The proposed sale of cardiovascular-device maker Guidant Corp. has been one wild ride for merger arbitrageurs. When Johnson & Johnson announced in December 2004 that it had agreed to buy Guidant for $76 a share in cash and stock, the arbs piled into the $25.4 billion deal. They knew that J&J, which had a reputation for getting deals done, needed Guidant to penetrate the rapidly growing market for implantable defibrillators, devices designed to correct dangerously abnormal heart rhythms. Many arbs stuck by the deal even as reports surfaced in summer 2005 of two deaths associated with Guidant’s defibrillators and of subsequent product recalls. Those that did stay could have used one of Guidant’s products, because on October 18, J&J revealed that it was reconsidering the terms of its offer -- and Guidant’s shares plunged a heart-stopping 11.4 percent."It was ridiculous that people believed J&J was going to close on the original terms,” says Nancy Havens, founder and president of New Yorkbased Havens Advisors, which manages $200 million in event-driven funds specializing in merger arbitrage and distressed debt.
Havens had played it safe with Guidant by cutting in half her firm’s position when the shares hit $71 last summer. In mid-November, after New Brunswick, New Jerseybased J&J officially lowered its offer to $63 a share, she started rebuilding the position. Her cautiousness was rewarded when Boston Scientific Corp. surprised the market in December with a $72-per-share offer for Guidant. Natick, Massachusettsbased Boston Scientific won the bidding war in late January with a final cash-and-stock offer of $80 per share, worth $27.2 billion. If Boston Scientific’s acquisition of Guidant closes in the spring, as many investors are expecting, arbitrageurs like Havens are looking at an annualized return on the deal of about 30 percent.
The Guidant saga illustrates both the hopes and the frustrations that for the past year have plagued merger arbitrage, one of the oldest strategies in the hedge fund playbook. Merger arbitrageurs try to capture the difference, or spread, between the price of an acquired company’s stock at the time a deal is announced and the price at which it closes. They tend to do well when deal activity is at its most frenetic.
Last year should have been a banner year for merger arbitrage. The global volume of announced mergers and acquisitons totaled $2.9 trillion, up 38 percent from 2004 and not far off 2000’s record $3.4 trillion, according to research firm Dealogic in New York. But despite the near record deal volume in 2005, merger arbitrageurs struggled. The HFRI merger arbitrage index, compiled by Hedge Fund Research in Chicago, was up 5.7 percent last year, compared with the 9.4 percent return for the broader HFRI composite index.
Much of the problem in 2005 was that spreads tended to be narrow, despite the large deal volume, because few acquirers were willing to pay big premiums -- and when they were, investors piled in, compressing spreads. The low-interest-rate environment didn’t help. Although it made it easier for companies to borrow money to make acquisitions, it also lowered the hurdle rate -- typically Treasury bill yields -- for arbs to invest in deals, further narrowing spreads. Increased activity by private equity firms, which tend to be careful not to overpay for an acquisition, also put pressure on spreads.
What was once a hot corner of the market -- merger arbitrage was the top-performing hedge fund strategy in 2000, up 18 percent that year, according to HFR -- has been relegated by many to the hedge fund dustbin. Indeed, last year’s mediocre performance caps off a five-year string of mostly low-single-digit returns for merger arbitrage. Although industrywide hedge fund assets have roughly doubled during the past five years, to $1.1 trillion, merger-arbitrage fund assets have remained almost flat, at roughly $15 billion, according to HFR. The number of pure merger-arbitrage managers in the HFR database has been declining since it peaked at 106 in 2002. Today, HFR tracks 96 such managers.
But the merger arbitrageurs that have survived are out to prove the skeptics wrong. Thrown into the Darwinian pool of the capital markets during the first half of this decade, many arbs have emerged more resilient -- as comfortable investing in debt and using derivatives instruments as they are buying equities. Many of them now employ strategies more typical of event-driven managers, investing in bankruptcies, restructurings and other special situations.
“These new arbitrageurs are more flexible, investing in credit and equities,” says Judith Posnikoff, a founding partner and managing director of Pacific Alternative Asset Management Co., a $7 billion fund-of-hedge-funds firm in Irvine, California. “They take on a little more risk than traditional arbs, but they are generating higher returns.”
