Free In an Uncertain World by Robert Rubin, Jacob Weisberg Page B

tying up $30.50 of the firm’s capital for three months. That works out to a return of approximately 5½ percent, or 22 percent on an annualized basis. A lower rate of return than that would have been a red light. We figured that it wasn’t worthwhile to obligate the firm’s capital for a return of less than 20 percent per annum.
    I’m simplifying in a variety of ways. You also had to factor in the risk that a merger would break up under conditions that would cause the target stock you’d bought—in this case Univis—to fall lower than its preannouncement floor or that would drive the acquiring company’s stock—the Becton Dickinson shares you’d sold short—higher. Or, even worse, both could occur at the same time. And you wouldn’t just make the decision to invest in this sort of deal and wait for the result several months later. The odds of a merger reaching closure changed constantly over time, as risks emerged and receded and share prices fluctuated. We had to stay on top of the situation, recalculating the odds and deciding whether to commit more, reduce our position, or even liquidate it entirely. And, of course, an arbitrageur would be involved in many such deals at any one time. You had to do a lot of them, because arbitrage is an actuarial business, like insurance. You expect to lose money in some cases but to make money over the long run thanks to the law of averages.
    In the case of Becton-Univis, the positive expected value prompted us to take a position—we sold short 60.75 shares of Becton Dickinson for every 100 shares of Univis we bought. As I explained, selling short the acquiring company—which we’d do by borrowing shares for a fee—was a hedge against the market risk. If the stock prices of both companies went down while the merger was under way—perhaps because the sector or market weakened—our profit would still be locked in, as long as the deal went through.
    Goldman’s trading records—which the firm graciously made available to us for this example—show that on my recommendation, we initially bought 33,233 shares of Univis at an average price of $30.28 and a total cost of just over $1 million—a significant amount at that time. We also sold short 19,800 shares of Becton Dickinson, into which the Univis shares would be converted. After increasing our positions in the interim, we stood to make around $125,000 if the merger closed. By the end of the year, Becton had risen to around $60, causing Univis to climb to $33¾.
    Unfortunately, the deal didn’t work out as we hoped. The merger fell apart in January because an unexpected decline in quarterly earnings at Univis prompted Becton Dickinson to pull out. When the merger went sour, the stock of Univis fell, not only back to its preannouncement price of $24½ but all the way down to $18. As a result, we suddenly had a loss on our books of $485,000. We also faced a second loss on our short position, because Becton Dickinson shot up to $64 after the deal fell apart. We would have to buy Becton shares for $64 in the open market to replace the ones we’d borrowed and sold short at $55, which was going to cost us an additional $190,000. Everything that could go wrong had gone wrong. This was it: the dreaded arbitrage perfect storm.
    By the end of January, we were down some $675,000 on the deal. That was a lot of money back then, more than we made on any other arbitrage transaction that year and a noticeable slice out of the firm’s yearly profits. Gus Levy, who always had terrific insight into deals in retrospect, was furious. He stalked around the trading room muttering that we should have known better than to think a merger like that would go through. L. Jay joked afterward that he’d been to “Univis University.”
    But a critical point was that while the result may have been bad, the investment decision wasn’t necessarily wrong. After