Risk

How do we get bureaucrats to take more risk?

There are many different strategies for investing in the public equity markets. Risk arbitrage (also known as merger arbitrage) is one of them. It involves betting on mergers and acquisitions before the completion of a deal. Let’s say company A wants to buy company T. Company A can pay for control of the target using cash, company A stock, or some combination of the two. To obtain control, the value of consideration that the acquirer offers is higher than the current value of the target’s stock. This value bump is called the control premium.

From the moment the deal is announced to the day it closes (when the consideration is exchanged for the outstanding equity of the target), there is a difference between the target’s trading price and the value of the consideration. This is called the deal spread. The spread collapses to zero on the completion of the deal. Risk arbitrage involves buying the spread and waiting for the deal to close. You can think of it as buying the consideration package at a discount in advance of delivery.

One simple way to capture the spread is to buy the target company’s shares and wait. If there is any acquirer stock in the package of consideration, we may consider shorting the acquirer stock we will receive. In an all-stock deal for example, when we buy the target company’s shares, we buy the acquirer’s shares at a discounted price. If we short the acquirer’s shares against buying the target company’s shares, we’re betting that the deal will consummate and we can monetize the spread.

If we knew with perfect certainty that the deal would close (and when it would close), then it’s an arbitrage. We pay four pennies today to receive a nickel in ninety days. It sounds easy, doesn’t it?

The trick is there are all kinds of reasons for deals failing to close. Antitrust regulators may deem the transaction to be anti-competitive for creating concentration in a particular market. There may be sufficiently bad news at either the target or the acquirer to give the other party the contractual right to back away. There could be a market crash or some disruption to financial markets that jeopardizes the financing. There could be some other type of idiosyncratic event. A big Louisiana hurricane could trip up a merger deal of offshore drillers if the target had a high portion of its business in the Gulf of Mexico, for example.

It's obvious why we call this strategy merger arbitrage. Why would we also call it risk arbitrage? One reason might be that the people who make these trades are arbitraging the risk that the deal doesn’t close. You initiate this trade if you think that the risk the market assesses of the deal failing is excessive.

Good arbs (as the people who specialize in this strategy call themselves) will find ways to isolate their exposure to different ways in which the deal could go pear-shaped. Depending on the consideration structure, they may short the equity of other comparable companies, for example. They may play a number of deals, constructing a portfolio of spreads that diversifies their exposure.

Risk arbitrage is a term that we can apply in a more general sense. Every stock has risk priced into it to cover the possibility that some event may cause it to fall. We don’t have to limit ourselves to merger situations. Perhaps the company has new management or they have announced a strategic restructuring. We can think of multiple dimensions of risk. One could be that interest rate conditions pivot quickly from accommodation to tightness. Or the enthusiasm for technology businesses exhausts itself as the narrative turns from severe optimism to depressed pessimism.

Markets move on story. There is data, to be sure. But the narrative interpretation of even the same data can vary. One day, bad news is interpreted as bad news and then, a few months later, bad news is seen as good news. Sometimes it’s all sunshine and unicorns. Other times, it’s darkness and monsters. The market can tell the same story every day or it can change to a new story for a short period before moving on to a third story, etc.

Some of the best investors in the world have decades of experience and can intuit these shifts in advance, with a good sense of what the future version will be. Imagine seeing Javier Milei speak at the World Economic Forum and recognizing that the narrative on Argentina would shift, soon and hard, for example.

The ultimate form of risk arbitrage is to understand the story that the market price of a security tells today and compare that to the story that one believes the price will tell at some fixed point in the future. If you want to get fancy about it, you might also have a sense for what the path should be (this is the kind of detail that drives using options to express a view). There are an infinite set of these stories in capital markets once we realize that they can involve individual securities or combinations of them. The investor purchases the spread between today’s price and tomorrow’s to capture the change in price he thinks this narrative shift will produce.

The one true risk is that the investor turns out to be wrong. They can be wrong about the story changing. They can be wrong about what the new story will say. They can be wrong about the path between here and there. They can be wrong about lots of things.

Good investors hedge against the risk of being wrong. They take bets that pay off if they are correct, offset by other bets that pay off if they are wrong. Ideally, the money they make on the winning bets more than offsets the bets they lose on the bets that don’t pan out. They are trying to tailor a stream of returns. They may lever their positions financially. Optimal position sizing is an art.

