No sleep for Wall St. speculators

Robert Rubin ran Goldman Sachs's risk arb desk.

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Putting on the risk

Many deals looked as if they wouldn't survive the credit crunch, but arbs that hung in saw their payday.

TXU

Shares jumped to $67.93 when a buyout by Apollo and TPG was announced in February. They tumbled to $62 in August, but the deal ultimately paid out at the original offer price, $69.25 a share.

FIRST DATA

Shares dipped to $30 when KKR's April offer of $34 a share looked as if it would wither on the vine this summer. But the deal closed in September for the promised amount.

HILTON

Blackstone said in July it would buy the hotel group for $47.50 a share. Despite up-and-down trading through the summer, arbs were paid the deal price in October.

(Fortune Magazine) -- Among Wall Street tribes, there has long been a group of swaggering deal specialists known as risk arbitrageurs, or risk arbs. Robert Rubin, the former Treasury Secretary now heading Citigroup, famously ran Goldman Sachs's risk arb desk; Ivan Boesky infamously made his name as Wall Street's alpha arbitrageur.

In the simplest form of arbitrage, these speculators pick up the spread between the current price and the agreed-to purchase price of a not-yet-consummated merger or acquisition. When deals close like clockwork, it's about as close to a sure thing as Wall Street offers. Arbs know how much they stand to make and when they will be paid - it's all in the merger announcement. (Because they tend to deal in narrow spreads, arbs typically need to make their money fast.)

During the recent upheaval in the credit market, however, risk arbs had their mettle tested as high-profile deals like Harman International Industries (Charts) and Acxiom (Charts) were announced - then fell apart.

But while the risk has gone up, so has the return for arbs who have hung in. And unlike in the '80s, firms today are diversified enough to escape ruin on arb deals alone.

Consider Harrah's (Charts, Fortune 500), one case of merger interruptus. Last December when buyout firms TPG and Apollo said they would buy the casino giant for $90 a share, the stock was trading at $82; it rose to $85 by May. But when the credit markets seized in August, the deal looked as though it might fall apart; at their nadir, shares traded below $80.

Many arbs who bailed took a hit. But some believed the financing would still come through and jumped in. They were richly rewarded when the stock recovered (it now trades at close to $88) and appears likely to close at the agreed-upon $90 a share.

"Opportunities like that don't come along every day," says Tom Burnett, a former risk arb specialist at Merrill Lynch and currently the executive vice president of research firm Wall Street Access. "All the spreads widened during the credit crunch and created huge opportunities."

To be sure, many arbs saw major losses. Some deals, like GE's (Charts, Fortune 500) proposed acquisition of mortgage company PHH Corp., cratered quickly: PHH (Charts) shares tumbled 15% in one day, too fast for many speculators to get out. Bad merger arbitrage bets so badly damaged British hedge fund De Putron Fund Management that UBS, a major investor, asked for its money back.

Other deals fell apart slowly, and investors had time to get out. Havens Advisors sold Harman shares while rumors of a broken deal were churning but before shares tumbled. Several indexes that track risk arbitrage have held up: Total returns are about even with the S&P, at 7% for the year.

Still, the volatility may cause a shakeout among risk arb desks reminiscent of the one that followed the insider-trading scandals of the late '80s. Back then Boesky, Rubin, Richard Rosenthal at Salomon Brothers, and Guy Wyser-Pratte at Bache Halsey Stuart Shields were known as the "four horsemen"; they so dominated the business that together they owned a third of Babcock & Wilcox stock by the time McDermott Inc. bought it in 1977.

But insider trading sullied arbitrage enough that most banks shut down their desks, and when a buyout of United Air Lines (Charts, Fortune 500) failed to close in 1989, arbs saw devastating losses.

Since then, arbitrage has risen from the ashes in the form of hedge funds that use the tactic and arb desks that are cogs in diversified investment firms. "A lot of people who do this do other things as well now," says Varun Gosain, who runs Constellation Capital Management, a New York hedge fund. The risk is more insulated - but for arbs with nerves of steel, the rewards are still there.