15 Risk Arbitrage

OCTOBER 1994

Four-Year Performance and Third Avenue Value Fund’s Objectives

It seems fair to state that the Third Avenue Value Fund’s (“The Fund”, TAVF) analytic modus operandi, first and foremost, is to try to avoid investment risk for the bulk of its investments. This means that TAVF acquires interests in situations where I believe there are minimal prospects that there will be fundamental deteriorations in a business, or in the entitlements attaching to the security in which TAVF has invested. Given a sense that this primary objective of avoiding investment risk is more or less achievable, the Fund then is willing to speculate about what the range of investment outcomes might be for a situation over, say, the next two to five years, as long as there seem to be reasonable prospects of TAVF earning either a total return, or a cash return, of better than 20% annually compounded.

While the Fund tries to guard against investment risk, it virtually ignores market risk. Gauging market risk requires one to have views about what the near-term price performance of any individual issue, or any particular market index, might be. Short-term price movements in securities markets, and market prices for non-arbitrage common stocks, are, in my view, a “random walk” to be studied, if at all, by abnormal psychologists, not financial fundamentalists who are passive investors. To pay attention to market risk, purely and simply, most of the time directly conflicts with an analyst’s attempts to invest in securities where minimal investment risks are combined with probabilities for above-average long-term returns.

As of the close of the 1994 fiscal year, TAVF completed the first four years of its existence. The Fund’s average annual return from inception through fiscal 1994 was 22.71%. To my mind, this was a satisfactory performance, especially against the background that TAVF’s expense ratio was quite high in the first two years, and that from 1990 through much of 1993, the amount of merger and acquisition and takeover activity — potential bailout areas for much of the Fund’s holdings — appeared to have been abnormally low.

The key question for TAVF shareholders, however, revolves around measuring the probabilities that the Fund will be able to achieve average annual returns of 20% or better over the next three, four and five years. My personal opinion is that it won’t be easy, simply because it may be impossible to avoid a major disaster in one or more individual portfolio positions.

If there is any one thing to which TAVF’s good 1990 through 1994 performance ought to be attributed, it is the absence of any permanent impairments in the fundamental values of any of the businesses in which the Fund invested, either as a creditor or an equity holder. I’ve rarely managed investments for a four-year period in the past without having a few disasters in the portfolio.

I’ve certainly never gone seven, eight or nine years without getting stuck in a few clinkers. Nobody can predict the future. Furthermore, if you operate in the real world, there seems to be a tendency for almost everyone, including TAVF, to relax investment standards on occasion. All good investors, passive investors anyway, seem to run into capital impairment problems from time to time. Warren Buffett, for example, has US Air; Peter Lynch had Crazy Eddie.

The Fund’s criteria for investing in equity and equity-type securities bottom on four factors which, if not compromised, ought to go part of the way toward providing insurance against permanent impairments. Yet compromises of investment standards seem to occur sometimes. Briefly, the four factors are as follows:

  1. The company in which the Fund is investing should have an extremely strong financial position. This is the single, most important element considered in deciding whether or not TAVF should invest and/or hold. As is pointed out below, the Fund compromises on this factor sometimes, but relatively infrequently.
  2. The company should be reasonably well-managed from the stockholder point of view. (Given the trends toward increased management entrenchment and increased insider compensation over the last twenty years, it does not seem to be possible for a passive money manager to invest in a diversified portfolio, say, consisting of at least 10 different issues without compromising this standard.)
  3. The company and its securities should be reasonably understandable to me as an outside, passive, minority investor using the public record to make investment decisions. That means, first and foremost, that the disclosures in written documents need to be comprehensive. Second, it means that financial statements published in accordance with Generally Accepted Accounting Principles need to be reliable as objective benchmarks (not truth) which can be used as tools of analysis.  As a manager of TAVF, reasonably understandable is a relative term; it is pretty easy for me to have a comprehensive understanding from the public record of, say, financial insurers, money management firms and electric utilities; on the other hand, my understanding of high-tech issuers and basic manufacturers always seems to contain meaningful gaps, no matter how much help I get from non-financial, industry-wise professionals.
  4. The price at which the equity is available to the Fund ought to be no more than 50% of what I think the business is worth as a privately owned enterprise, or as a merger/acquisition or takeover candidate. I do not ever consciously compromise this standard.

The permanent impairments to the Fund’s portfolio are probably just as likely to come from unpredictable surprises and straight out misanalysis as from having compromised the standards just enumerated. The compromises, however, give rise to “worry situations,” characterized by acute angst on my part about particular holdings, even when the Fund does not sell those holdings. I tend to become particularly concerned about those portfolio positions where the underlying issuer lacks a strong financial position. In these cases, there is very little, if any, margin for error in predicting the future.

Risk Arbitrage

Risk arbitrage can be defined as acquiring interests in situations to earn above average returns based on gauging what reasonably determinate workouts will be within reasonably determinate periods of time. There are all kinds of risk arbitrage: currency arbitrage, convertible arbitrage, commodity hedging, derivatives arbitrage, Corporate Events Risk Arbitrage (CERA), etc. TAVF’s interest in risk arbitrage is limited to CERA.

CERA, whether it involves mergers and acquisitions, takeovers, liquidations, or reorganizations, requires much the same fundamental analysis as does value investing. Both activities are document driven; the practitioner had better understand well (and read slowly and carefully) the public record. Even interviews of insiders are much more productive if the interviewer has first done his or her homework based on public records. One of the big differences between CERA and value investing is that if you want to be a player in CERA, you need to be prepared to pay up; in value investing you try never to pay up versus fundamental value. The underlying reason for paying up in CERA is that market prices have a much greater tendency toward efficiency than is the case in value investing. Efficiency here might be defined as “the price is right.” Excess returns cannot be earned.

All markets tend toward efficiency. A market is defined as an arena in which parties with adverse economic interests reach agreements as to price and other terms which the parties believe are the best achievable under the circumstances. In most markets (e.g., the value investing market, the corporate takeover market, and the market for Inverse Floaters from the point of view of a buy-and-hold investor) the tendencies toward efficiency are so weak that they ought to be all but ignored completely. These markets are characterized by long time horizons and/or very complex sets of variables that are difficult to analyze and weight.

On the other hand, there are stronger tendencies toward efficiency in markets where time horizons are short; and where the investment determinations are governed by a very few variables which are simple, understandable and, perhaps, computer programmable. CERA, therefore, has much more of a tendency toward efficiency than does value investing because first, time horizons are short and relatively determinate; and second, workout values frequently are not that hard to figure out. Value investing is, if you will, a pre-deal business, while CERA is mostly an announced-deal business.

Despite this tendency toward efficiency, and my personal reluctance to pay up, it appears that there may be a fair number of CERA opportunities available to TAVF, in part, because I hope to have on-site an analyst who will spend full time analyzing and reporting on announced deals, whether they are cash tender offers, exchange offers, proposed mergers, or reorganizations.

I doubt that CERA will ever account for a substantial part of the Fund’s portfolio, but there ought to be a fair number of low-risk opportunities for TAVF where above average returns can be earned. In great part, these opportunities seem attributable to built-in inefficiencies in CERA markets. So many American passive investments are being managed by top-down investors, such as most mutual funds, who appear ill-equipped to perform any fundamental analysis at all, whether CERA or value, that price inefficiencies just have to go with the territory. Needless to say, TAVF will not consciously invest material amounts in any single CERA deal if it appears to me that such an investment entails the risk of a permanent impairment of capital.

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