Risk Arbitrage E-Book

Guy Wyser-Pratte

• Herausgeber: John Wiley & Sons
• Kategorie: Fachliteratur
• Serie: Wiley Investment Classic Series
• Sprache: Englisch

Seitenzahl: 252

Veröffentlichungsjahr: 2009

Beschreibung

Originally published in 1982, Risk Arbitrage has become a classic on arbitrage strategies by the "dean of the arbitrage community." It provides an overview of risk arbitrage, how it has been used over the centuries and particularly in modern markets, with a focus on merger arbitrage. From average expected returns to turning a position, cash tender offers, exchange offers, recapitalizations, spinoffs, stub situations, limited risk arbitrage, and corporate freeze-ins, the book provides a step by step walk through of a world of arb strategies illuminated by real world examples and case studies.

Leseprobe

Table of Contents

Introducing Wiley Investment Classics

Title Page

Copyright Page

Preface

Chapter 1 - Introduction

Derivation of Risk Arbitrage

The Arbitrage Community

A Changing Community from the 1970s to 2000

Chapter 2 - Merger Arbitrage

General

Gathering Information

Figuring of Parities

Determination of the Time Element

Return on Investment

The Risks

Average Expected Returns

Taking a Position

Turning a Position

Consummation

Tax Strategy

Treatment of New Convertible Securities

Antitrust Considerations

Summary

Chapter 3 - Merger Arbitrage:Practical Applications

Mergers Prior to 1971

Mergers from 1971 to the Present

Use of Options in Merger Arbitrage

Chapter 4 - Cash Tender Offers

Situations Prior to 1971

Cash Tender Wave of the Late 1970s and Early 1980s

Chapter 5 - Other Risk ArbitrageSituations

Exchange Offers

Recapitalizations

Spinoffs

Stub Situations

Limited Risk Arbitrage

Chapter 6 - Corporate “Freezeins”:The SubterfugeSyndrome

Introduction

Some Notable Examples

Conclusion

Chapter 7 - Active Arbitrage

The Bache/Pru-Bache Years (1967-1991)

The Wyser-Pratte Years: Years of Increasing Activism (1991-Present)

Chapter 8 - Summary andConclusions

Appendix A

Appendix B

APPENDIX C - Active ArbitrageInitiatives

Notes

Bibliography

Index

Introducing Wiley Investment Classics

There are certain books that have redefined the way we see the worlds of finance and investing—books that deserve a place on every investor’s shelf. Wiley Investment Classics will introduce you to these memorable books, which are just as relevant and vital today as when they were first published. Open a Wiley Investment Classic and rediscover the proven strategies, market philosophies, and definitive techniques that continue to stand the test of time.

Books in the series include:

Only Yesterday: An Informal History of the 1920’sFrederick Lewis Allen

Lombard Street: A Description of the Money MarketWalter Bagehot

The Go-Go Years: The Drama and Crashing Finale of Wall Street’s Bullish 60sJohn Brooks

Fifty Years in Wall StreetHenry Clews

Value Averaging: The Safe and Easy Strategy for Higher Investment ReturnsMichael E. Edleson

Common Stocks and Uncommon Profits and Other WritingsPhilip A. Fisher

Paths to Wealth Through Common StocksPhilip A. Fisher

Extraordinary Popular Delusions and the Madness of Crowds by Charles Mackay and Confusionde Confusiónes by Joseph de la VegaMartin S. Fridson, Ed.

Where the Money Grows and Anatomy of the BubbleGaret Garrett

Manias, Panics, and Crashes: A History of Financial CrisesCharles P. Kindleberger and Robert Aliber

Reminiscences of a Stock OperatorEdwin Lefèvre

The Battle for Investment SurvivalGerald M. Loeb

A Fool and His Money: The Odyssey of an Average InvestorJohn Rothchild

The Common Sense of Money and InvestmentsMerryle Stanley Rukeyser

Where are the Customers’ Yachts? or A Good Hard Look at Wall StreetFred Schwed, Jr.

