This year’s takeover of the iconic British confectioner Cadbury by US food conglomerate Kraft was not only one of the surest signs of a return to big-time dealmaking in the post-credit crunch world, but also of the growing influence of the $2,000bn (£1,400bn, €1,626bn) hedge fund industry on the way takeover battles are fought and won.
By the time Cadbury’s board agreed to recommend the takeover to shareholders in January, more than 30 per cent of the company was owned by hedge funds – up in a few short weeks from just 5 per cent.
For the funds involved – specialists in so-called merger arbitrage – the takeover was an opportunity to make serious money. For Cadbury’s veteran executives, it was a fait accompli.
In a speech to the Saïd Business School at Oxford in February, Roger Carr, Cadbury’s outgoing chairman, called for hedge funds and other short-term “speculators” in corporate stocks to be banned from voting in takeover battles. “It may be unreasonable that a few individuals with weeks of share ownership can determine the lifetime destiny of many,” he said.
Mr Carr’s inference was clear: hedge funds had piled into Cadbury stock, expecting a takeover and making it impossible for the board of the company to refuse. Their influence was undue and unwanted.
Even Lord Mandelson, then the UK’s secretary of state for business, appeared to agree with Mr Carr, commenting that corporate takeover rules needed to be skewed towards “long-termism” and away from the rights of short-term share owners to influence the outcome of deals.
However, merger arbitrageurs are certainly doing something right. Over the past 12 months, the average event arbitrage fund – a strategy that covers merger arbitrage – has returned 28.53 per cent on its investments for clients, compared with an industry average of roughly 19.6 per cent, according to Hedge Fund Research, a Chicago-based consultancy.
In a basic merger arbitrage trade – the bread and butter of most event arbitrage strategies – a fund takes a long position in the stock of a company that is the target of an acquisition. As the deal moves closer to completion, the stock price gradually rises to meet the offer price made by the acquiring company.
The art of most hedge funds lies in the way they construct complex hedges through derivatives and short positions to offset the risk of the deal collapsing. In the perfect merger arbitrage trade, a hedge fund’s pay-off can be large – whether the deal goes through or not.
John Paulson, manager of Paulson & Co, last year’s most successful hedge fund, cut his teeth as an event arbitrageur. His flagship fund, Paulson Advantage Plus, which runs the strategy, was up 5.6 per cent in the first four months of 2010. Paulson Partners, his dedicated merger arbitrage fund, has fared even better, up 6.5 per cent. Paulson & Co was – like many of its peers – a significant buyer of Cadbury.
Amid such high returns, the number of merger arbitrage funds is growing. In November 2009, the launch of Tyrus Capital in London, an event arbitrage fund set up by Tony Chedraoui, former manager of US-based Deephaven Capital, was the biggest European launch of the year, raising $800m. The fund now has an estimated $1.5bn under management. One of its first big plays was Cadbury-Kraft.
Fears that the growth of merger arbitrage will lead to poor dealmaking are largely unfounded, however. Most event-driven funds – even those that came to dominate the Cadbury share register – are content to allow deals to take their natural course, rather than try to skew the outcome unfairly.
In the case of Cadbury, for example, it is tempting to blame hedge funds for the ease with which a politically unpalatable takeover was accepted. Yet 70 per cent of Cadbury investors were not hedge funds, and by and large supported the deal.
With pension funds and other large long-only investors still nursing huge losses in the wake of the financial crisis, mergers and acquisitions can offer a quick and easy way to realise potential in battered portfolios.
What is more, while hedge funds may take huge stakes in companies that are the subject of takeover bids, their actual ability to influence the outcome of the deal is overestimated. Most hedge funds – which are concerned primarily with reducing, not taking on, risk – build positions through derivatives such as so-called contracts for difference, which give economic exposure but do not necessarily come with voting rights. Even activist hedge funds have moderated their behaviour.
By and large, hedge funds’ interest in most companies remains passive – particularly where mergers and acquisitions are concerned. The size of hedge fund interest in Cadbury was not so much an indicator of a wolf-pack mentality as a symptom of supply and demand.
While the number of merger arbitrage funds and the money they control may be growing fast, so far the number of deals they can make money from has been limited.
It remains to be seen whether the situation will be reversed in the second half of 2010, and whether merger and acquisition activity takes off in the way many hedge fund investors are predicting.