Arbitrageurs today have learned to be more creative. Managers like Havens -- who ran both international merger arbitrage and high-yield trading at Bear, Stearns & Co. before leaving to launch her own fund in 1995 -- invest in both credit and equities. John Paulson, founder and president of $4.5 billion New Yorkbased Paulson & Co., sees similarities between investing in the debt of a company in bankruptcy and making a routine arbitrage play.
“Both are still arbitrage positions,” says Paulson, who began his career at Odyssey Partners, a New Yorkbased hedge fund, and spent four years as a managing director in mergers and acquisitions at Bear Stearns. “In a bankruptcy the spread is the difference between where the bonds are trading and the consideration received when the company emerges from bankruptcy.”
Arbitrageurs are getting a boost from an old friend. Interest rates and deal flow -- the economic and market forces underpinning their original specialty -- are now playing solidly in their favor. AT&T Corp.'s attempt to re-create the old Ma Bell by paying $67 billion for BellSouth Corp. is just the latest in a string of big mergers that have been announced since last fall. Add to that rising U.S. interest rates, and it’s no wonder typical spreads on deals in which arbitrageurs are invested have recently widened to about 11 percent, nearly double what they were in early 2005.
“There are times when it is extremely ripe to be in merger arbitrage, and this is one of them,” says longtime arbitrageur Peter Schoenfeld, founder and CEO of P. Schoenfeld Asset Management, a $1 billion New Yorkbased firm. PSAM’s flagship global event-driven fund, which includes merger arbitrage among its strategies, returned 12.8 percent after fees for the 12-month period ended January and has produced an average annualized return of 11 percent after fees since its 1997 inception.
Merger arbitrage exists because markets are not entirely efficient. In theory, shares of a company being acquired should trade at the announced acquisition price, but a variety of economic, market and regulatory factors can create uncertainty over the likelihood of the deal’s completion, widening the spread. In an all-stock transaction, arbitrageurs try to lock in the spread by purchasing shares of the company being acquired and simultaneously shorting shares of the acquirer. In a cash-and-stock transaction, arbitrageurs ordinarily short just the stock portion of the deal.
The more complex the merger’s structure, the more variables that have to be considered when putting on a trade. Many deals today, like the bids by J&J and Boston Scientific for Guidant, come with a collar -- a provision whereby the number of shares offered to shareholders of the target company can vary depending on the acquirer’s stock price. The artistry -- and alpha -- come from assessing how to take advantage of a given deal’s structure, as well as from avoiding those mergers that ultimately aren’t consummated.
Arbitrageurs typically don’t realize a profit until a deal has closed. That makes completed deal volume a more accurate indicator of actual success than are the announced figures. Some of 2005’s blockbuster transactions, including Bank of America Corp.'s $35 billion acquisition of credit card company MBNA Corp. and telecommunications giant Verizon Communications’ $8.5 billion purchase of MCI, closed early this year. During the first two months of 2006, $234 billion in deals had been completed globally, up from $134 billion during the same period a year earlier, according to data from Dealogic. HFR’s merger arbitrage index was up 4.4 percent this year through February.
The fortunes of merger arbitrageurs have long been tied to the boom-and-bust cycle of the deal market. The strategy -- whose origins on Wall Street go back more than a half-century to the early trading days of Goldman, Sachs & Co. chairman Gustave Levy and Bear Stearns’ chairman Salim (Cy) Lewis -- came of age in the leveraged-buyout era of the late 1980s. In 1988, at the height of the craze, merger-arbitrage funds returned 37.2 percent, according to the Hennessee Group, a New Yorkbased hedge fund investment consulting firm.
By 1989 scandal had caught up with risk arbitrage, as the strategy is called on Wall Street: Arbitrageur Ivan Boesky was serving time for insider trading and junk bond king Michael Milken was indicted for fraud and racketeering. Tainted, with deal activity drying up and the economy in recession, merger arbitrage drifted. The strategy came back during the bull market of the 1990s, earning returns of at least 14 percent six out of the eight years from 1993 through 2000, according to HFR. But by 2001 the stock market bubble had burst and M&A activity slowed again.
