Unless stocks take off in the fourth quarter, 2005 is shaping up to be snoozer for investors. When it comes to deals, though, it's already going down as a sizzler. Low interest rates, clean corporate balance sheets and the urge to merge have turned 2005 into a banner year for mergers and acquisitions. According to John Orrico, portfolio manager for the $123 million ( ARBFX) Arbitrage fund, an open-end mutual fund that invests in both stock and cash deals, global M&A volume through September was $1.75 trillion, up from $1.25 trillion last year. Europe alone is on target to crack the $1 trillion mark for the first time since 2000, says Orrico. As for his own fund, the Arbitrage Fund is flat this year, compared with a 1.5 percentage-point loss for the S&P 500. But don't judge its performance too harshly; the fund isn't designed to correlate with the greater market, an element that makes it a welcome addition to a diversified portfolio. TheStreet.com checked in with the arbitrager Orrico to get the down-and-dirty on investing in deals. How would you describe your fund's strategy? We run a mergers-and-acquisition based risk arbitrage fund, which means we invest in things like announced deals, spinoffs and corporate reorganizations. While that may sound overly complicated, our goals are fairly simple: capital preservation and consistent positive returns which are noncorrelated to equity or fixed income markets. Over the past five years we are up about 7% annualized, vs. negative 2% for the S&P 500. Could you give a recent example of a deal you invested in? Federated's ( FD) purchase of May is a good example. That was a stock and cash deal where the time line was dependent on an antitrust review. The deal, which closed in about six months, was $17.75 cash plus 0.3115 share of FD for each share of MAY. For every share we bought of May, we shorted 0.3115 shares of FD in order to lock in a spread of about 6% gross. So on an annualized basis, we earned about 12%. This was a $12 billion deal and faced some intense scrutiny from antitrust regulators concerned about concentration in the retail market.
Is this a good climate for deals? I think it may be the best climate in five years. There has been a significant pickup in domestic and foreign deal flow. There is a long list of reasons for the great environment: strong global economies, a booming China, strong stock markets worldwide, record levels of private equity funds, record levels of cash on corporate balance sheets, low long-term interest rates and an improved environment in boardrooms following the wave of scandals in recent years. How do interest rates affect what you do? Merger arbitrage is one of the few investment strategies that actually benefits from rising short-term rates. Our spreads track off of short-term rates, with a risk premium attached. All else being equal, rising short-term rates lead to higher spreads -- and therefore greater profit potential. With short rates up over the last 18 months, we are seeing that show up in the returns available to us in the deals in which we invest. Are you seeing more international deals? And if so, are these deals harder or easier to navigate? Yes, we are seeing more international and cross-border deals. There has been a global pickup in deal flow because of factors like the single currency in the E.U., and the migration of regulatory structures in the E.U., Japan and Far East closer to what we see here in the U.S. and Great Britain. That is very positive for deal flow and consolidation in parts of the world that up until recently have witnessed quite low levels of deal flow relative to the U.S. and Western Europe. Would you rather have cash or stock deals? The ideal scenario is a mixture of each type of consideration, as they each have their pros and cons. Cash deals tend to have a higher return on capital, but spreads on those deals experience higher levels of volatility and are harder to hedge. Stock deals are less volatile but employ greater capital due to the fact that we need to short shares of the acquiring company. However, stock deals have no financing risk but do have other issues with regards to the structure of the deals. Also, for diversification purposes, we like to have a mix in the portfolio in terms of consideration received, as well as a good diversification among industries and market caps.
Should retail investors try what you are doing, or is this a strategy that's too risky for folks to try at home? It's probably not a good idea. A portfolio needs to be diversified, and we engage in complex hedging strategies to reduce risk in the portfolio, as well as short-selling on stock-for-stock deals. We invest in 50 or so deals at one time and over 150 deals over the course of a year. Engaging antitrust counsel, performing fundamental research around each party to a transaction, along with the currency hedging on foreign deals all make this an institutional investment strategy. Where does the Arbitrage fund fit in with the rest of somebody's portfolio? Is it a core holding? It's a core holding in our opinion, although I guess we are somewhat biased. But a noncorrelated alternative strategy should be part of every portfolio, and depending on your risk profile that percentage will vary. Maybe it should be between 10% and 50% of your portfolio. It seems like you are running a hedge fund-styled investment strategy, but in the form of an open-end mutual fund. That's not a bad way to characterize it. Since the early 1960s, risk arbitrage has been a core investment strategy for the nation's wealthiest families to preserve their capital. More recently for institutional investors such as pensions and endowments. The Arbitrage Fund, our fund, is one of the first and few funds to make this strategy available to the public. And our management team comes out of the hedge fund and family office environment for the most part, which is a huge advantage for investors.