Merger arbitrage specialists always like a vigorous deal market, and this year they have not been disappointed. Global M&A activity through August jumped to $1.3 trillion from $922 billion for the same period in 2003, according to Thomson Financial. The number of announced deals rose from 19,822 in the first eight months of 2003 to 20,552 through August of this year.
Yet the average merger arb fund was flat through August -- a mere 19 basis points better than the Standard & Poor’s 500 index and some 54 basis points behind Hennessee Group’s broad hedge fund index. The poor performance extends a three-year drought for M&A arbitrage. From 2001 through 2003, Hennessee reports, merger funds appreciated at an annualized rate of just 4.2 percent. This year through August, M&A ranked 15 out of 23 in performance in Hennessee’s hedge fund sectors, a scant improvement over 2003’s 18 out of 23.
Why? Too much money chasing the deals. Merger arb fund assets more than doubled, to $32 billion, in 2002, although by the end of August 2003, assets had declined to $28.5 billion. “There are simply too many managers chasing these deals, and it’s producing razor-thin spreads, especially in larger deals,” observes Paul Glazer, principal of New Yorkbased Glazer Capital Management, which has $70 million under management in merger arb strategies. Nor does it help that more deals are breaking up. John Moore-Stanley, head of alternative investments at HSBC in New York, estimates that about 6 percent of all deals came unglued this year through the middle of August. That’s up from a 3 percent breakup rate during 2002 and 2003.
Among the more noteworthy busted transactions: Philip Green’s $16 billion bid for Marks and Spencer Group, Lockheed Martin Corp.'s proposed $1.88 billion takeover of Titan Corp., Permira Advisers’ $1.3 billion offer for WH Smith, and Leonard Green & Partners’ $890 million offer for Hollywood Entertainment Corp. Deals that are still alive but face obstacles are also plentiful: Anthem’s $16 billion bid for WellPoint Health Networks and Tellabs’ $1.9 billion acquisition of Advanced Fibre Communications.
“These are further tiring an already fatigued M&A industry that has been waiting for a turnaround for the past three years,” says Judith Posnikoff, a founder and managing director of $5 billion Pacific Alternative Asset Management Co., which has about $200 million tied up in merger arbitrage funds.
Uncertainty about the direction of the U.S. economy is exacerbating the skittishness among arbs, Posnikoff adds. “Nothing is clear right now, which can reduce premiums and deal spreads,” she says.
Faced with a high incidence of broken and shaky deals, fund managers are mixing up their traditional moves, sometimes shorting acquisition targets and going long the acquirer, sometimes managing risk by selling calls on the target’s shares. That way, if the deal gets into trouble and the price falls, the seller profits from the price paid for the call; if the deal proceeds as scheduled, the call reflects most of the difference between the current price and the deal price.
Betting against a merger’s completion has proved especially profitable this year. Titan, a high-tech defense contractor, was under investigation by the U.S. Justice Department for alleged bribery and illegal technology sales to restricted countries even before defense manufacturer Lockheed Martin announced its intention to bid. “But the investigation risk was not priced into the original offering,” notes Charles Gradante, managing principal of Hennessee. Lockheed subsequently lowered its offer, from $1.88 billion to $1.66 billion, in response to these concerns. When the spread between the stock price and acquisition bid closed to within 5 percent of the target price, two M&A funds and a billion-dollar multistrategy manager, whom Gradante declines to identify, placed reverse trades, betting about 1 percent of their assets that spreads would widen on news that the deal was in trouble. When spreads did expand, Gradante says, the funds earned an average annual rate of return of 35 percent.
These three managers made similar trades during the spring and summer of this year, betting that the proposed takeover of Advanced Fibre Communications, a provider of broadband access and switching platforms and network management systems, by Tellabs, a bandwidth management and optical transport company, would unravel when Tellabs more closely examined the target’s underlying financials. AFC subsequently reported weak second-quarter earnings and provided a discouraging outlook for the rest of the year, pushing spreads from 5 percent to 10 percent on speculation that Tellabs would revisit the terms of the deal or possibly walk away from it. On September 7, Tellabs amended the deal.
