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Riskier Business, Part 2

An aggressive new approach to antitrust law will shape tomorrow's deals.
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In Part 1, risk arb David Brail explored the many pending merger deals that had been blocked by antitrust concerns. Here he tells what this trend means for future deals.

Why has the government chosen to step up its scrutiny of pending merger deals, particularly now? There are two possible explanations. One is that we are at the end of a long merger boom. Many industries have consolidated, concentrating market power in fewer remaining participants. In the government's eyes, any further consolidation may be the straw that breaks the camel's back. If so, cable television and supermarket mergers may be increasingly more difficult to get approved by the regulators.

A second explanation is that merger policy changes have quietly occurred -- a new set of standards will be applied, and the government will be much less willing to allow consent decrees to be used to facilitate marginal deals. Instead, those deals will simply be blocked.

This may be manifesting itself in the difficulty

Microsoft

(MSFT) - Get Microsoft Corporation Report

is facing in closing its

deal with

Visio

(VSIO)

, where the spread has grown from under $2 to more than $7 in the three months since the merger was announced. In the case of

British Petroleum

and

Atlantic Richfield

(ARC) - Get ARC Document Solutions, Inc. Report

, the government seems to be taking the novel (and in my view, absurd and bogus) view that the market for crude oil sourced in Alaska and shipped to California is somehow distinct from the market for oil in the rest of the world.

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My view is that the second explanation better describes what we are seeing. Joel Klein, the head of the

Justice Department's

antitrust division, signaled his new stance when he brought the landmark suit against Microsoft last year. This aggressive posture has spread throughout the Justice department, and the

Federal Trade Commission

as well. Even mergers with minimal antitrust issues are being put through the wringer, with longer reviews and more stringent consent decrees. It used to be a merger could close based on the promise to sell specified assets in the future. Now a signed contract with a buyer is frequently required in many cases, and in others a fully consummated sale.

All of this adds risk for an arb. The downside in broken deals can be severe, as evidenced last week when the risk spread in the

Alza

(AZA)

/

Abbott

(ABT) - Get Abbott Laboratories Report

deal went from $3 to $20 in about four days (it closed Tuesday at around $13.30). That represents enormous pain for arbs, at a time of year when it's least welcome. Less obvious is the decay in the return earned in successful transactions when an antitrust review takes six months instead of an expected two months, as in the case of Visio.

Antitrust analysis is difficult to conduct from the outside. You can scrutinize the competition section of the 10-K, look at the geographic implications of a deal using the locations of stores and plants, and talk to suppliers, customers and competitors. But in the end, it's hard to get inside the heads of the regulators. It is one of the risks in risk arbitrage that is the hardest to quantify and evaluate. The rewards when you are correct can be dramatic. Arco currently sports a $13 spread. If that merger closes in one month, a cool 200% annualized return is available.

The result of more severe antitrust review should be wider spreads in future deals that have a component of antitrust risk. And newly announced transactions will be quickly evaluated as being "clean" or not. All of this means that antitrust risk will bifurcate the market of arbs spreads, at least until a new administration brings with it new antitrust leadership at Justice and the FTC. I am personally counting the days.

David Brail is the president and portfolio manager of Palestra Capital, a Manhattan-based hedge fund that focuses on risk arbitrage, and has been an investor in risk arbitrage and bankruptcy securities since 1987. At the time of publication, Palestra Capital was long Alza, Arco, Viasoft and Delta and Pine Land, and short Abbott Laboratories and British Petroleum although holdings can change at any time. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. Brail appreciates your feedback at

dbrail@thestreet.com.