The greatest risk arb of all-time

I wish this story had some colourful characters to make it more interesting. In fact, any characters at all would be a help. The truth of the matter is that I don’t know the specifics of the tale. I don’t even know the traders’ names at the centre of the story. Most of what I learned about this trade was through rumours heard at bars and tidbits passed along the trading desk at slow moments. Yet I think I know the story well enough to recount the tale of one of the gutsiest risk arbitrage plays of all time.

When most think about Bear Stearns, images of the pot-smoking, bridge-playing, overly-aggressive CEO Jimmy Cayne most likely spring to mind. Or the infamous $2 bill taped to the Bear front door after the firm was forced into the arms of JP Morgan for the embarrassingly low price of $2 per share to avoid bankruptcy.

Yet, in my mind, Bear Stearns conjures up images from a different period. I recall when Bear Stearns was an eat-what-you-kill crew of shrewd risk-takers that refused to participate in the Long Term Capital Management bailout because they had wisely avoided many of the trades the rest of Wall Street was choking on.

Bear was also one of the greatest risk arbitrage firms out there. They invested the partners’ money in merger arbitrage opportunities with a finesse and expertise unrivalled on Wall Street. Their cunning risk-taking resulted from the unique leadership of CEO “Ace” Greenberg. Ace was my kind of guy. In fact, Ace was admired by almost everyone, including even Warren Buffett:

“Ace Greenberg did almost everything better than I do-bridge, magic tricks, dog training, and arbitrage-all the important things in life.” -WARREN BUFFETT

I remember desperately trying to get my hands on the weekly Bear Stearns risk arbitrage research report. It was like the holy grail for those trading take-over situations. And I even remember talking to a salesman at Bear who politely (actually, maybe not so politely) told me to go pound sand when I asked for a copy. The Bear Stearns’ risk arbitrage report was only for clients willing to pay commission in size. It was simply that good.

The reason I wanted the report so badly? After watching Bear Stearns navigate their way through AT&T’s purchase of Canadian telecom company, Metro Net Communications, I became convinced they were the greatest risk takers I had ever seen. Here is my recount of that tale…

During the DotCom bubble, one of the hottest sectors was telecommunication stocks. These companies were the toll takers for the mushrooming internet business and investors could not get enough of them. During this time, many fortunes were made as smaller more nimble companies carved out new territory. A small upstart from Calgary called MetroNet had managed to quickly grow their business to the point where it had a $7 billion dollar market capitalization.

AT&T, wanting to quickly expand into Canada, decided to buy MetroNet.

Now, it has been a couple of decades since this occurred, so please excuse if I get some of the facts wrong. Although I might not recall the specifics perfectly, I can still tell you the story of how this became one of the great risk arbitrage plays of all time.

Even though MetroNet shareholders were keen to sell to AT&T, the Canadian Federal government was in the midst of making some legislative changes before foreign companies were permitted to own Canadian telecommunications companies. AT&T’s purchase of Metronet was therefore structured to have an extremely long closing (I think it was more than 2 years) to allow for the necessary changes to Canadian law.

The takeover agreement accounted for this by stipulating that the purchase deal price increase at a set amount every year. So, if the deal closed in the first year, the take-over price was something like $60 per share but every year thereafter it rose by another $3.50. This was AT&T’s concession to the fact they were foreign buyers whose deal closing would take an indeterminate amount of time.

So far so good – MetroNet shareholders sell out to the world’s biggest telecommunications company at a price that ratchets higher if the deal takes longer to close. Sounds like a risk arbitrageurs dream come true.

For a while it was a great trade that attracted many risk arb funds. The benefits were obvious – a great credit buying a company with a long time frame where you could lock in a great yield that more than compensated for the risks. Or at least everyone thought so…

But then the DotCom bubble burst. Telecommunications stocks were decimated.

Other Canadian telecommunication companies that had not sold to AT&T found their stock prices halving every six months. The pain was monstrous.

Yet, for a long time, the price of MetroNet did not waver as it was trading more like a risk arbitrage play rather than a telecommunications stock.

However, as the pain from the dotcom bubble bursting increased, risk arbitrageurs could no longer ignore the risks that perhaps AT&T would try to squirm their way out of the deal.

Remember, the way a risk arbitrageur prices a takeover oppurtunity is by estimating the probability of the deal closing, and from there calculating a risk-adjusted payoff profile based on the different outcomes. For example, if at first there was a 95% chance of AT&T completing the $60 purchase of Metronet and a 5% chance of the deal collapsing which would cause an estimated $10 loss if Metronet was trading solely on fundamentals, then the risk-adjusted take-over price would be $59.50. Risk arbitrage traders try to buy takeover situations where the expected profit against the risk-adjusted price would result in an outsized return. Of course, these are all estimates and that’s where the true art lies.

As the bursting of the dotcom bubble intensified, the underlying business conditions of the telecom industry deteriorated and the chances of AT&T not completing the deal increased. Even more importantly, the price that Metronet would trade at in the absence of a deal declined significantly. The math became more like a 75% chance of AT&T paying $60 with the other 25% probability resulting in a $45 loss in Metronet if AT&T walked away. In this case, the risk-adjusted take-over price fell to $48.75.

In fact, it got even worse than that. As the bear market in telecom stocks continued, eventually not only did the fundamental enterprise value of Metronet fall to the point where the underlying equity was worthless, but increasingly bond traders were pricing the possibility that the entire Metronet capital structure was worth less than the total amount of bonds outstanding.