Another way to manage risk is to be careful about entry points. Let’s say that the current price for Acme Corp stock is $200. They think that in the new version of the story Acme can trade up to $300. We say that they’re playing for $100 of upside. They also calculate that the worst case for the stock that they can imagine (if they’re wrong about the narrative shift) is $180. They have a risk of $20. Would you risk losing $20 (potentially) to make $100? That tradeoff is called the “risk/reward” and here it is 5:1. (I know it’s inverted, but reward/risk doesn’t sing, does it?)

What if you could enter the trade at a point where the risk/reward was 10:1? This corresponds to waiting for an entry price of $190.91. But does it go down before it goes up? Or does it go straight up, say because of some new product announcement? Maybe you start to nibble at $200 with a view to adding more as the risk/reward becomes more attractive, averaging into your target position size.

What does this have to do with bureaucracy? Everything.

Bureaucrats have risk, too. It’s reputation risk. They cannot stand to be embarrassed. It’s career risk. Extending our markets analogy for the purpose of comparison, imagine that you work at an asset management company with a weird bonus structure. There, you could buy Acme stock at $185 but you wouldn’t get any bonus if you were correct and Acme prints at $300 and you lose your job if it goes to $180. Strangely, at this firm, nobody really knows what you do. Or, if they do, your value-add is deemed to be a drop that is impossible to measure, lost in the sea of the organization’s broader activity . All you have to do is show up and attend some meetings. You wouldn’t trade. You’d sit on your hands all day, look just busy enough that you kept your job, and collect your salary (along with a share of the bonus pool funded by the profits from the other traders in your organization). This is better than getting fired. In that case, you lose your job, you lose your salary, you lose your benefits, you lose your status, and, most importantly, you lose your pension.

This is the bureaucrat’s curse. Personally, they see themselves as having no upside but plenty of downside. Even if they wanted to do something impactful and risky, they must swim upstream, fighting resistance from their colleagues. The bureaucrat is stuck playing a game that is stacked against them, or so they perceive.

When you see a doer in a bureaucracy who is committed to making things happen, it’s a beautiful thing. It’s like seeing a war hero in real life. These people go “above and beyond” what their defined duties are to advance the organization towards its objective. The decorated soldier helped his unit secure an objective when things seemed impossible. He risks his life and limb for his unit, for his friends. Some of them do superhuman things. It’s a wonder that they survive. Many of them do not. The anonymous bureaucrat doer risks her career to advance the cause. She should get medals, too.

Maybe that’s not a bad idea: awards for bureaucrats for taking risks. They could wear them as ribbons, like members of the military. Just as service members can tell a Navy Cross apart from a time-served good conduct medal, people would be able to distinguish the doers who make things happen from the seat-warmers just by looking at them. There should be public write-ups extolling their virtues, enshrining values of excellence under pressure, self-sacrifice, and dedication. Too often, the current culture fetes the seat-warmer who drifts higher on a trajectory of inoffensive inertia.

The risk arbitrage for our bureaucratic doer is that she sees the perceived career risk as excessively priced. She imagines a narrative in which if her success in executing a difficult, uncertain project will be rewarded with promotion and praise. The rewards can be significant given how rare it is for people to take risk. She understands that she can stick handle failure by highlighting the learnings from the exercise, getting buy-in and public endorsement from people above her in the organization, and being transparent. In covering her, ahem, position, she hedges herself. She knows that even in the worst case, where she is fired from her job, she can find employment at a private sector consultant or contracting firm. They’ll see her as a hard-charging risk taker who knows how the machine works and is willing to make things happen or die trying.

If enough people believe this, the perceived level of risk diminishes. More arbs come into the market and take on hard projects just as more money flowing into merger arbitrage collapses deal spread returns in the equity markets.

Bureaucracy can become ossified just as armies can become demoralized. The culture flags. This becomes a question of leadership. If there are senior members of the bureaucracy with a personal history of successful risk-taking who can mentor these junior achievers, who can provide air cover that frees them to take this risk and who promote them when they succeed, then the culture can change.

Make no mistake. There are successful doers in every bureaucracy. Sometimes they do it in spite of the culture. Other times they make things happen until they hit their first bump in the road, at which point they leave (or are ejected).

The kicker is the mix between doers and seat-warmers. The natural entropy of the bureaucracy is to make things as difficult as possible for the doer.