Risk Arbitrage

The Concept

Risk arbitrage (historically known as "Work-outs") involves making investments in shares of companies subject to announced corporate events—mergers, liquidations, recapitalizations, or reorganizations. Unlike classic arbitrage (simultaneous buying and selling in different markets), risk arbitrage involves the risk that the announced event may not occur.

The Four-Question Framework

In the 1988 Letter, Buffett formalized four key questions an investor must answer to evaluate an arbitrage situation:

1. Likelihood: How likely is it that the promised event will indeed occur?
2. Duration: How long will your money be tied up?
3. Competition: What chance is there that something still better will transpire (e.g., a competing bid)?
4. Downside: What will happen if the event does not take place (e.g., due to antitrust action or financing glitches)?

Key Case Studies

🌲 Arcata Corp (1981-1988)

A prime example of "speculative claim" arbitrage. Berkshire bought into Arcata while it was being acquired by KKR, knowing there was a massive legal claim against the US Government for seized redwood timber lands.

• The Result: Berkshire's patience and willingness to evaluate the litigation as "a whole lot" rather than "zero" led to a massive payout ($29+ per share) years after the initial deal closed.

🍱 RJR Nabisco (1988)

A case of "Being There." Berkshire participated in the RJR Nabisco buyout (immortalized in Barbarians at the Gate), making a quick $64 million profit by simply reading the newspapers and evaluating the probabilities.

Philosophy

Buffett notes that arbitrage "keeps you out of bars"—it is a productive alternative to holding cash when long-term opportunities are scarce. However, he warns against trading on rumors or "guessing" takeover candidates, which he distinguishes from professional arbitrage.

Related Concepts

• Efficient Market Theory
• Margin of Safety
• Opportunity Cost