Credit Crunch Hits Merger Funds

Editor's note: This is the fourth of a series of stories reviewing the third quarter in mutual funds

Mutual funds that bet on corporate takeovers had a rough ride in the third quarter as the credit crunch took its toll.

Merger arbitrage funds generally profit by purchasing shares of companies involved in mergers, takeovers, spinoffs and other kinds of deals. The shares of companies being acquired typically don't realize their full purchase price until the deal is completed, reflecting the risk that the deal won't go through.

When a deal is completed, fund managers pocket the difference between the price they paid and the acquisition price.

In some cases, arbitrage funds also hedge their bets by shorting the stock of the acquiring company.

But when the credit markets started seizing up in July, private equity firms were suddenly unable to finance previously announced buyouts. That pushed spreads wider on all kinds of deals, whether they were financed by private equity firms or not.

Stocks on which these fund managers were "long" fell back to toward pre-acquisition levels, leaving them with losses, at least on paper.

"Spreads have widened to incredible levels as investors try to figure out which transactions will close," says Thomas Kirchner, portfolio manager for the $5 million (PAEDX Quote)Penn Avenue Event-Driven fund, which employs merger arbitrage as a main strategy. "There are still a lot of pending deals in damage control mode so there is still a lot to do."

The Penn Avenue Event Driven fund lost 2.7% in the third quarter, although it was still up 3.87% for the first nine months of the year, according to Morningstar.