by Robert Rubin
However, you receive the profit only if the transaction goes through. If the deal breaks up, you are left with a position that you bought at a deal premium (Acme) and a short position (BigCo)—with almost certain losses on one or both. In this type of transaction, the potential profit is much larger than in a classical arbitrage trade—$1.50 for every share costing $14.50 in my hypothetical example. But the risk is also much greater, since the takeover might fail to close for any number of reasons. In practice, such transactions become enormously more complicated and more interesting.
Gus, a great financial innovator with the gentle disposition of an active volcano, had developed this kind of transaction after World War II in response to anomalies produced by the wartime boom. During the Great Depression, a number of railroads had filed for bankruptcy, leaving the prices of their shares and bonds badly depressed. During the war years, however, the railroads had been operating at full capacity and, as a result, were flush with cash. Coming through bankruptcy court, they were due to be reorganized in ways that would unlock their real value. Arbitrageurs like Gus would buy the stock of such technically insolvent companies and wait for them to be restructured.
By the end of the 1950s, that kind of opportunity was also becoming rare. But in the mid-1960s, around the time Gus and his protégé L. Jay Tenenbaum hired me as the junior man in the arbitrage department at Goldman Sachs, the risk-arbitrage business was picking up again, thanks to a wave of takeovers and mergers. By the end of the decade, Goldman Sachs was making significant profits in the context of the times—several million dollars a year—using its own capital for these transactions. Because the work was risky, complicated, and highly profitable, it had also acquired a certain mystique. Firms like Goldman didn’t want their competitors to know how they went about the arbitrage business. In 1966, the year I was hired, L. Jay was quoted in Business Week: “Asking about our arbitrage operations is like walking into a couple’s home and asking about their sex life.” While arbitrage is still a big business on Wall Street, it has become much less secretive.
I’ll try to explain what we did in those days by describing an arbitrage transaction I actually worked on in 1967. Although this deal was in many ways typical of the hundreds I was involved in during my first several years at Goldman Sachs, I remember it well for reasons that will become clear. It was a merger of two companies that were traded publicly: Becton Dickinson, a medium-sized manufacturer of medical equipment, and Univis, a somewhat smaller company that made eyeglass lenses. Under the terms of an announced friendly takeover, Becton Dickinson would buy all outstanding shares of Univis for about $35 million in stock. Shareholders in Univis would get a .6075 share of Becton Dickinson for each share of Univis they held.
At the time the deal was announced, on September 4, 1967, Becton Dickinson was trading at around $55 a share and Univis at around $24½. If the merger was to be completed, A, or Univis, would become B, or Becton Dickinson, and a Univis share would be worth $33½—at the price of Becton Dickinson when the deal was first announced (.6075 x $55). To decide whether to engage in arbitrage, we had to estimate the odds of the merger coming to fruition, what we would make if it did, and what we would lose if it didn’t—my framework, you might say, for dealing with most decisions in life.
Such an announced merger could fail to be completed for any number of reasons. It might be called off after either side performed its “due diligence” of examining the other’s books in detail. Or the shareholders of either company might reject the terms of the transaction as not favorable enough. The Justice Department or the Federal Trade Commission might decide that a combination of the two companies was anticompetitive. Regulatory issues might surface. One of the firms might have a history of announcing deals and not completing them, and simply change its mind or be too unwilling to make accommodations on specific matters that arose after the initial agreement in principle. We would weigh and balance the different factors to decide whether or not to take an arbitrage position.
The first order of business was rapid, intensive research. I had to examine all the publicly available information I could obtain. I had to talk to proxy lawyers and antitrust lawyers. Then I had to speak to officers at both companies, much as a securities analyst does. I almost never had all the information I would have liked. Seldom did I have enough time to think everything through.
But even with as much information and time as I might have hoped for, risk arbitrage would have fallen far short of science. Many of the notes I put down on my legal pad weren’t quantitative or measurable points of data. They were judgments. And once I finished all my analysis and reached a point of relative clarity, a correct answer wouldn’t simply present itself. The final decision was another judgment, involving my sense of a situation. We might pass up a transaction where the numbers looked promising simply because of a feeling that two companies didn’t make a good match or because we didn’t trust some of the people involved.
But recognizing the essential component of experienced feel in this kind of judgment is different from not having a framework and making decisions in a nonsystematic way or on the basis of instinct. Some arbitrageurs at other firms operated on a far more ad hoc and subjective basis, their decisions driven by bits of information, trading activity, and gossip. At Goldman, our decisions were driven much more by analysis. We always tried to think of everything that could possibly go wrong with a deal and then tried to evaluate how much weight to accord to such risks in our analysis. Despite the all-too-human tendency to lose sight of one’s own disciplined framework, we tried our best to be cool and hardheaded. Emotion, like instinct not moored in analysis, could be misleading. If you became frightened easily—or were greedy—you couldn’t function effectively as an arbitrageur.
