In Cabot Wealth Daily, our goal is to share interesting investing information that can help our readers become well-rounded investors, consider investment opportunities from other angles, or identify potential opportunities that they may otherwise miss.
And while the Daily may flag those opportunities, it is not a trading service insofar as it does not offer entry prices, exit prices, timing, or the other crucial details that investors receive in any of Cabot’s slate of paid investment advisories.
In other words, it’s rare for us to revisit a trade after the fact. But given the performance of a recent Bitcoin arbitrage trade that we identified in November of last year, as well as Capital One’s (COF) upcoming acquisition of Discover Financial (DFS), we thought it would be instructive to revisit the Bitcoin trade to add clarity on arbitrage trading in general.
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First and foremost, some clarification is in order. In the most traditional sense, a pure arbitrage trade relies only on pricing mismatches and is structured to remove company- or asset-specific risks. The clearest example, and one we’ll delve into later, is buying shares of a company that is being bought in an all-stock transaction and selling the shares of the acquiring company.
If XYZ Company is buying ABC Company, and ABC shareholders each get two shares of XYZ stock, an arbitrage trade would be a buy of one share of ABC and the simultaneous sale of two shares of XYZ. It creates a position that nets out to zero upon completion of the merger.
The reason an investor would undertake this trade is to take advantage of any discount ABC may be trading at relative to XYZ, generally due to the time associated with a merger.
In the case of our Bitcoin trade, it wasn’t a pure arbitrage trade. Grayscale Bitcoin Trust (GBTC) was trading at a material discount to the value of its actual Bitcoin holdings—the net asset value (NAV)—before the SEC approval of Bitcoin ETFs.
Here’s what we wrote at the time:
…for the last few years, GBTC has traded with a 10-20% discount to NAV, although that figure reached as high as 40% over the summer. As of October 31, the fund was trading at a 13.7% discount to NAV…
Should the SEC ultimately approve the ETF application, or signal that it is likely, GBTC could close some or most of that gap, even if Bitcoin itself does not rally on the news.
Flat (or rising) Bitcoin prices would still allow for double-digit appreciation in the fund on what is ultimately a binary event.
Now, a pure arbitrage trade would have been the purchase of GBTC and the simultaneous sale (or short sale) of an equivalent value of Bitcoin. Your net Bitcoin holdings would effectively be zero, and you’d simply be relying on GBTC approaching NAV, profiting as it does so.
At the time, there were no simple ways for investors to take a short position in Bitcoin, so the trade was positioned as additional upside for investors who were already bullish on Bitcoin.
The SEC has since approved Bitcoin ETFs, and GBTC is currently trading at a 0.07% discount to the net asset value. The fact that Bitcoin has also continued rising certainly doesn’t hurt the trade, but simply closing that NAV gap netted GBTC holders an additional 13% beyond the return of Bitcoin itself.
The rationale for revisiting the Bitcoin trade is that there’s a similar opportunity with Capital One’s (COF) plan to purchase Discover Financial (DFS).
Capital One recently announced that it plans to acquire Discover in an all-stock transaction that will net Discover shareholders 1.0192 shares of COF for each share of DFS.
At the time of writing, shares of COF are trading for 134.90 and shares of DFS are trading for 121.98.
Assuming the merger is approved, that means that DFS shares are trading at a 12.7% discount to their post-merger value.
1 DFS = 1.0192 shares of COF x 134.90 = 137.49
So, a share of DFS that’s currently trading for 121.98 should be worth 137.49.
If you were inclined to structure this as an arbitrage trade, you could simply buy 100 shares of DFS and sell short 101 shares of COF (per the terms of the SEC filing, DFS shareholders will receive cash in lieu of any fractional shares).
In that case, you’d be holding a position that will net out to zero exposure to either company upon completion of the merger, and you’d make 12.7% for the privilege.
Discounts and Risks in Arbitrage Trades
So why the discount?
Well, there are two reasons.
Regulatory Risk
The biggest risk to the trade is regulatory risk. Should regulators decline to approve the merger, you’re now long DFS shares (which will likely fall in value) and short COF shares (likely to climb in value as the cost of the merger would no longer be a hit to Capital One).
The trouble is, there’s no effective way to hedge regulatory risk, which is why the discount is sizable (the lower the perceived risk, the smaller the market’s discount).
Time Value
The second element of the discount is time value. Even assuming the deal is approved, you could be looking at a year or longer for the merger to be completed, and your capital is tied up until that happens.
How do we address those risks?
If you’re a DFS shareholder you can sell now and take advantage of the price bump shares got when the offer was announced (an especially good option if you think the merger will be rejected); you can hold shares with the plan of accepting COF shares when the merger is completed; or, if you think the merger will be approved but don’t want to own COF, you can feasibly take a short position in an equivalent number of COF shares (and tie up capital, potentially pay to borrow shares, etc.).
The last option is a lot of hoops to jump through for an additional 12.7%, but it’s doable; worth talking to your broker about at least.
If you’re a COF shareholder, simply trade the shares like any other investment (no arbitrage opportunity for those shareholders) and consider the possible impacts of the proposed merger both in the short term on share price (acquiring companies frequently take a haircut when a deal is completed) and in the long term on the company’s future prospects.
If you’re a holder of neither company’s shares, you can consider implementing an arbitrage trade like the one cited as an example above, but it is very much a bet on regulators and not the underlying companies themselves.
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