The Aggressive Conservative InvestorMartin J. Whitman and Martin Shubik

Copyright © 2009 by Guy Wyser-Pratte. All rights reserved.

Published by John Wiley & Sons, Inc., Hoboken, New Jersey.

Published simultaneously in Canada.

No part of this publication may be reproduced, stored in a retrieval system, or transmitted in any form or by any means, electronic, mechanical, photocopying, recording, scanning, or otherwise, except as permitted under Section 107 or 108 of the 1976 United States Copyright Act, without either the prior written permission of the Publisher, or authorization through payment of the appropriate per-copy fee to the Copyright Clearance Center, Inc., 222 Rosewood Drive, Danvers, MA 01923, [phone], fax [phone], or on the web at www.copyright.com. Requests to the Publisher for permission should be addressed to the Permissions Department, John Wiley & Sons, Inc., 111 River Street, Hoboken, NJ 07030, [phone], fax [phone], or online at http://www.wiley.com/go/permissions.

Limit of Liability/Disclaimer of Warranty: While the publisher and author have used their best efforts in preparing this book, they make no representations or warranties with respect to the accuracy or completeness of the contents of this book and specifically disclaim any implied warranties of merchantability or fitness for a particular purpose. No warranty may be created or extended by sales representatives or written sales materials. The advice and strategies contained herein may not be suitable for your situation. You should consult with a professional where appropriate. Neither the publisher nor author shall be liable for any loss of profit or any other commercial damages, including but not limited to special, incidental, consequential, or other damages.

For general information on our other products and services or for technical support, please contact our Customer Care Department within the United States at [phone], outside the United States at [phone] or fax [phone].

Wiley also publishes its books in a variety of electronic formats. Some content that appears in print may not be available in electronic books. For more information about Wiley products, visit our web site at www.wiley.com.

Library of Congress Cataloging-in-Publication Data:

Wyser-Pratte, Guy P. Risk arbitrage / Guy Wyser-Pratte. p. cm. - (Wiley investment classics) Rev. ed. of: Risk arbitrage II. [c1982]. Includes bibliographical references and index.

eISBN : 978-0-470-44291-3

1. Arbitrage. 2. Consolidation and merger of corporations. 3. Tender offers (Securities) I. Wyser-Pratte, Guy P. Risk arbitrage II. II. Title. HG6041.W97 2009 658.15’5-dc22 2008047000

Preface

Risk Arbitrage was originally the subject of the author’s MBA Thesis at the Graduate School of Business Administration New York University in June, 1969. It was re-edited and published in The Bulletin of the Institute of Finance in May, 1971. It was republished by Salomon Brothers Center for the Study of Financial Institutions at the Graduate School of Business Administration New York University in 1982.

This updated version of Risk Arbitrage follows the development of the arbitrage community from the 1970s to the present time. A new chapter—“Active Arbitrage”—has been added to reflect the incipient melding of arbitrage and activism as a new art form.

The point of view of this work and its content reflects the author’s practical experience as an arbitrageur/shareholder activist.

The author wishes to acknowledge the valuable assistance of the following people: his father, Eugene Wyser-Pratte, whose many years of arbitrage experience find their trace herein. He would also like to acknowledge the invaluable contribution of his two colleagues, Michael Kelly and Scott Principi who assisted in updating Risk Arbitrage to its present form. He also received valuable assistance from the administrative staff of Wyser-Pratte and Company in completing the work.

Chapter 1

Introduction

Derivation of Risk Arbitrage

The simple definition of “arbitrage”—buying an article in one market and selling it in another—has undergone considerable refinement over the decades. Arbitrage had its origin in the late Medieval period when Venetian merchants traded interchangeable currencies in order to profit from price differentials. This “classic” arbitrage, as it was and continues to be carried on, is a practically riskless venture in that the profit, or spread, is assured by the convertibility of the instruments involved.