In merger transactions such as Becton-Univis, our projected loss would typically be much larger if the deal fell apart than our projected gain if it went through. That meant that the odds had to be substantially in our favor for us to choose to participate. But how greatly did they have to be in our favor? Someone who had been to business school would have recognized the charts I made on my yellow pad as expected-value tables, used to calculate the anticipated outcome of a transaction. After a while, organizing my analysis according to these tables became second nature and I’d do them in my head. But I still constantly scribbled notes and numbers on a legal pad—a lifelong habit with me.
The basic inputs in an arbitrage expected-value table are the price you have to pay for a stock; what you will get for the stock if a deal goes through (the potential upside); what you will have to sell it for if the deal doesn’t go through (the potential downside); and finally—the most difficult factor to assess and the heart of risk arbitrage—the odds that the transaction will be completed. With the help of some papers from Goldman’s archives, I’ve re-created an expected-value table for Becton-Univis. After the merger was announced, Univis stock traded at $30½ (up from $24½ before the announcement). That meant the upside potential from an arbitrage trade was $3, because a Univis share would be worth $33½—.6075 of a share of Becton Dickinson—if the deal went through. If the deal didn’t go through, Univis would be likely to fall back to around $24½, giving our investment a downside potential of around $6. Let’s say we rated the odds of the merger being completed as slightly better than six to one (about 85 percent success to 15 percent failure). On an expected-value basis, the potential upside would be $3 multiplied by 85 percent. The downside risk would be $6 multiplied by 15 percent.
$3 x 85 percent = $2.55 upside potential
– $6 x 15 percent = – $0.90 downside risk
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Expected value = $1.65
The $1.65 was what one could expect to earn by tying up $30.50 of the firm’s capital for three months. That works out to a return of approximately 5½ percent, or 22 percent on an annualized basis. A lower rate of return than that would have been a red light. We figured that it wasn�
�t worthwhile to obligate the firm’s capital for a return of less than 20 percent per annum.
I’m simplifying in a variety of ways. You also had to factor in the risk that a merger would break up under conditions that would cause the target stock you’d bought—in this case Univis—to fall lower than its preannouncement floor or that would drive the acquiring company’s stock—the Becton Dickinson shares you’d sold short—higher. Or, even worse, both could occur at the same time. And you wouldn’t just make the decision to invest in this sort of deal and wait for the result several months later. The odds of a merger reaching closure changed constantly over time, as risks emerged and receded and share prices fluctuated. We had to stay on top of the situation, recalculating the odds and deciding whether to commit more, reduce our position, or even liquidate it entirely. And, of course, an arbitrageur would be involved in many such deals at any one time. You had to do a lot of them, because arbitrage is an actuarial business, like insurance. You expect to lose money in some cases but to make money over the long run thanks to the law of averages.
In the case of Becton-Univis, the positive expected value prompted us to take a position—we sold short 60.75 shares of Becton Dickinson for every 100 shares of Univis we bought. As I explained, selling short the acquiring company—which we’d do by borrowing shares for a fee—was a hedge against the market risk. If the stock prices of both companies went down while the merger was under way—perhaps because the sector or market weakened—our profit would still be locked in, as long as the deal went through.
Goldman’s trading records—which the firm graciously made available to us for this example—show that on my recommendation, we initially bought 33,233 shares of Univis at an average price of $30.28 and a total cost of just over $1 million—a significant amount at that time. We also sold short 19,800 shares of Becton Dickinson, into which the Univis shares would be converted. After increasing our positions in the interim, we stood to make around $125,000 if the merger closed. By the end of the year, Becton had risen to around $60, causing Univis to climb to $33¾.
Unfortunately, the deal didn’t work out as we hoped. The merger fell apart in January because an unexpected decline in quarterly earnings at Univis prompted Becton Dickinson to pull out. When the merger went sour, the stock of Univis fell, not only back to its preannouncement price of $24½ but all the way down to $18. As a result, we suddenly had a loss on our books of $485,000. We also faced a second loss on our short position, because Becton Dickinson shot up to $64 after the deal fell apart. We would have to buy Becton shares for $64 in the open market to replace the ones we’d borrowed and sold short at $55, which was going to cost us an additional $190,000. Everything that could go wrong had gone wrong. This was it: the dreaded arbitrage perfect storm.
By the end of January, we were down some $675,000 on the deal. That was a lot of money back then, more than we made on any other arbitrage transaction that year and a noticeable slice out of the firm’s yearly profits. Gus Levy, who always had terrific insight into deals in retrospect, was furious. He stalked around the trading room muttering that we should have known better than to think a merger like that would go through. L. Jay joked afterward that he’d been to “Univis University.”