To understand this development better, let’s say for example that when AT&T had decided to purchase Metronet, they agreed to pay $60 per share for all thirty million shares outstanding (I just made up that number to make things easy) while also assuming five billion dollars of debt. At that point, the total enterprise value of Metronet was $6.8 billion dollars ($1,800 million of equity and $5,000 million of debt).

As the market waited for the Canadian government to pass the required legislation allowing AT&T to buy Metronet, investors began to realize that not only was there a chance that AT&T would walk away from the deal, but if they did, the enterprise value of Metronet was so low that the bonds would be not be covered. The equity was worthless, and the company’s total value had collapsed to the point where the bonds were trading like equity.

If AT&T had not agreed to buy MetroNet and it was free to trade on its own, then the relative valuation would have probably meant more than a 50% decline in the enterprise value, meaning that the equity would have been wiped out and the bond holders would have taken an haircut.

But AT&T had entered into the agreement, and according to all the risk arbitrageurs, the agreement was solid. Yet what if they were wrong? What if AT&T found a loop hole? Usually, the breaking of a deal would not result in a 100% loss in the target stock’s price. But in this case, that was exactly what would happen if AT&T found a way out.

Investors, sensing that the risks were monstrous, abandoned the stock in droves. Metronet’s equity price collapsed. The ensuing decline in Metronet’s stock price meant that the deal was trading at a 20+% yield to close if it was completed. And it kept melting as time dripped on. AT&T’s purchase of Metronet was a big liquid deal that was trading like it was going to blow up.

Traders were scared. The carnage in the telecom industry was devastating. Companies were going bankrupt at a frightening pace.

Metronet’s bonds started trading at 90 cents on the dollar in anticipation of the deal breaking. Then 85, then 80.

All the while, AT&T kept mum. They did not comment, which scared the risk arbs even more.

Into this panic is where the trade reached legendary status.

Now, I don’t know the specifics of what Bear bought and sold. And as I mentioned, most of what I know was told to me in whispers like when you are told of an distant acquaintance who inherits an ungodly sum of money.

But here is what I gather.

Bear Stearns’ risk arbitrage desk conducted extensive research and determined the deal was rock-solid. They put it through the legal microscope and determined there was no way AT&T could get out of the purchase.

But the next part of their conclusion was even more shocking. Bear, in a move of pure genius, concluded that even though AT&T would spend $2 billion on a piece of equity that was completely worthless, AT&T would not follow through and buy the rest of the company.

In the takeover document, there was no obligation that AT&T assume the debt. They were simply obligated to pay the $60 plus ratchet for the equity piece. The market had just assumed that since AT&T spent so much on the equity, they would follow through on the bonds.

So, Bear Stearns (along with a few other savvy traders) did the exact opposite move that most would expect. Instead of buying the supposedly ‘safe’ bonds that were trading at a big discount, they shorted them. They started wailing away at the $85 bid, and then the $80 bid, and kept leaning hard on the quote.

And instead of also shorting the supposedly ‘risky’ piece of equity that was trading at a price implying the chances of the deal being completed were low, they bought it. In size.

Think about that for a second. They were buying a piece of equity that they knew was fundamentally worthless and shorting a bond that was theoretically ahead in the capital structure. In a typical distressed situation, arbitrageurs buy the bonds and short the equity. But this was no usual situation.

Although Bear Stearns would eventually blow up trading mortgage derivatives, during this period, they were one of the wiliest traders on the street. This trade proved their cunning.

Even though almost everyone on both Bay and Wall street assumed AT&T would attempt to get out of their purchase and sink the deal, Bear Stearns gambled that there was no way out. And even more insightful was the realization that Metronet bonds were trading too rich relative to the equity on the belief that AT&T’s assumption of the debt would make them money good. The market assumed that if the stock portion of the deal went through, then AT&T would also take the debt. Well, Bear Stearns shrewdly identified another glaring market mispricing and exploited it to their full advantage.

In 2003, the deal finally closed. AT&T paid for the equity exactly as the contract stipulated. AT&T did not even try to get out of the obligation. Yet, much to the surprise of a group of stunned bond traders, AT&T walked away from rest of the company. AT&T realized the enterprise value of Metronet had fallen drastically below the value of the debt obligations and there was no economic reason to take over the company. I say stunned bond traders, but really, there was one group of bond traders that were not surprised in the least. In fact, the risk arbitrageur traders at Bear were there with blue tickets in hand, ready to buy back all the bonds they shorted north of $80 for pennies on the dollar.

So, the next time you are thinking about using Bear Stearns as the punchline in a joke about the Great Financial Crisis, remember back to a time when they were some of the greatest risk takers that ever lived.

You might ask what happened? How did they go so wrong? Well, Bear was a different firm under Jimmy Cayne than Ace Greenberg. And I am sad to say that Ace passed away in 2014, so we won’t be able to hear any more nuggets of wisdom from the famed trader. But I will leave you with this final story from Josh Brown that sums up how great Ace truly was…

“After we had made some remarks about Ace Greenberg’s passing on Friday, NYSE stalwart and legendary trader in his own right, Art Cashin, came over to the Post 9 set we do the show from. I leaned back and Art whispered that Ace’s final trade may have been the best one he had ever made – the sale of all but 15,000 shares of his Bear Stearns stake at prices above $100 before the crisis spiraled out of control. Mr. Greenberg may not have had control over the amount of risk the firm had taken under Jimmy Cayne’s stewardship, but he certainly wasn’t going to abandon the “small losses” ethos that had guided him throughout a 65-year career on one of the meanest streets in America.”