Hedge funds that practice convertible arbitrage continue to bleed assets and remain one of the poorest performers of any category this year. But here's a secret, according to a hedge fund manager: Convertible issuance is back. Convertible financings have rebounded because interest rates are up and it costs less for companies to issue these stock-and-bond hybrids than traditional corporate paper. Also, while companies may be sitting on a lot of cash, they've still found uses for borrowed money in the area of share buybacks, acquisitions, and to fund research and development. With that in mind, says the manager, investors should be wary of certain names that have shown a propensity for convertible offerings in the past. He mentioned First Data ( FDC), Radian ( RDN) and Weatherford International ( WFT). If a company sets a convertible sale, arbitragers are sure to short the underlying stock.
Tough LegacyLife is full of surprises when you're Biovail ( BVF). Uncertainty around the Ontario pharmaceutical firm has created a feeding ground for hedge funds that see the stock as a pure "event" play. Biovail got a boost earlier this month when it announced a marketing partnership with Johnson & Johnson ( JNJ) for the sale of Tramadol ER, a pain reliever. "The partnering is fantastic news. They found the best partner," says David Maris, a Banc of America Securities analyst who is neutral on the stock. New York-based Deerfield Management, a specialized life science hedge fund, is long the stock and held 3.77 million shares, according to its most recent 13H filing. On the downside, Biovail, which manufactures Wellbutrin XL, is facing generic competition. OrbiMed Advisors, a hedge fund specializing in life science products, sold its 2.1 million-share position based on the generic risk, according to a source familiar with the sale. York Capital Management also sold almost a million shares, according to regulatory filings. Both trades looked prescient Thursday when Biovail tanked 13% to $22.30 after Anchen Pharmaceuticals obtained tentative approval for its generic version of Wellbutrin XL.
The vulnerability to generic competition was part of the reason the company announced Tuesday that it would spin off its off-patent drugs ("legacy assets") next year. That news sent the stock down 6% Wednesday. "This is one of the few cases where a spinoff takes away value," says Maris, explaining that Biovail, in creating a distinct company, is giving up some of its earnings while concentrating the risk on Wellbutrin. "You should do a spinoff to extract value, not to extract cash from the business," he says. That's an interesting distinction, especially when hedge fund activists preach spinoffs as a panacea to unlock shareholders' value.
mined for profits by certain vulture funds ), but rather the bankruptcies' impact on the ability of other troubled companies to raise money. The uncertainty produced negative returns for the strategy in October, says Justin Dew, a hedge fund analyst at Standard & Poor's. Convertibles had been in recovery mode since last summer, but that ended last month, according to a convertible arbitrager. Apparently, some so-called outright-convertible investors, (long the bond without shorting the underlying stock) took profits last month, while redemptions continued to hit the convertible hedge fund sector, he says. The redemptions led to forced selling, the departure of portfolio managers, and, in some cases, funds shutting down. Outright investors are typically institutional investors and multistrategy hedge funds that play the convertible bond market without hedging. They were a major contributor to the summer rally. On the positive side, global macro, a strategy in which participants take leveraged directional bets in all global securities, including stocks, bonds and currency, based on macroeconomic views, was the big winner, according to S&P. Perceiving a recession, those managers were short the U.S. equity market and long Asia, and this was a rare occasion in which they got it right on both sides of the trade, says Dew.
Rough PatchEverybody agrees that October was an ugly month for hedge funds, but the devil is in the details. Among various categories, so-called special situation strategies were hit hard by the bankruptcies of Refco ( RFXCQ) and Delphi ( DPHIQ). The problem wasn't necessarily investments in those specific situations (indeed, the Refco scandal was