In late 2015, U.S.-based Pfizer and Ireland-based Allergan announced a merger that would create “a new global biopharmaceutical leader with best-in-class innovative and established businesses.” The combined firm would broaden an “innovative pipeline with more than 100 combined mid-to-late stage programs in development.” It would maintain executive offices in Dublin.

In late 2017, Singapore-based chipmaker Broadcom bid for U.S chip supplier Qualcomm, the largest tech merger ever proposed. “This complementary transaction will position the combined company as a global communications leader with an impressive portfolio of technologies and products,” said Broadcom CEO Hock Tan. The combined firm would keep Broadcom’s Singapore headquarters.

Both mergers were ultimately halted by U.S. political maneuvers. Pfizer–Allergan would have benefited from domiciling in low-tax Ireland, but the $160 billion deal was terminated in April 2016 because of new rules from President Barack Obama’s Treasury Department that sought to reduce “inversion” mergers in which firms move abroad to reduce taxes. In March 2018, President Donald Trump followed the recommendation of the inter-agency Committee on Foreign Investment in the United States (CFIUS) and blocked Broadcom’s $117 billion deal, citing “national security.”

Welcome to the world of risk arbitrage, which involves trading market price differentials. The practice is fraught with political risk and oftentimes sensationalized in media accounts. In the mid-1980s, Time magazine and others elevated Ivan Boesky as the quintessential arbitrageur. The Securities and Exchange Commission later charged Boesky with insider trading and he received a 3½-year sentence and $100 million fine. But the practice has a long history.

Scholar Meyer H. Weinstein, in his classic 1931 treatise Arbitrage in Securities, observed, “There was a time when the word ‘arbitrage’ brought to mind a picture of a mysterious realm in finance which few people seemed to be inclined or at least to have the knowledge to discuss.” That soon changed. Benjamin Graham presented a simple formula in Security Analysis, first published in 1934 and now in its sixth edition (with co-author David Dodd). Graham’s best-known student, Berkshire Hathaway’s Warren Buffett, has also written about merger arbitrage. In Berkshire’s 1988 report, he explains, “To evaluate arbitrage situations you must answer four questions: (1) How likely is it that the promised event will indeed occur? (2) How long will your money be tied up? (3) What chance is there that something still better will transpire — a competing takeover bid, for example? and (4) What will happen if the event does not take place because of anti-trust action, financing glitches, etc.?” Analyzing the risk of an antitrust authority nixing a proposed deal is also crucial to the practice. Political decisions in the past decade have made it an even more challenging field for investors.

Kate Welling and Mario Gabelli’s recent book Merger Masters is not a treatise on antitrust policy or political risk. Rather, it raises the curtain on arbitrage strategy by profiling leading practitioners in line with money manager Gabelli’s vision to explain “the underappreciated criticality of risk [arbitrage]…, the proper understanding of values and valuation on which the entire edifice of finance rests.” The practice is multidisciplinary. Arbitrageurs have backgrounds in finance, marketing, economics, and law. The book also presents the “other side,” i.e., executives who faced “arbs” in hostile takeovers.

Sussing out arbs / The book offers insights from a colorful cast of financial wizards. Jeffrey Tarr counted Milton Friedman among his clients. George Kellner’s parents fled Hungary when he was 3. Karen Finerman is a CNBC Fast Money panelist. Guy Wyser-Pratte’s 1969 New York University thesis on arbitrage was later published as a book, but by the 1990s he was challenging managements “that were not doing right by their shareholders.”

Activist arbs use “their capacity for risk-bearing and expertise in corporate valuation” to recognize “situations where inept corporate managements have created ‘value gaps’ and where they can employ their capital to catalyze change.” Martin Gruss explains that arbs provide “a valuable service to shareholders who may not want to take the risk of a deal successfully closing.” They provide liquidity, Michael Price notes, for investors who don’t want to wait for a merger to close.

Arbitrage’s dimension as insurance is oftentimes overlooked by critics. Arbs assume the risk that a deal will not close. Clint Carlson observes, “The arb spread is my underwriting premium.”

Successful arbitrageurs must have a keen understanding of relationships. Will the “marriage”—merger or acquisition—work, or is it really a “divorce,” a selling-off of a bad property? John Bader terms this aspect of the trade “constituency analysis.”

But it is in the regulatory realm where their skills face perhaps the greatest challenge. Pfizer’s 2015 proposal to buy Allergan in a stock transaction valued at $363.63 per share represented a premium of more than 30%. Yet the deal died because of the Treasury Department’s “inversion” action, following Obama’s calling global tax avoidance a “huge problem” and tax inversions a “loophole.” A proposed 2014 merger between drug companies AbbVie and Shire was also killed by Treasury action, which the U.S.-based AbbVie termed a reinterpretation of “long-standing tax principles in a uniquely selective manner designed specifically to destroy the financial benefit of these types of transactions.”

In both cases, politics—not antitrust law—was the deciding factor. The mergers were not anticompetitive for consumers. Kellner says the failed Pfizer–Allergan merger taught arbs “the Obama administration was willing to take things to the edge.”

Geopolitics strikes back / Different politics have emerged under President Trump, whose antipathy to trade with China has ended mergers with firms with Chinese ties. The federal enforcer is CFIUS, created by a 1975 executive order to merely study foreign investment. The 1988 Exon–Florio Amendment mandated a review of foreign investments that might affect “national security” and gave the president power to block deals. The 2007 Foreign Investment and National Security Act further empowered the government. In 2018, Trump signed another measure, the Foreign Investment Risk Review Modernization Act, which expands CFIUS’s authority. Today, CFIUS includes representatives from 16 federal departments.

Firms wishing to merge must jump through this additional regulatory hurdle, which means arbitrageurs must be more astute in their understanding of geopolitics. Recent deals involving Chinese firms illustrate this new political dimension. In 2016, U.S. legislators called for CFIUS to review China National Chemical’s bid to purchase Sygenta, a Swiss agricultural company, citing the potential for “risks to our food system.” But CFIUS blessed the deal and it occurred in 2017. Later that year, Lattice Semiconductors’ sale to a firm with Chinese ties was blocked by Trump, citing CFIUS and national security. In 2018, Trump blocked Broadcom’s deal for Qualcomm, again citing CFIUS and national security—Qualcomm supplies chips to the Pentagon. CFIUS found the deal would jeopardize the firm’s lead in 5G technology, a focus of Chinese research efforts.

Conclusion / The book profiles big players. Capitalism, though, is dynamic and it also produces successful small arbs. That means there are plenty of opportunities for plenty of arbitrageurs. To tweak an old adage: “Give a man a fish and you feed him for a day. Teach him how to arbitrage and you feed him forever.”

Why be optimistic about this corner of capitalism? Because it’s open to nearly everyone. James Dinan, profiled in the book, observes: “A kid with Wi-Fi has 99.9% of the information I have. Thirty years ago, there were only 20 firms.” Price differentials will always exist in free markets, despite regulatory attempts to impede them.