Smooth sailing in rough seas for merger arbitrageurs

Merger arbitrageurs – hedge fund managers that aim to make money from takeover situations by betting money on deals succeeding or falling apart – have had a disappointing 12 months.

This year was supposed to be the one in which merger arbitrage bounced back. With M&A activity almost as subdued in 2009 as it was in 2008, most merger arbitrage hedge funds missed the industry-wide bounceback that lifted other hedge fund strategies back towards rude health last year.

With confidence in the strength of the financial recovery and the return of normalised equity market valuations, this year was meant to see a wave of takeover activity.

Indeed, turn the clock back to the last months of 2009 and merger arbitrage funds were enjoying big inflows from optimistic investors.

In Europe, Tyrus Capital, a new hedge fund manager launched by Tony Chedraoui, the ex-Deephaven star trader, became the biggest start-up since 2007, raising $800m on day one and doubling that in the space of a few months. However, Tyrus, like most merger arbitrage and event-driven funds, simply trod water in 2010. Year to date, it is up 5.39 per cent, according to an investor.

The average merger arbitrageur returned 4.32 per cent to the end of October – less than the hedge fund industry average of 6.16 per cent.

Even the biggest and most established players have struggled to deliver big returns or have underperformed their own historical benchmarks. Paulson & Co’s Paulson International fund, for example – one of the world’s oldest and most respected merger arbitrage funds – has returned 7.94 per cent so far this year, compared with an average annual return of 14.3 per cent. Centaurus, Europe’s most prominent merger arbitrageur, raised more than $1bn for its new fund in 2009, but has returned just 2.76 per cent so far this year.

Such returns belie the conviction most managers – and investors – have in this strategy outperforming in the coming months. The performance of merger arbitrage is strongly correlated to mergers and acquisitions activity, and some predict M&A volumes next year could surpass those seen at the peak of the boom in 2006 and 2007.

“It’s too early to say whether there will be an M&A wave, but we are bullish on the possibility,” says Tim Beck, a senior research analyst at Stenham, the fund of hedge funds. “Corporations have improved their balance sheets and cut fat. They have a lot of cash now. To grow in the difficult economic environment, they will have to purchase or merge with other companies.”

The problem so far has been the relative volatility in equity markets this year. The takeover of the UK’s Cadbury by Kraft, the US food conglomerate, seemed to set the bar for takeover activity. Merger arbitrageurs flooded into the deal, eventually holding close to a third of Cadbury shares. But the Greek debt crisis in April and the ensuing jitters in global markets put many M&A ambitions on ice.

“There is greater confidence in equity prices but I still think we need more confidence for corporations to do more M&A,” says Mr Beck. “So far, a lot of the deals have been hostile.”

Where M&A has occurred, as he notes, it has been particularly aggressive, suggesting that the boards of target companies are still uncomfortable with market valuations.

For merger arbitrageurs, though, hostile deals have proved lucrative. Peter Schoenfeld, head of P Schoenfeld Asset Management, the US hedge fund, says: “Hostile bids have been the highest profile of late – the bids have been very successful, which is good.” Hostile situations, he adds, often involve the most uncertainty and therefore the most pricing asymmetry – the kind of situations that hedge funds are supposed to excel in playing.

Mr Schoenfeld cites the Korea National Oil Corporation takeover of Dana Petroleum, the Scottish oil company, earlier this year as a prime example. Others see it as a game changer. The move was the first-ever example of a state-backed Asian company going hostile in a cross-border transaction. As growing Asian economies seek to secure access to natural resources, there will be more, say M&A bankers.

The other side of growing resource nationalism is greater government intervention in deals, however – a situation of which many merger arbitrageurs are wary. But “regulation of all kinds” remains a problem for arbitrageurs, Mr Schoenfeld says. Governments are becoming more proactive in blocking or discouraging merger activity in fields they consider of strategic, national or even economic importance, as was the case in Anglo-Australian miner BHP Billiton’s recent $39bn bid for Canada’s PotashCorp.

The Canadian government blocked the deal on the grounds that a foreign buy-out of the huge minerals concern would not be of “net benefit” to Canada. It appeared that few arbitrageurs lost their shirts on the intervention – most were already wary of uncertainty in the situation and had hedged accordingly. Some even made money.

Notwithstanding the potential impact of government intervention, the Potash and Dana deals highlight another trend in M&A activity that arbitrageurs hope to ride in the coming months: its growing internationalisation.

Mr Schoenfeld’s PSAM now has nearly half of its funds in non-US investments. Other fund managers report similarly diversified books. While 2010 has been disappointing for many arbitrageurs, it has also been very instructive. Managers previously tightly focused on the glut of deals in their own back yards have had to look abroad to find profitable investments and gained valuable experience trading in new environments.

With an increasingly global focus, merger arbitrage has certainly become more diversified, but perhaps also riskier: managers can find themselves dabbling in markets and playing in politically sensitive situations that they may not fully understand. Next year may well see merger arbitrage take off as a strategy. But it could also see the humbling of many individual arbitrageurs.

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