Communications, rudimentary as they were, assumed strategic importance on the European financial scene. The notable London merchant bank of Rothschild, as the story goes, staged an unprecedented “coup de bourse” by use of carrier pigeons to receive advance notice of Wellington’s victory at Waterloo. Upon learning the news, Rothschild began, with much ado, selling various securities, particularly British Government Bonds, on the London Stock Exchange. This was naturally interpreted as a Wellington defeat, thereby precipitating a panicky selling wave. The astute—and informed—Rothschild then began quietly purchasing, through stooges, all the Government Bonds that were for sale. When an earthbound messenger finally brought the news of an allied victory, Rothschild had a handsome profit.

As identical securities began to be traded on the different European exchanges, and as communications evolved from the pigeon to the wireless, simultaneous transactions in securities arbitrage gave way to “tendency” arbitrage. Thus, if for example one had good wire communications with London and Paris, where an identical security was being traded, one would try to detect a general market tendency in both markets. Should there prove to be sellers in London and buyers in Paris, an arbitrageur would sell into the buying in Paris, and try to cover his short position somewhat later when the selling tendency bottomed out in London; or vice versa. In any event, improved market liquidity and more advanced communications were providing the opportunity for “tendency” as well as “simultaneous” transactions.1

Riskless arbitrage found its way into the American securities market by way of instruments that are convertible into common stock (i.e., convertible bonds and convertible preferred stocks, rights, and warrants). This kind of arbitrage, according to Morgan Evans, “. . . is not a wild scramble of buying X common in New York, then selling it in San Francisco in a matter of moments, like the international arbitrageur who buys Shell Trading in Amsterdam and sells it in New York. Instead it is chiefly concerned with the buying of a security at one price and the selling of its equivalent (security) at a higher price, usually in the same market. . . . Convertibility of exchangeability lies solely in one direction. In this respect it differs from . . . two-way convertibility or exchangeability, which is associated with the foreign exchange markets.”2

There were two distinct developments in the 1930s that had a profound influence on the evolution of arbitrage in the United States. First, many railroads in the late thirties were coming out of bankruptcy. In order to remove their heavy debt burdens and improve their capital structures, many of them were reorganized, (i.e., recapitalized). These reorganization plans, which had to be approved by the various classes of security holders, often required the issuance of new securities to be exchanged for the old debt and preferred issues. Arbitrageurs, finding that they could sell such new securities on a “when-issued” basis, would buy the shares being recapitalized at prices lower than, or below the parity of, these “when-issued” securities. These price discrepancies, or spreads, were available because of the inherent risk that the reorganization plan might not be consummated, thereby precluding the requisite one-way convertibility. The arbitrageur was able to take advantage of the spread and willing to incur the risk. Arbitrage was now moving, in fact, from riskless to risk operations.

The second and equally important development in this period was the 1935 Public Utility Holding Company Act, requiring many public utilities to divest themselves of their holdings of subsidiaries. As the parent companies formulated divestiture plans, “when-issued” markets developed not only in the shares of their subsidiaries, but also in the stock of the parent ex-distributions. Arbitrage was thus possible when the sum of the prices of these “when-issued” securities (i.e., the sum of the parts) was greater than the market price of the parent company (the whole) cum-distributions.

“The profits realized from these recapitalizations and reorganizations led the arbitrageur ultimately to exploit the stock price differentials, or spreads, available in mergers, liquidations, and tender offers.”3 The spreads were, however, only turned into profit when the necessary one-way convertibility of the riskless arbitrage became a legal fact through consummation.

The expansion of risk arbitrage on Wall Street is directly attributable to the great corporate merger wave of the 1960s when a surging supply of selling candidates was matched by an equally impressive list of buyers. The new notion of “synergy,” that one plus one equals three, gained acceptability; inflated stock prices provided cheap financing in an ever-tightening money market; accounting for acquisitions on a “pooling of interests” basis permitted seductive proforma earnings calculations for acquisition-minded companies; and most important, a variety of tax savings was intensively exploited via a variety of security-exchange packages.

