Earlier this week, Berkshire Hathaway (BRK.A 0.39%)(BRK.B 0.27%), a nearly $800 billion holding company that owns a diversified portfolio of businesses and stocks, announced the acquisition of Alleghany, also a holding company, for $11.6 billion. After the acquisition, Berkshire will still have a remaining cash and cash equivalents position north of $130 billion. While Berkshire is unlikely to acquire another company any time soon, here's why it could very well add to an existing position in its portfolio.
A history of arbitrage
Perhaps no other investor is as well known for his or her patient, long-term investment strategy as Warren Buffett. As a result of his investing philosophies, Berkshire Hathaway has become one of the largest companies in the world. But there's a short-term investing strategy that even Warren Buffett favors, called "merger arbitrage," or buying stocks of companies trading below their acquisition price.
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In Warren Buffett's 1988 annual shareholder letter, he wrote this about the practice: "We prefer, of course, to make major long-term commitments, but we often have more cash than good ideas. At such times, arbitrage sometimes promises much greater returns than Treasury Bills and, equally important, cools any temptation we may have to relax our standards for long-term investments."
In 2018, shortly after IBM announced it would be buying Red Hat at $190 per share, Berkshire Hathaway purchased over 4.1 million shares of Red Hat at an estimated $175 per share. The "spread," or the percentage between the stock's trading price and buyout price, in this particular case, was about 8.5%. Which meant Berkshire would see gains of 8.5% on its investment as long as the acquisition went through as planned. Berkshire would buy nearly a million more shares over the first quarter of 2019 and Q2 2019 before IBM completed the acquisition on July 9, 2019. All told, Berkshire cleared an estimated $70 million from the Red Hat merger arbitrage.
A new arbitrage opportunity
Earlier this year, Microsoft announced the acquisition of Activision Blizzard ATVI +0.00% for about $69 billion, or $95 per share. Activision Blizzard recently traded at $79 per share, creating a spread of about 20%.
Coincidentally, Berkshire opened a position in Activision Blizzard in Q4 2021 to the effect of $1.1 billion. Due to the timing, Buffett penned an open letter to emphasize that his company had no insider knowledge of the acquisition and that the average cost of the shares was $77.
Will Berkshire buy more shares of Activision Blizzard?
In Buffett's 1988 annual shareholder letter, he outlined the questions to ask before investing in a merger arbitrage:
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 antitrust action, financing glitches, etc.?
First, while Big Tech has recently drawn Congress's ire, Microsoft has developed a friendly relationship with lawmakers. And due to the fact that gaming, a highly competitive industry, contributes to only 8% of Microsoft's total revenue, regulators might be hard pressed to nix the deal based solely on antitrust concerns. Second, Microsoft expects to close the acquisition sometime during its fiscal year 2023 (July 2022 to June 2023), meaning the potential gains could take anywhere between three to 15 months to actualize.
Third, a competing takeover bid appears unlikely, considering there hasn't been any mention of a time window for a competing offer, and not too many public companies can afford to pay the nearly $69 billion price tag. Finally, if the deal doesn't go through, Activision Blizzard's stock price will likely fall. However, knowing a Berkshire investing manager liked the gaming company before the Microsoft deal, then it shouldn't be detrimental to Berkshire whether or not the acquisition occurs.
What to watch
To sum up Warren Buffett's thoughts on merger arbitrage, in his 1989 annual shareholder letter, he wrote, "We will engage in arbitrage from time to time -- sometimes on a large scale -- but only when we like the odds." While the odds are in dispute on this particular situation, Activision Blizzard might just check off all Warren Buffett's boxes. Look to Berkshire Hathaway's next 13F -- a quarterly report that discloses a holding company's stock positions -- to find out its updated holdings from Q1 2021 and whether or not the odds are favorable.