After doubts arise about a potential takeover, there is, of course, always the chance that the deal will get back on track. That, in turn, creates new arb opportunities. Health care insurer Anthem’s proposed takeover of rival WellPoint, announced in October 2003, is a case in point. Twelve of 13 state insurance regulators approved the deal; only California insurance commissioner John Garamendi opposed it, on the grounds that it could harm policyholders and involve excessive executive compensation. In early July, when rumors first surfaced about Garamendi’s possible objection to the deal, the spread increased 89 percent, from $0.95 to $1.80, in a single day. When the California regulator formally opposed the deal at the end of July, the spread ballooned from $2.08 to $6.72. Anthem has subsequently taken Garamendi to court, charging that he is demanding excessive concessions to approve the takeover.
Reza Hadizad, who manages the $140 million, Dublin-based Pioneer Global Equity Arbitrage fund, believed that arbs were overreacting to the news and that although the deal’s outcome was far from certain, fears and spreads would subsequently ease, at least temporarily.
Hadizad had already been hurt by Garamendi’s decision. Upon news of the roadblock, he sold 70 percent of his initial investment at a loss of 1.7 percent. He then doubled his remaining position when spreads hit $6.75. When they narrowed to $5.50, he closed out his entire investment, recouping nearly 20 percent of his original loss.
Says Hadizad: “With uncertainty surrounding so many deals these days, arbs have gotten very gun-shy when potential opportunities present themselves with deals in which they’ve already been hurt. To better exploit the market’s current turbulence, they need to look beyond past failings and ask, ‘Would I do the deal today?’”
After arbs pulled back from the Anthem-WellPoint deal, spreads soared beyond $8 as U.S. investors departed for the Labor Day weekend. Hadizad said at the time that “one had a good chance of making money as arbs reexamine the spreads and reestablish positions, which would likely contract the gap.” He added that he would consider stepping in if spreads widened to $8.50, but that never happened. By September 22 the spread had shrunk to $6.98.
Another popular strategy that helps mitigate risk: covered calls, in which an investor sells calls on a target while maintaining a long position in its stock. “This approach enables managers to sell off volatility,” explains money manager Glazer. In May, several months after Genzyme Corp., a global biotechnology company, announced plans to acquire ILEX Oncology, a biopharmaceuticals business focused on cancer treatment, for $26 a share, Glazer purchased the target’s shares for $22.50 each. Then in July he sold an equivalent number of August calls at a strike price of $25 for $0.95. He believed the options were overvalued and didn’t expect the deal to close before they were set to expire on August 20.
When Glazer exercised the calls, the stock traded at $25.15. That’s $0.80 less than his combined cost for the calls and the stock, which amounted to $25.95. In hindsight, the options were indeed overpriced; the value of the $25 calls should have been about $0.15. Selling calls enabled Glazer to lock in some profits before the deal closed, which it’s expected to do before the end of the year.
Michael Shannon, director of research at Valhalla, New Yorkbased Merger Fund, which returned an average annual 2.4 percent between 2001 and 2003, notes that his fund has occasionally made money buying and holding target stocks that fell too far when mergers unraveled. “The market often overreacts, selling off the target below its fundamental value,” he says. When Tyco International’s 2002 bid to take over McGrath RentCorp fell through, the price of McGrath’s shares was cut in half. But in two years the share value of McGrath, which sells and rents modular offices, doubled, exceeding Tyco’s bid price.
What’s ahead for the M&A arb sector? HSBC’s Moore-Stanley envisions a “push-pull phenomenon where the lack of profitable opportunities will push some money out of merger arbitrage while rising interest rates will further attract capital away from the industry.” He surmises that these two forces will gradually increase deal spreads and attract capital back to the M&A game.
Paolo Vicinelli, arbitrage research specialist at Gabelli Asset Management, thinks the game is simply tougher. “In the past, many managers could profit in merger arb by just showing up,” he says. “Not so today. So it’s no surprise that money is now leaving at the bottom of the cycle. Those who remain and succeed will be distinguished by their due diligence.”