While this 1960s merger wave enabled the arbitrageur to develop expertise in the realm of risk arbitrage, the trade itself continued to generate new types of situations where the professional could apply a sharp pencil. In addition to mergers and recapitalizations, then, risk arbitrage, came to encompass stock tender offers, cash tender bids, stub situations, and spinoffs. As the number of synergistic mergers declines in weak securities and tight monetary markets, liquidity or necessitous mergers and un-merging activities are providing work for the enlarged arbitrage community.

The Arbitrage Community

“The big money makers of Wall Street often mask their expertise in mystery, and among them the most mysterious is a cliquish band of specialists known as arbitrageurs. On the Street, they are a peculiar group apart, noted for their ability to spot instantly tiny profits that can be jockeyed into big ones. ‘It would take me an hour of paperwork to see that profit,’ says one member of the New York Stock Exchange, ‘and in that hour the chance would be gone.’ Says another: ‘I think of them as vague shadows with European backgrounds. I don’t even know who they are.’”4 Arbitrageurs love it that way.

The financial press has increasingly tried to explore the activities of the risk arbitrageurs over the past few years, yet has been unable to delve with any depth into their operations. Many arbitrageurs have been approached, but have been generally unhelpful, though congenial. “Arbitrageurs tend to keep their operations to themselves. ‘Frankly, I’d prefer the average person didn’t know how to accomplish arbitrage,’ says one. ‘Therefore, the less I say about it, the better.’”5 Even Morgan Evans, whose Arbitrage In Domestic Securities In The United States surpasses anything yet published on the subjects of both riskless and risk arbitrage, falls short in explaining the modus operandi of these professionals.

The Arbitrage Community, then, consists of a dozen-plus Wall Street firms, who commit house capital as one of their primary functions, in the various forms of arbitrage. The list includes such outstanding firms as Lehman Brothers-Kuhn Loeb, Goldman Sachs, L.F. Rothschild, Morgan Stanley, and Salomon Brothers.

Many of the arbitrage firms will engage the capital of foreign banks in risk arbitrage situations. Most are reluctant to do so for domestic clients, as the latter are thought to be somewhat less discreet than their European counterparts. Some, in order to avoid conflicts of interest, will avoid arbitrage for client accounts altogether.

The Community is extremely cliquish. Each member of the club has his own particular set of friends within the Community with whom he will freely exchange ideas and information, often via direct private wires. Sometimes good friends will even work on a joint account for a particular deal. But to all others, both within and without the Community, the member will turn a cold shoulder.

Many Wall Street firms and many private investors have tried, at one time or another, to participate in risk arbitrage activity. Having neither (a) schooling or experience in the finer points of the trade, (b) the requisite expert staffs, or (c) membership in the Community, they tend to fall by the wayside. The cancellation of a few proposed mergers always singles out the amateurs and sends them scurrying back to the good old-fashioned business of investing in securities.

Any proper discussion of the Wall Street arbitrage community’s changing dynamics over recent decades would be incomplete without some consideration of the context in which these professional traders were operating. For it has always been the talent of the skilled arbitrageur to distill from a complex and ever-changing marketplace, those opportunities that others fail to capture. As the most popular, or, as some might say, “notorious” community of arbs operated primarily in the field of mergers and acquisitions, a brief synopsis of the developments of the structure of the M&A business is essential for any student in assessing the challenges that confronted arbs as they adapted and thrived in the growing world of risk arbitrage. The mergers and acquisitions business as it existed in the late 1960s may seem like a foreign landscape to today’s student of Wall Street practices. While each passing decade has brought new developments in the structure and pace of the deal market, the 1970s and 1980s were particularly formative years in laying the groundwork for the modern deal structure. Indeed, few developments in recent years match the pace of innovation seen during this critical period. The arbitrageur who ventured into these markets needed to be both agile and somewhat innovative in his own right. With the public face of the arbitrageurs, as well as the banker, and other participants, in the deal community becoming clearer, their activities gained a notoriety not seen before on Wall Street. The takeover battles of the 1970s assumed a “spectator sport” appeal to the rest of the financial and business community. Amid the growing deal frenzy, arbitrageurs grappled with an ever-changing terrain, formed by the ebb and flow of the economic, political, financial, and legislative conditions that were all refocused during this profound reshaping of corporate America.

