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  1. Home
  2. / Investing
  3. / Energy

The Quest for Arbitrage Opportunities

Arbitrage is the holy grail of investing -- constantly sought after but seldom discovered.
By SHAM GAD May 22, 2012 | 11:30 AM EDT
Stocks quotes in this article: PBY, VQ

Investment arbitrage is essentially an attempt to profit from price inefficiencies by making transactions that offset each other. A common example is merger, or deal arbitrage. That is, when company A decides to buy company B for X dollars while shares in company B sell for less than X, so you buy company B until the deal closes and profit from the price differential.

The obvious concern here is that the merger or acquisition actually goes through. A big price differential suggests that the markets have doubts about the deal going through. These are precisely the opportunities in which opportunistic investors can make the best arbitrage profits.

For example, automotive repair shop Pep Boys (PBY) recently agreed to sell itself to private equity firm Gores Group for $15 a share in cash. When the deal was announced, Pep Boys shares surged to nearly $15. A couple of weeks ago, however, Gores Group asked Pep Boys to delay the May 30 shareholder vote to approve the deal. Pep Boys had a weak first quarter and the buyers decided to delay the deal, citing a "material adverse change." Shares in Pep Boys now trade for around $11. In all likelihood, the deal will not close in June as originally anticipated. More so, there is a possibility that the buyer will try to lower the deal price or perhaps walk away.

As I've suggested before, Pep Boys is an intriguing business in the midst of a turnaround. At current prices, it's not a bad buy, but you now get the option of a buyout. At $15, the spread is over 30%. Even if the deal is made at a slightly lower price, the gap today is wide enough to make this an interesting name to watch. If PBY shares fall any lower, the business will be a bargain.

Shareholders in oil company Venoco (VQ) were recently offered $12.50 a share in cash from the company's CEO. Shares in Venoco currently trade for $9.50, implying an approximate 30% premium if the deal goes through. What's interesting here is that this offer was originally made in January and, at the time, represented a 75% premium to the share price. And since the CEO and others representing over 50% of shares are in favor of the deal, only a majority of the minority shareholders (about 23% of remaining shares) have to approve the deal. Last year, the company tried to sell itself, and the only two offers it got were both below $12.50 a share.

The deal gap exists because so far CEO Tim Marquez has been hush-hush about his plans to finance the deal. Shareholders are set to vote on this deal on June 1. If the deal is approved - and given the disconnect between the share price and offer price, restless shareholders may decide to tender at $12.50 -- shares may jump but probably will still trade below $12.50 until more color is provided.

Venoco is currently a $550 million company with about $600 million in net debt. The company made over $60 million in profit from $330 million in revenue in 2011. Venoco holds a valuable 200,000-acre plot in California, covering an area known as the Monterey Shale, where six of the biggest oil fields in the U.S. can be found. Perhaps Marquez would attempt to sell assets if the deal was approved.

Given the potential upside from a deal going through, keep a close eye on Venoco.

Careful participation in arbitrage investment opportunities can often serve as a type of hedge that provides a portfolio with attractive gains in a relatively short period of time.

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At the time of publication, Gad had no positions in the stocks mentioned.

TAGS: Investing | U.S. Equity | Energy

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