Broker Offers Lone Investors Chance to Join in Arbitrage
For a lot of people, the word arbitrage conjures up thoughts of Wall Street brokers making buckets of money on illegal insider trading tips.
But that hasn’t stopped Newport Securities, a Costa Mesa brokerage, from marketing an arbitrage investment service designed to let individual investors share some of the rewards of the takeover craze that swept corporate America in the 1980s.
Unlike the exploits of Dennis Levine and Ivan Boesky, however, Newport Securities President Jeff Kilpatrick promises that what he does is perfectly legal.
“Ivan Boesky paid people to tell him which companies were about to get bought,” Kilpatrick said. “We don’t do that.”
Keeps Track of Targets
Instead, Newport Securities goes about the rather tedious chore of keeping track of publicly announced takeover targets whose share prices are likely to rise before the deals are closed. There’s nothing new about that.
Long before the fall of Boesky gave arbitrage a bad name, most Wall Street brokerage houses routinely made money on legitimate risk-arbitrage operations. And they still do.
The game, in simple terms, is to identify a potential takeover candidate before it becomes an actual target, buy stock in the company and then watch the price soar if and when a deal is announced.
A somewhat safer version of that game, and the strategy that Kilpatrick has adopted, is to quickly snatch up stock as soon as a company becomes an announced takeover target. The share price probably will have risen by that time, but there still may be enough of a spread between the trading price and the proposed buyout price to prove profitable.
What is novel about the Newport Securities arbitrage operation is that it is intended for retail investors.
Traditional Limits
Typically, risk arbitrage has always been limited to professional players: large Wall Street brokerages and specialized arbitrage houses that have the time to research deals and who are willing to commit the large pools of capital often needed to make the trades worthwhile.
Professional arbitragers tend to invest in big takeovers, like the $20.5-billion buyout of RJR Nabisco, in which they can invest millions of dollars in a single deal.
“The Wall Street firms focus on the mega-deals,” Kilpatrick said. “They want to make a big hit on a single, huge transaction. Most of our investments they wouldn’t even bother with. We take a nickel-and-dime approach.”
The pending acquisition of Micro D Inc., a publicly traded computer products distributor based in Santa Ana, by Ingram Industries Inc., a private Nashville conglomerate, is “a perfect example of what we try to do,” Kilpatrick said.
When Ingram announced a $12.50-per-share buyout offer for Micro D in December, Newport purchased more than 10,000 shares of the company at slightly under or right at $12.50 per share, Kilpatrick said.
When, a few days later, Micro D rejected Ingram’s offer but indicated that it would favor a merger at a higher price, Newport bought more shares in the low $12 range, he said.
Last week, Micro D agreed to a merger with Ingram at $14.75 per share, and Kilpatrick said he stands to realize an annualized gain of 57.6% for his clients.
Other, more dramatic trades last year included Lucky Stores, Federated Department Stores and Champion Industries. In each case, Newport earned well over 100% on an annualized basis. As attractive as this form of investing sounds, playing deal stocks can be extremely risky. Wall Street found that out the hard way when Boesky was indicted in November, 1986, for insider-trading activity. The event temporarily chilled the merger and acquisition market, and the price of many potential takeover stocks fell sharply. A similar decline occurred after the October, 1987, stock market crash.
The losses were exacerbated by the widespread practice of investing in deal stocks through margin accounts, in which the brokerage loans the buyer part of the purchase price. When share prices fell, many professionals were squeezed by margin calls and were forced to sell their stock at lower prices.
In the last 3 months of both 1986 and 1987, most Wall Street “arbs” lost everything they made in the first 9 months of each of those years, according to William Smith of Zimbalist Smith, a Westport, Conn., firm that analyzes merger and acquisition activity for institutional investors.
Faces Same Risks
Since the success of any risk-arbitrage strategy generally depends on remaining invested in deal stocks until transactions are completed, Kilpatrick’s smaller operation faces all the same risks that the big-time Wall Street arbs must deal with. Although he does not encourage investing on margin, about a quarter of his more aggressive investors leverage their investments, Kilpatrick said.
One of the worst trades on a percentage basis last year occurred when Kilpatrick purchased shares of American Technical Ceramics at $4.625 a share, after a proposed buyout at $5.25 a share was announced. The deal subsequently fell apart. Kilpatrick sold the stock at $3 a share for an annualized loss of 180% on the investment. And some clients who bought the shares on margin lost substantially more than that. But generally, Kilpatrick said, the accounts are managed fairly conservatively. In 1987, a bad year for takeover stocks, Newport’s model portfolio realized a 10% annualized gain.
In 1988, there were plenty of takeover stocks to choose from. Last year, 3,310 mergers and acquisitions were completed at a total value of $282.4 billion, according to IDD Information Services in New York. That’s a 29% increase over 1987.
Invested in 60 Deals
Newport Securities invested in 60 of these deals for about 45 clients. A model portfolio realized an annualized return of 25.8%, and Kilpatrick said most of his clients enjoyed similar returns or higher. He is now managing a total of about $3 million in the arbitrage service, which he began offering 3 years ago. Each account is individually managed and is diversified into at least five separate takeover stocks. Although the minimum investment is $25,000, Kilpatrick said investors stand a better chance of doing well with investments of $50,000 or more, which allow for greater diversification.
“That’s a very, very low minimum,” said William Smith, of Zimbalist Smith. Smith said he is aware of only one group of takeover funds open to the public. And those funds, offered by Oppenheimer & Co., require a minimum investment of $250,000 and are subject to limited availability.
Perrin Long, a securities analyst for Lipper Analytical Securities Corp. in New York, said none of the large Wall Street brokerages offer specialized arbitrage services for individual investors, although some brokers may advise their clients on potential deal stocks.
“This is unique,” Long said. “On the other hand, there are a number of individual investors who jump in and buy these stocks on their own.”
