Busy Year For Merger Arbitrage Hedge Funds, Trend Set To Continue

Dec 15 2014 | 7:36am ET

By Tara Lachapelle, Angus Whitley and Brett Foley (Bloomberg) -- Merger-arbitrage traders didn’t have enough risk last year. This year, they got more than their share -- and it’s not going away.

Companies announced $2.8 trillion of acquisitions, making 2014 the busiest year since before the financial crisis. Unprecedented amounts of money were spent in some industries, such as pharmaceuticals, and the transactions skewed larger than at any other time this century, according to data compiled by Bloomberg. The slew of deals gave merger-arbitrage traders plenty to wager on, after last year’s scarcity of profit opportunities.

The explosion of megamergers brought volatility back to the investing strategy. The deals have been fraught with challenges, from regulatory scrutiny to the plummeting price of oil and the government’s attempt to deter tax inversions. Betting on them didn’t always pay off. More than $100 billion of potential takeovers unexpectedly blew up, like when drugmaker AbbVie Inc. called off its $55 billion purchase of Shire Plc. That burned merger-arbitrage funds, some of which will end the year at a loss even as stocks around the world surge.

“Drought conditions turned into basically flood conditions this year,” Louis Meyer, a New York-based event-driven analyst for Oscar Gruss & Son Inc., said in a phone interview. “Volatility is good, but it can be a double-edged sword. The positive aspect is you do have deals and the trend seems to be continuing. On the other hand, you’ve had real risk emerge and portfolio managers can no longer work on cruise control.”

Merger Spreads

This is how merger arbitrage is supposed to work: Company A announces that it’s buying Company B. Over the time that it takes for the deal to close, the target’s stock should rise to the same price as the acquirer’s offer. Traders take positions to capture that spread and reap a profit when the deal is completed.

There was too much investor money chasing too few transactions in 2013, so spreads were very tight and profits were small. Acquisitions that were pending completion around this time last year had a median spread of just 1.7 percent, compared with 4 percent now, data compiled by Bloomberg show.

In the U.S., the largest deals have some of the widest spreads. Oilfield-services provider Baker Hughes Inc. is trading about 11 percent below Halliburton Co.’s $38 billion offer as oil prices have continued to slump. Regulatory risk has left gaps of more than 5 percent in other big deals including the $26 billion merger of cigarette makers Reynolds American Inc. and Lorillard Inc., AT&T Inc.’s $66 billion purchase of DirecTV, and Comcast Corp.’s $68 billion takeover of Time Warner Cable Inc., the biggest transaction of the year.

Deal Blowups

All the activity is good for investors who speculate on deals, unless of course the situations unravel. Two days this year dealt huge blows to traders. On Aug. 6, Sprint Corp. ended talks to buy T-Mobile US Inc., and Twenty-First Century Fox Inc. withdrew its bid for Time Warner Inc. Then in October, AbbVie got cold feet over its Shire deal, which would have been the largest tax inversion on record. Shire’s stock plunged 28 percent in two days.

“There have been an unusually large number of deal cancellations recently making it very difficult to generate positive returns,” Keith Moore, an analyst for MKM Partners, said in a note to clients after AbbVie-Shire broke down. This week, describing the risk-arbitrage environment, he said “a lot of comments come to mind: difficult, volatile, surprising, unpredictable or the ultimate roller-coaster ride.”

The Bloomberg Global Merger Arbitrage Hedge Funds Index was climbing in the first half of 2014, but is now down 1 percent for the year. The Standard & Poor’s 500 Index has gained 8.3 percent.

Going Global

Deals are on the rise in other parts of the world, too, with a 31 percent jump in European takeovers and a 33 percent increase in Asia. Europe hasn’t seen as many large transactions stumble, with the exception of Pfizer Inc.’s failed cross-border pursuit of London-based AstraZeneca Plc. Spreads also haven’t been as wide in Europe as in North America and Asia, though European deal activity probably will pick up next year.

In Asia, the perils have often outweighed the potential rewards. Investors have attached more risk to Australian deals than those in any other Asian market, according to data compiled by Bloomberg. The chances of picking the final outcome may be too slim, even for traders who specialize in betting on potential takeovers, said Tristan K’Nell, Sydney-based head of trading at Quay Equities.

“Definitely you want to see some upside, but just in the short term, we’re probably seeing a little too much risk to actually put the deals together,” he said by phone.

Iron Slump

The price of iron ore, Australia’s biggest export, has plummeted about 49 percent this year and investors are concerned about an economic slowdown in China, the world’s biggest buyer of the commodity and Australia’s largest trading partner. Economic growth in Australia unexpectedly slowed for a second straight quarter in the three months ended September.

At the end of last week, Goodman Fielder Ltd., Australia’s largest baker, traded 8.1 percent below the value of a bid from palm oil producer Wilmar International Ltd. and Hong Kong investment group First Pacific Co. That offer had already been cut after the suitors studied Goodman’s accounts and the deal still needs Chinese regulatory approval.

Bradken Ltd., an Australian supplier of mining equipment, traded 12 percent shy of a reduced A$872 million offer from Bain Capital Asia and Pacific Equity Partners. Transfield Services Ltd., the builder of Melbourne’s Gateway Bridge, was 13 percent under the value of an initial A$1 billion bid from Ferrovial SA.

‘Zero Tolerance’

Some deals in Australia have fizzled before terms have been set. Private equity suitors including KKR & Co. failed to follow through with initial offers of A$3.4 billion for Treasury Wine Estates Ltd., the maker of Penfolds Grange wine. And an indicative bid of as much as A$1.1 billion for Australian standards company SAI Global Ltd. from Pacific Equity Partners also never led to a final offer.

“There is zero tolerance” regarding transactions where an agreement hasn’t yet been reached, James Santo, a special situations trader at Aviate Global in Sydney, said by phone.“Even in the event of a binding agreement, you want to see low regulatory risk and a high chance of completion.”

As a rule, traders would prefer an environment with more deals, even if it means more volatility. That said, it takes a lot of work and a broad set of skills to navigate the risks and still make money.

Arbitrage “requires a full tool belt just to compete,” Meyer at Oscar Gruss said. “We’re back in an environment where all of a sudden, all the tools need to be taken out of the belt because they’re all going to be needed.”    

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