But a critical point was that while the result may have been bad, the investment decision wasn’t necessarily wrong. After a deal broke up, we’d always reexamine it, looking for clues we might have missed. But even a large and painful loss didn’t mean that we had misjudged anything. As with any actuarial business, the essence of arbitrage is that if you calculate the odds correctly, you will make money on the majority of deals and on the sum total of all your deals. If you take a six-to-one risk, the foreseeable risks will occur and you will lose money every seventh time. Other times deals will break up for reasons that you could not reasonably have foreseen (a potential that also needs to be worked into your calculations). To an outsider, our business might have looked like gambling. In fact, it was the opposite of gambling, or at least of most amateur gambling. It was an investment business built on careful analysis, disciplined judgments—often made under considerable pressure—and the law of averages.
Flux and uncertainty made arbitrage quite nerve-racking for some people. But somehow or other, I was able to take it in reasonable stride. Arbitrage suited me, not only temperamentally but as a way of thinking—a kind of mental discipline. I took naturally to being rigorously analytical in weighing probabilities. I described this as being like a mental yellow pad. Risk arbitrage sometimes involved taking large losses, but if you did your analysis properly and didn’t get swept up into the psychology of the herd, you could be successful. Intermittent losses—sometimes greatly in excess of your worst-case expectations—were a part of the business. I accepted that, though some in our business did seem highly stressed much of the time. Having Gus Levy remind you of all the reasons you were a moron wasn’t always the most pleasant way to begin a day. But not only could I live with risk without becoming a nervous wreck; risk taking actually comported with my way of looking at the world.
Did arbitrage suit me because I instinctively thought the way an arbitrageur thinks? Or did I learn to think in terms of probabilities by practicing arbitrage? Arbitrage certainly reinforced my instinct to look at issues probabilistically. But that instinct had been formed long before I got to Goldman Sachs. The arbitrage business I learned there was consistent with the way I thought about life, as a process of weighing odds in a world without absolutes or provable certainties. This outlook was rooted in my basic temperament and shaped by the intellectual influence of various teachers and friends. Looking back at my life up to that point, I think you could trace the development of the mental processes and temperament of an effective arbitrageur.
I GREW UP with the influence of my two grandfathers, Morris Rubin and Samuel Seiderman. As I look back, I think both of these men affected me in ways I wasn’t really aware of while they were alive.
Morris Rubin was my paternal grandfather. He was born in 1882 in Minsk, Russia, from which he fled as a teenager to avoid being drafted into the Czar’s army—somehow, as a young Jew, he didn’t think the Russian military would be a terrific career choice. Morris arrived at Ellis Island as a penniless immigrant at the age of fifteen. The first question he asked was Where can I learn to speak English? He found work delivering milk and in 1906 married Rose Krebs, my paternal grandmother. Born in Poland, my grandmother Rose was the opposite of my grandfather Morris in every apparent respect—taciturn where he was exuberant, a worrier where he was a perennial optimist. They began their married life in a tenement on the Lower East Side of Manhattan.
Sometime after their first child, my father, Alexander Rubin, was born in 1907, Morris and Rose moved to Flatbush, Brooklyn, a rung up the socioeconomic ladder from the Lower East Side. The family did well until the early 1920s, when my grandfather became gravely ill with an infection contracted following a tonsillectomy. After he was on disability for a couple of years, Rose felt that her husband was dying. A doctor told her that his only chance of survival was to live in the sun. So the Rubins picked up and moved to Miami, Florida. After just a few months there, Morris completely recovered.
My grandfather was a little man with a huge force of personality and tremendous commercial instincts. His arrival in Miami coincided with a big Florida land boom and he quickly made a good deal of money speculating in real estate with large leverage. For a short time in the 1920s, Morris Rubin was a wealthy man. Then came the Florida land bust, which preceded the stock market crash of 1929 by a couple of years and wiped him out. This was an enormous psychological blow. In 1930, he arrived at my father’s Columbia Law School graduation unshaven and unkempt, having driven from Miami with a pistol in the glove compartment of his Chevy. Financially ruined and distraught that he couldn’t help his eldest son open a law office in New York, he couldn’t decide whether to attend my father’s graduation or shoot himself.
This story makes Morris Rubin sound like som
eone for whom financial success was terribly important. But having gotten past that crisis some years before I was born, my grandfather developed an extraordinary sense of equanimity about his lost fortune. By the time I was a little boy, everyone knew him as an irrepressibly affectionate little man with a thick European accent and a joyful attitude toward life. He greeted everyone with a bear hug. Most days, Morris would be out in the garden in back of his house on Prairie Avenue, just a mile from ours in Miami, tending his mango and avocado trees. After his crisis, he still dabbled in the stock market and real estate. But he had somehow changed his way of thinking so that his happiness wasn’t contingent on being wealthy or successful. My grandfather transformed himself into someone whose identity wasn’t tied to his net worth. Though he would never again be rich, he didn’t lament his losses. He had enough to live on, and there were greater pleasures in life.