Merger arbitrage is one of those dangerous games on Wall Street best left to the pros. Luckily, one of the longest-running funds devoted to the practice,
The Merger Fund
(MERFX), reopened Wednesday to new investors.
The Merger Fund has been investing in deals since 1989, but has been closed since March 2004, when its inflows were too high and investable deals too few. Fund co-manager Fred Green says the time is right to reopen now that the risk/reward profile in the market has improved and his asset base is more manageable at roughly $1.2 billion.
The Merger Fund, which has a high expense ratio of 1.77% but a low volatility to soothe nervous investors, has returned 2% annually over the last five years, about 1.6 percentage points better than the
index. Year to date, the fund is up 1.1%.
For those unfamiliar with merger arbitrage, here are the basics. When one company acquires another, it shells out a premium above the target company's current stock price. Since the deal could fall apart because of wrinkles such as regulatory problems, a "spread" is created between the target's current price and its acquisition price. It's the arbitrager's job to safely capture that spread by purchasing the stock of the target company and, in some cases, shorting the stock of the acquirer.
A good example of the hazards of merger arbitrage could be seen in the battle for cardiac device maker
. Recalls of Guidant's devices spurred acquirer
Johnson & Johnson
to reduce its offer for the company from $76 to $63 a share. Green's fund was initially hit by the cut, but the fund was confident the deal would close, so the managers added to their Guidant position. In the end,
jumped into the fray and made several bids for Guidant, finally winning the company Wednesday for $80 a share.
Green chatted with
about his decision to reopen his fund, as well as to comment on the current environment for deals.
TheStreet.com: Why are you reopening the fund?
: First of all, the environment for merger arbitrage appears to be taking a turn for the better. Dealmaking is expected to continue to strengthen in the year ahead, and arbitrage spreads have become more favorable, even for "plain-vanilla" transactions. Another positive for our investment approach is the increasing frequency of strategic overbids, in which corporate buyers aggressively target companies that have already agreed to be acquired by other firms. Competitive bidding situations can result in "windfall" profits for arbitragers, helping to offset losses incurred when deals are terminated or renegotiated.
We have also been sensitive to the issue of liquidity, never allowing our fund's assets to grow to a level that makes it difficult to profitably execute our investment strategy. We are not close to that point now. On the contrary, we have substantial excess capacity.
Why are arbitrage spreads becoming more favorable?
Part of it is supply and demand. We think there's less money committed to merger arbitrage than there used to be, especially among multistrategy hedge funds. At the same time, M&A activity is picking up. A $30 billion mega-deal can soak up a lot of arbitrage capital. Also, because many arbs employ significant leverage, spreads tend to widen as rising short-term rates push up borrowing costs.
Which sectors will we see the most M&A action from in 2006?
We don't spend much time in front of a crystal ball; we go where the deals are. Having said that, it's likely that some of the sectors that were active last year, such as health care and energy, will see more of the same in 2006. Thanks to the Energy Policy Act of 2005, which eliminated barriers to out-of-region utility takeovers, we'll probably see more dealmaking in this sector as well.
Are you seeing more international deals? Are international deals easier or more difficult for you to invest in?
Europe saw a 37% increase in M&A volume last year, fueled in part by acquisitive private-equity firms, and we expect activity there to remain strong in 2006. In recent years, The Merger Fund has invested up to 25% of its assets outside of North America.
Depending on political and regulatory factors, some countries are easier to invest in than others. We won't play a deal if we think we might be the last to hear some important piece of news. Exchange-rate risk can be hedged away easily.
Which investment banks will be leading the way when it comes to deals this year? Does the investment bank matter to you as an arbitrager?
We hope that dealmakers at all the major investment banking firms will be celebrating record bonuses this time next year. We rarely base our investment decisions on who's advising the parties to a deal. We focus, instead, on the strategic rationale for the transaction, whether the merger agreement is tightly written, regulatory issues and other factors that are much more important to a successful outcome.
As an arbitrager, what lessons can be learned from the topsy-turvy battle for Guidant?
Risk management is extremely important. There were times to be big in this deal and times to batten down the hatches. We basically got it right.
What are some deals you currently like?
If I told you, I'd have to kill you.
What are some of the risks you see in the M&A world? What dangers lurk on the horizon?
An external shock to the system, such as another terrorist attack, would roil the financial markets and cause arbitrage spreads to widen, but relatively few deals would be at risk. After the Crash of '87, virtually all of the strategic transactions in our portfolio got done. The same held true following 9/11. One of the things we like about merger arbitrage is that most of the time we face little systemic risk.