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
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
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.