The recent dismal returns may be good news for those still in the game, because they have driven out much of the hot money that poured into merger arbitrage in the late 1990s. Paulson says that many multistrategy managers, macro hedge funds and investment banks have moved on. He estimates that, in total, 80 to 90 percent of the capital allocated to merger arbitrage at its peak of popularity has exited the strategy in the past five years. “A lot of people got hurt and took money out of the sector,” agrees Havens. “That has helped widen spreads.”
At the same time, M&A activity shows no signs of slowing, as the strengthening global economy has left many corporations flush with cash. U.S. and international companies have regained the confidence to pursue mergers and acquisitions in industries as diverse as financial services, natural resources and telecommunications. Although Paulson says the spread on AT&T’s purchase of BellSouth is not particularly attractive, the deal is a strong indicator of the health of the overall market. “It shows the strength of M&A activity, especially in the telecom sector,” he notes.
Most arbitrageurs were holding AT&T last year when SBC Communications acquired it in a deal that closed in November. (The combined company kept the AT&T name.) Paulson himself profited from a sizable stake in the debt of bankrupt telecom giant WorldCom that he bought in 2004. When the company emerged from Chapter 11 bankruptcy protection in April 2005, his bonds were converted into a 3.5 percent equity stake in the newly renamed MCI. A month later, MCI became the object of a bidding war, which Verizon won with an $8.5 billion offer, edging out Quest Communications.
Although rising interest rates up the cost of borrowing for companies to finance acquisitions, M&A activity is unlikely to be affected as long as the increases are moderate. Indeed, merger arbitrage benefits under that scenario, as spreads widen. “Merger arbitrage is one of the few disciplines where high interest rates are a positive,” says Schoenfeld, who started his career on the arbitrage desk at Wall Street brokerage firm White Weld in 1972.
Still, although deal flow is back, the investment landscape has gotten more complicated. Merger and acquisition activity is far more global, requiring managers to contend with trading in different markets and currencies, as well as having to understand the regulations and politics of different regions and countries.
Schoenfeld is encouraged by the growing global nature of the M&A market. He and other arbitrageurs are looking to Canada, Europe and Asia for profit. “The opportunity set domestically and internationally is greater than we have seen in years,” says Schoenfeld, who has had an office in London since he founded his firm in 1997.
Deals themselves can also be more complex. The rapid expansion of the derivatives market has given traders far more options for how they anticipate and play transactions. Arbitrageurs must also contend with the influx of private equity capital. Private equity transactions are all-cash deals, leaving the arbs without a natural hedge and forcing them to use options if they want protection from a deal’s potential collapse. Private equity firms were involved in 12 percent of announced global deals last year, up from 4 percent in 2001, according to Dealogic.
Pension fund money has flooded into the private equity asset class, providing tremendous buying power to firms like Blackstone Group and Kohlberg Kravis Roberts & Co. As of the end of 2005, J.P. Morgan Chase & Co. estimated that private equity firms were sitting on $125 billion of “dry powder” -- that is, capital they can put to work. And they can leverage that four to five times, giving them buying power in excess of $500 billion.
The advent of club deals -- private equity buyers teaming up to acquire larger targets -- is having a big impact as well. In early March, New Yorkbased Blackstone and KKR led a group of buyout firms in a E7.5 billion ($8.9 billion) offer for the Netherland’s VNU, which owns market researcher ACNielson. Nearly 60 percent of last year’s private equity transactions were club deals, according to Dealogic.
Some arbitrageurs welcome the increased activity. Private equity players tend to be fairly disciplined buyers, but their mere presence on the sidelines can fuel bidding wars. “Private equity only benefits merger arbitrage,” says Paulson.
As sanguine as merger arbs are about their current prospects, they know that inevitably their strategy is beholden to the cycles of the deal market. This time, however, they expect to be ready when M&A activity slows. Havens says her fund will continue to look for opportunities in both merger arbitrage and distressed debt. “The two strategies are countercyclical,” she explains. “Merger arbitrage remains a fine strategy to use in context with other strategies.”
