Buffett on Valuation: Risk Arbitrage Edition

My post on Anheuser-Busch and Buffett was, for one brief shining moment, the most popular article on Seeking Alpha.  In the comments I directed interested readers to the 1988 Berkshire Hathaway letter to shareholders, in which Buffett discusses one of his arbitrage positions that year, Arcata.

Below I reproduce the relevant excerpts from the letter for my Buffett on Valuation series:

	To evaluate arbitrage situations you must answer four 
questions: (1) How likely is it that the promised event will 
indeed occur? (2) How long will your money be tied up? (3) What 
chance is there that something still better will transpire - a 
competing takeover bid, for example? and (4) What will happen if 
the event does not take place because of anti-trust action, 
financing glitches, etc.?

   Arcata Corp., one of our more serendipitous arbitrage 
experiences, illustrates the twists and turns of the business. 
On September 28, 1981 the directors of Arcata agreed in principle 
to sell the company to Kohlberg, Kravis, Roberts & Co. (KKR), 
then and now a major leveraged-buy out firm. Arcata was in the 
printing and forest products businesses and had one other thing 
going for it: In 1978 the U.S. Government had taken title to 
10,700 acres of Arcata timber, primarily old-growth redwood, to 
expand Redwood National Park. The government had paid $97.9 
million, in several installments, for this acreage, a sum Arcata 
was contesting as grossly inadequate. The parties also disputed 
the interest rate that should apply to the period between the 
taking of the property and final payment for it. The enabling 
legislation stipulated 6% simple interest; Arcata argued for a 
much higher and compounded rate.

   Buying a company with a highly-speculative, large-sized 
claim in litigation creates a negotiating problem, whether the 
claim is on behalf of or against the company. To solve this 
problem, KKR offered $37.00 per Arcata share plus two-thirds of 
any additional amounts paid by the government for the redwood 
lands.

   Appraising this arbitrage opportunity, we had to ask 
ourselves whether KKR would consummate the transaction since, 
among other things, its offer was contingent upon its obtaining 
“satisfactory financing.” A clause of this kind is always 
dangerous for the seller: It offers an easy exit for a suitor 
whose ardor fades between proposal and marriage. However, we 
were not particularly worried about this possibility because 
KKR’s past record for closing had been good.

   We also had to ask ourselves what would happen if the KKR 
deal did fall through, and here we also felt reasonably 
comfortable: Arcata’s management and directors had been shopping 
the company for some time and were clearly determined to sell. 
If KKR went away, Arcata would likely find another buyer, though 
of course, the price might be lower.

   Finally, we had to ask ourselves what the redwood claim 
might be worth. Your Chairman, who can’t tell an elm from an 
oak, had no trouble with that one: He coolly evaluated the claim 
at somewhere between zero and a whole lot.

   We started buying Arcata stock, then around $33.50, on 
September 30 and in eight weeks purchased about 400,000 shares, 
or 5% of the company. The initial announcement said that the 
$37.00 would be paid in January, 1982. Therefore, if everything 
had gone perfectly, we would have achieved an annual rate of 
return of about 40% - not counting the redwood claim, which would 
have been frosting.

   All did not go perfectly. In December it was announced that 
the closing would be delayed a bit. Nevertheless, a definitive 
agreement was signed on January 4. Encouraged, we raised our 
stake, buying at around $38.00 per share and increasing our 
holdings to 655,000 shares, or over 7% of the company. Our 
willingness to pay up - even though the closing had been 
postponed - reflected our leaning toward “a whole lot” rather 
than “zero” for the redwoods.

   Then, on February 25 the lenders said they were taking a 
“second look” at financing terms “ in view of the severely 
depressed housing industry and its impact on Arcata’s outlook.” 
The stockholders’ meeting was postponed again, to April. An 
Arcata spokesman said he “did not think the fate of the 
acquisition itself was imperiled.” When arbitrageurs hear such 
reassurances, their minds flash to the old saying: “He lied like 
a finance minister on the eve of devaluation.”

   On March 12 KKR said its earlier deal wouldn’t work, first 
cutting its offer to $33.50, then two days later raising it to 
$35.00. On March 15, however, the directors turned this bid down 
and accepted another group’s offer of $37.50 plus one-half of any 
redwood recovery. The shareholders okayed the deal, and the 
$37.50 was paid on June 4.

   We received $24.6 million versus our cost of $22.9 million; 
our average holding period was close to six months. Considering 
the trouble this transaction encountered, our 15% annual rate of 
return excluding any value for the redwood claim - was more than 
satisfactory.

   But the best was yet to come. The trial judge appointed two 
commissions, one to look at the timber’s value, the other to 
consider the interest rate questions. In January 1987, the first 
commission said the redwoods were worth $275.7 million and the 
second commission recommended a compounded, blended rate of 
return working out to about 14%.

   In August 1987 the judge upheld these conclusions, which 
meant a net amount of about $600 million would be due Arcata. 
The government then appealed. In 1988, though, before this 
appeal was heard, the claim was settled for $519 million. 
Consequently, we received an additional $29.48 per share, or 
about $19.3 million. We will get another $800,000 or so in 1989.

Comments

[Nick Gogerty]

That is pretty interesting. It took awhile (6) years for the other shoe to drop, patience is definitely in order. I wonder how many month to month or quarter to quarter hedgies would have held on.