A Changing Community from the 1970s to 2000

1970s

The 1970s saw the initial deal wave of the late sixties gather considerable momentum and, in the process, broaden the variety and the style of acquisition structure available to the corporate buyer. With mixed reactions from within the community, it also introduced the arbitrageur to the public. As could be expected, attention begets even greater attention and by the end of the decade the arbitrageur might be said to be swimming in a sea of deals . . . and arbitrageurs!

The 1970s could best be characterized as the years that propelled the M&A business toward increasingly novel and flexible deal structures. The unfolding techniques were more aggressive, the press more inquisitive, and the once congenial club of arbitrageurs who plied their expertise out of only a handful of firms found themselves in a market crowded by newer players.

One of the more significant developments, foreshadowed by the 1969 hostile takeover bid for BF Goodrich by Northwest Industries, was the first truly large-scale hostile cash tender offer. Launched in 1974 by Inco for ESB Corporation, the offer was significant not only for this new currency of the hostile offer, but also for what it represented: a bold new dimension in the world of deal making. The significance to the arb community was in the additional arrow it placed in the quiver of the would-be corporate buyer and, of course, the modification of the risk/reward considerations for those who assumed positions in such deals. Any expansion in the options available to bidder corporations expands in equal measure the profitable opportunities for the arbitrageur. In taking an offer directly to the shareholders, the debate over the appropriate balance between a board’s fiduciary obligations, and shareholder’s rights, began inching toward center stage—a position it would firmly occupy decades later. As “shareholder-friendly” generally equated to “arb-friendly,” the new hostile tenders were, of course, greeted with open arms.

The decade was not finished with innovation, however, and the next change to come would involve the allocation of payment that the arbitrageur received. Typically, a tender offer for control is followed by a squeeze-out merger to bring the bidder to 100 percent control. Conventional expectations at this time were that an owner of stock acquired in a deal, whether hostile or friendly, would receive equal monetary consideration on both the front and back ends. The value of cash or non-cash consideration paid in the first stage tender offer would equal the consideration on the back end. The first significant departure from this assumption took place in the takeover fight for Pullman between McDermott and Wheelabrator Frye. McDermott offered a package that featured cash on the front end, with back-end securities that were markedly lower in value than the front. Ultimately, Pullman was acquired by Wheelabrator in a white knight rescue, but the “two-tiered” offer had arrived. It altered some of the financial constraints normally associated with the structure and financing of a bid, adding to the deal frenzy by allowing for more creatively structured deals and a reduced reliance on cash in a hostile approach.

The arbitrage community, while enjoying the increase in deal volume, was less excited by the new entrants it attracted to the business. The arb’s return on investment is a direct function of the demand for that particular spread. With five or six arbs willing to trade a deal for no less than a 25 percent annualized return, the arrival of a new player who is willing to accept 20 percent compresses the profit available to the others. The new player will bid up the target’s price while selling down the acquirer’s price, leaving those who require a higher return outside or “away” from the market. This new crowding of the arb market can best be described in the words of the arbs themselves during this period as printed in a story run by Barron’s.

“By the seventies . . . the arbitrage community was having difficulty hiding its role in the mounting volume of corporate takeovers. In 1975, Ivan Boesky, lawyer, accountant, and securities analyst, established what probably was the first large limited partnership specializing in risk arbitrage. Boesky, to attract capital and much to the disgust of the rest of the community, stomped all over the unwritten rule proscribing publicity. “Boesky was the first of the queens to come out of the closet,” says Alan Slifka, a partner in L.F. Rothschild Unterberg Towbin’s arbitrage division. In 1977, Boesky was spread across two pages of Fortune, wreathed in smiles over the $30 million he and a handful of other arbitrageurs had picked up in the takeover of Babcock & Wilcox by United Technologies. The jig was up!

