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) 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.

Now that financing for buyouts has dried up, there are also fewer deals in the pipelines to provide future investment opportunities.

The sum of August's 96 private-equity-related buyouts of U.S. companies came to $4.2 billion, according to Thomson Financial, a total that is down 68% from the same time in 2006.

Not too long ago, investors would regularly awaken to news of two or three individual deals of just that size. Relatively speaking, that translates into the lowest monthly level of domestic buyouts since January 2004.

"LBO activity has fallen off and that's to be expected given the turmoil in the credit markets," says John Orrico, portfolio manager for the $175 million ( ARBFX) Arbitrage fund.

He expects activity to pick up again as private equity players find other ways to finance deals. "In the meantime, we've got a number of strategic and international deals pending."

Orrico says the flow of "strategic deals," which are the kind he prefers to invest in, remains robust.

He uses Medtronic's ( MDT) recent $3.9 billion acquisition of Kyphon ( KYPH) as an example of a strategic deal because it enables Medtronic to expand its reach into spinal treatment.

"We like it when operating companies purchase other operating companies for the right reason," says Orrico. "We generally try to avoid financially engineered take-outs."

Orrico's fund fell 0.85% in July, although it recovered the lost ground to finish the third quarter up 1.62%, according to Morningstar. For the first nine months of the year, it was up 5.8%, in line with its three- and five-year annual average returns.

Orrico also expects more international deals due to the weak dollar and strong global economy. He cites as an example Basel, Switzerland-based Roche Holding AG's $3 billion hostile bid for U.S.-based cancer-testing company Ventana Medical Systems ( VMSI).

In some cases, fund managers have actually doubled down on their bets that certain deals will go through -- setting them up for bigger gains if the deals succeed, or bigger losses if they don't.

The granddaddy of merger arbitrage funds is Fred Green's $1.8 billion ( MERFX) Merger fund. Morningstar senior analyst Dan Culloton says that when he spoke with Green after the initial turmoil, the fund manager felt pretty good about his positions and was selectively adding to them because he thought the deals still had a good chance of closing.

The Merger fund also lost money in July, when it fell 0.61%, but it finished the third quarter up 1.1% and gained 5.95% for the first nine months of the year.

While such returns pale in comparison to the booming S&P 500 over the last half-decade, arbitrage funds are designed for investors looking for a vehicle independent from the greater market rather than something that will shoot the lights out.

Both the Arbitrage and Merger fund sport betas of around 0.3, according to Morningstar. In other words, if the market moves 10% in either direction, then the fund will only move 3%.

Culloton says returns for merger arbitrage funds tend to range from the high single digits to the mid double digits. He notes that the Merger Fund has only had one losing calendar year since it was launched in 2002.

Not all merger funds are alike. For example, ( EMAAX) AXA Enterprise Mergers and Acquisitions , which is sub-advised by Gamco Investors' ( GBL) Mario Gabelli, has the latitude to purchase shares of companies believed to be likely acquisition targets. That means investors might gain early entry into potential takeover profits.

This latitude didn't necessarily help the fund in July, when it lost 2.52%, according to Morningstar. However, Gabelli trimmed those losses to 0.31% for the quarter and the fund was still up 6.54% for the first nine months of the year.
Before joining TheStreet.com, Gregg Greenberg was a writer and segment producer for CNBC's Closing Bell. He previously worked at FleetBoston and Lehman Brothers in their Private Client Services divisions, covering high net-worth individuals and midsize hedge funds. Greenberg attended New York University's School of Business and Economic Reporting. He also has an M.B.A. from Cornell University's Johnson School of Business, and a B.A. in history from Amherst College.

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