q3 hedge fund letters, conference, scoops etc
Paulson: “Say you get a $50 offer from a company that was trading at $35 and it immediately jumps to $49,” he offers. “Now most investors don’t want to stick around for the last dollar and risk losing $14 if the deal breaks. They made a good profit and want to take the property and go home. On the other hand, the arbitrageur steps in, and for that extra dollar, takes the $14 risk of deal completion. Now a dollar may not sound like a lot. But a dollar over 50 is roughly a two percent return. And let’s say it’s a tender offer and will close in 60 days. That means you can do that deal six times a year so six times two is a 12 percent rate of return. That can be an attractive rate of return for a relatively short-term investment.”
But a 12 percent return isn’t outsized by any means, let alone by hedge fund standards of excess. There are other reasons to invest, namely the fact that risk arbitrage is not correlated with the market. “Let’s use that same example,” he says. “If you bought the stock at $49, and the market fell 10 percent over the next two months—you would still earn that 12 percent annualized return, just as long as the transaction closed.”
“The beauty of arbitrage is you can earn good returns that are non-correlated with the market. A deal like this could get exciting if another bidder came in and offered $60. That would be a 20 percent bump, or $10. That would boost the return from 12 percent annualized to 120 percent annualized. It doesn’t happen all the time but it happens often enough that we spend a lot of time trying to determine which of the announced deals could get a competitive bid to capture that potential excess return.”
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The Acquirer's Multiple
The Acquirer’s Multiple® is the valuation ratio used to find attractive takeover candidates.
It examines several financial statement items that other multiples like the price-to-earnings ratio do not, including debt, preferred stock, and minority interests; and interest, tax, depreciation, amortization.
The Acquirer’s Multiple® is calculated as follows:
Enterprise Value / Operating Earnings*
It is based on the investment strategy described in the book Deep Value: Why Activist Investors and Other Contrarians Battle for Control of Losing Corporations, written by Tobias Carlisle, founder of acquirersmultiple.com.
The Acquirer’s Multiple® differs from The Magic Formula® Earnings Yield because The Acquirer’s Multiple® uses operating earnings in place of EBIT.
Operating earnings is constructed from the top of the income statement down, where EBIT is constructed from the bottom up. Calculating operating earnings from the top down standardizes the metric, making a comparison across companies, industries and sectors possible, and, by excluding special items–earnings that a company does not expect to recur in future years–ensures that these earnings are related only to operations.
Similarly, The Acquirer’s Multiple® differs from the ordinary enterprise multiple because it uses operating earnings in place of EBITDA, which is also constructed from the bottom up.
Tobias Carlisle is also the Chief Investment Officer of Carbon Beach Asset Management LLC.
He's best known as the author of the well regarded Deep Value website Greenbackd, the book Deep Value: Why Activists Investors and Other Contrarians Battle for Control of Losing Corporations (2014, Wiley Finance), and Quantitative Value: A Practitioner’s Guide to Automating Intelligent Investment and Eliminating Behavioral Errors (2012, Wiley Finance). He has extensive experience in investment management, business valuation, public company corporate governance, and corporate law.
Articles written for Seeking Alpha are provided by the team of analysts at acquirersmultiple.com, home of The Acquirer's Multiple Deep Value Stock Screener.
All metrics use trailing twelve month or most recent quarter data.
* The screener uses the CRSP/Compustat merged database “OIADP” line item defined as “Operating Income After Depreciation.”