Money poured into risk arbitrage. Merrill Lynch and Morgan Stanley quickly set up arbitrage departments. Many experienced arbitrageurs formed their own limited partnerships, and a whole slate of smaller firms joined the act.

With quality firms selling for bargain-basement multiples, it had become cheaper for a company to acquire another than to make a capital investment itself. But the flat equity markets also meant that takeover stocks became “the only game in town”—a game in which hungry registered representatives were eager to interest equity-shy clients. At least two large brokerages, Oppenheimer & Co. and Bear Stearns, launched an organized assault publishing research for retail and institutional clients. No figures are available, but the guesstimate is that as much as half the arbitrage activity in some deals was “non-professional.”

“A shakeout is the best thing that could happen in this business,” says John Monk, an arbitrageur at Cohn, Delaire and Kaufman. Chief among Monk’s beefs is the narrowed spreads brought about by too many players jockeying for a piece of the same action. “The single greatest complaint I hear these days is the spreads,” Monk says. “A few years ago, if $25 was bid for a company, you might see it open up at $19 or $20. Everybody was reasonable. Today, spreads are nothing.”

Disorderly markets are another problem. “There are 33,000 registered reps out there,” continues Monk, “and they can cause severe dislocation in the market. The non-professionals tend to get out at the first sign of trouble, dumping all their stock back into the market.”

Complains Steve Hahn of Easton & Co.: “There never used to be any problem of getting as much stock as you wanted. Now I find sometimes I’ll go after 5,000 shares of something and only be able to get, say, 3,000.” But arbitrageurs used to dealing in blocks ten or a hundred times larger scoff at such squawks. Their sanguine philosophy is that “when the going gets tough, the tough get going.” Says one whose firm is believed to put some $100 million at the disposal of its arbitrage department: “Markets have a magnificent way of correcting themselves. For example, if you take a situation like we saw with Marathon, where the stock was quickly run up to $90 after the Mobil bid of $85, you’ll find that most of that was non-professional or inexperienced money. Not till the stock came down again to the low eighties did you find the arb money coming in a significant way.”

Certainly, the year was trying for professionals and non-professionals alike. Stratospheric interest rates dampened most investment sectors. High rates cut two ways in arbitrage. On the one hand, the carrying costs must be factored into the spreads on any given deal, although one arbitrageur declares: “If the difference between 15 percent and 20 percent interest rates is the deciding factor in whether you do a deal, you probably shouldn’t be even considering it in the first place.”

It is the author’s contention that the private as well as the institutional investor should be more conversant with risk arbitrage, for it often appears as though one-half of the list on the New York Stock Exchange would like to swallow the other half. Thus, stocks involved in mergers and other forms of risk arbitrage will often perform in accordance with other than their fundamental or technical characteristics. In addition, the average investor should know how to evaluate a particular package of securities offered in exchange for those securities that he is holding. The answers to some of these problems will enable the investor to make an important investment decision: whether to hold his position in the security, or dispose of it. It is thus the author’s intention to explain and describe these market reactions by discussing the various activities in which the arbitrageur gets involved.

Whereas in the first edition of Risk Arbitrage there was extensive coverage of merger arbitrage reflecting the emphasis of the 1960s, cash tender offers became much more important in the 1970s and 1980s and are given greater coverage in later sections. Indeed, cash tenders became the favorite vehicle for effecting what were called “Saturday Night Specials,” or hostile tender offers. It will be shown in the examples that follow that participation in these cash tender offers was far more profitable for the arbitrage community than participation in mergers, in that the former usually forced the target brides to seek competitive bids.

