By Lina Saigol
Published: February 15 2010 02:00 | Last updated: February 15 2010 02:00
Hedge funds have always liked playing with train sets. After all, the genesis of many hedge fund strategies was the reorganisation of US railways in the 1930s.
Then there was the “Burlington Arbitrage” of 1988. When Burlington Northern Railroad Company spun off its energy and lumber group, Burlington Resources, arbs simultaneously bought one stock while selling short the other.
Now, the arbs are playing the $26bn (£16.5bn) takeover of Burlington Northern Santa Fe by Warren Buffett’s Berkshire Hathaway.
It’s one of the biggest opportunities in decades for index arbitrage.
Under the terms of the deal, Berkshire is buying Burlington with $10.5bn in Berkshire stock and $15.8bn in cash.
Crucially, however, the stock portion will come from Berkshire’s existing B-class shares which Mr Buffett split 50-for-1.
The minute the deal was announced in November, arbs started betting that Berkshire Hathaway’s stock would rise. This was because the newly split B-class shares became eligible for inclusion in the S&P 500 index.
By rights, with a market capitalisation of $170bn, Berkshire should always have been in the index, but, based on its tiny freefloat, S&P had long reasoned that the company was too illiquid to include.
The split changed that by lowering the price of the Berkshire shares and opening it to a wider investor base.
The arbs were quick to realise the significance of the inclusion: unlike most new index entrants who enter at the bottom, Berkshire would go straight in as the 19th largest company in the S&P 500.
That would force index funds tracking the S&P 500 to acquire shares in Berkshire on a large scale, potentially driving a big increase in its share price.
Since the stock split was approved in late January, the expectation of such a situation has seen Berkshire’s shares rise 15 per cent, while the S&P 500 is down 5.45 per cent during the same period.
For arbitrageurs who have managed to hedge the downside by shorting the S&P 500, the deal will pay handsomely.
For Mr Buffett, the benefits are even better. The rising share price of Berkshire means he will pay far less for Burlington than originally expected.
Now that’s class M&A.
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