1980s

The eighties brought the arbitrage business to new heights on the back of the largest takeover boom to date. Propelling the expansion in deals was the introduction of high-yield-bond or “junk” financing for hostile takeovers. The concept of purchasing a corporation using its own assets as the collateral had been long pondered but not put to significant use with public companies. This decade brought such action and did so on a scale never before imagined. The prowess of Michael Milken’s junk bond desk at Drexel Burnham Lambert was such that, at times, it seemed that no deal was too big or too bold to be launched. The unbridled success, or some may say, excess of Drexel financing and those who profited from it would ultimately end in the indictment of arbitrageur Ivan Boesky, and later Milken, in a widespread insider trading scandal. Alongside these developments came the beginnings of the collapse of the junk bond market and Drexel itself. But not before this financing machine and the man who ran it left an indelible mark on both M&A and the arbitrage business.

What Milken created was a market for corporate raider debt obligations. Milken’s new debt instruments stood on their own, requiring no convertibility to equity. They allowed the corporate raider to, among other things, finance a bid entirely in cash and work around the Mill’s Bill, which had disallowed the deduction of interest on takeover debt linked to equity. A raider needed only a “highly confident” letter from Drexel that it could raise the necessary financing and it could be assured that its intentions would be taken seriously by the Street and a target’s board.

The eighties also brought an increase in the frequency of “white knight” rescues. Among some notable examples were DuPont’s 1981 winning bid for Conoco following an initial bid from Seagrams and Occidental Petroleum’s 1982 rescue of Cities Service from T. Boone Pickens’ Mesa Petroleum. That year also brought a new term to the deal lexicon: PacMan defense—used to describe a defensive tactic where the target of a hostile offer bids for its suitor. Bendix found itself the victim of such a defense by Martin-Marietta after it had launched its own hostile bid for the latter. In the end, Bendix was acquired in a white knight rescue by Allied Corporation. All of these situations meant one thing for the arbitrageur: opportunity. The frequency of bidding wars was obviously a boon to the community. As the decade progressed both the risk arbitrage and M&A businesses would be shaped by the opposing forces of the Drexel money machine and, on the legislative side, the counterweight of antitakeover legislation.

One of the more onerous developments of the 1980s was the widespread adoption of the “poison pill” takeover defense. In upholding the pill, the Delaware Superior Court essentially sanctioned a device that would for years impair the rights of shareholders to receive a fair price from a suitor deemed unfriendly by a sitting management. The obvious conflict between this new antitakeover defense and the basic rights of shareholders was, and is to this day, inexplicably lost on the Delaware courts. Adopted by a simple board resolution, the poison pill had the effect of a charter amendment without shareholder approval. The basic concept behind a poison pill was to dilute the voting power of a hostile shareholder by disallowing its shareholder’s equal participation in a discount stock issue that would be triggered by the raider crossing a stated percentage shareholding threshold. In the 1985 case of Moran vs. Household International the Delaware Supreme Court rejected a request by Moran to strike down Household’s poison pill. This historic decision solidified the presence of an antidemocratic takeover device that, regrettably, continues to undermine shareholder rights.

The stock market crash of 1987 was the defining event of the decade and brought the first major macroeconomic shock to the arb community. Since, at the time, most of the high-profile announced deals were for cash consideration, the arbitrageur lacked the short side which, when moving in tandem with the long, insulates a position from day-to-day market movements. Spreads widened so sharply on that historic day that the entire arb community suffered significant losses. The question in the immediate aftermath of the crash was: What’s next? Opinions varied on the future of the risk arbitrage business as the financing of mergers and acquisitions business itself hinges on investors’ appetite for risk. Some firms elected to close their arbitrage operations entirely, while others, seeing a quick end to what they believed was simply an index arbitrage melt-down, elected to extend additional credit lines to their arb desks. The idea was to capitalize on the drastically oversold market conditions and mispriced spreads brought on by the panic selling. Those firms that withstood the panic profited handsomely, as the market stabilized under the watchful eye of the Federal Reserve, spreads narrowed, and the naysayers were proven wrong. Only one year late in fact, KKR, armed with Drexel’s war chest, won a bidding war and acquired RJR for $25 billion in the largest LBO to date.