Risk arb funds seek M&A rebound to spur returns

By Nadia Damouni and Megan Davies

NEW YORK (BestGrowthStock) – Broken deals, hostile offers and volatile markets put the skids on arbitrage funds this year, but traders are looking for a better year in 2011 as deal volume is set to rebound further.

Arbitrage traders try to make money by taking positions in stocks that are takeover targets.

While this year saw a checkered performance for arbitrage funds, with only lackluster returns, some firms are ramping up office space in preparation for a rush of new hires to be able to handle an expected rise in deals.

“(Risk arbitrage) has certainly gone from sub-zero to the teens in temperature,” said Steve Gerbel, founder and president of Chicago Capital Management.

By investing in companies that are the subject of takeover bids, arbitrage traders try to make money on the difference, or spread, between the share price and the price the purchaser will pay for the shares. They sometimes hedge that position by short-selling the shares of the potential purchaser.

Traders can also make money by betting a rival offer will emerge and pay more — pushing a target’s share price above its offer. Still, there were only a handful of deals that traded that way this year, said Sachin Shah of Capstone Global Markets.

Shah said the majority of deals this year had very tight clauses in their agreements, meaning that breaking the contract would be almost impossible. That led to tighter deal spreads and less opportunities for traders.

As a result, net returns for the average risk arbitrage fund only hit single digits this year, according to three traders.

The estimated average returns this year have been between 2 percent and 7 percent, they said, a fall from the double digit returns of 2008 and 2009. The figures are anecdotal because they are not publicly available.

VOLATILE MARKET

Arbitrage funds were also hurt by significant volatility and uncertainty in the market this year, caused by such factors as Greece defaulting on its sovereign debt and the “flash crash” in the United States in May. This shook confidence and stalled some deals, traders said.

In addition, low interest rates caused spreads to tighten, limiting the ability of traders to make money, said one fund manager. With interest rates in the United States at zero, there was little incentive for large companies to buy rivals, said one trader.

The increase in high profile hostile deals also hit returns.

“Hostiles are fun to do, but their return on time is always a poor testament,” said one arbitrageur who preferred anonymity as he is not authorized to speak with the media. “At the end of the day, you can make a big payday, but boy, your time could have been better spent working on 10 other deals.”

Hostile deals included BHP Billiton Ltd’s (BHP.AX: ) $40 billion bid for Potash Corp of Saskatchewan Inc (POT.TO: ), which was blocked; Air Product and Chemicals Inc’s (APD.N: ) unsolicited $5.88 billion offer for rival Airgas Inc (ARG.N: ) and the pending $18.5 billion takeover bid by pharmaceutical company, Sanofi Aventis SA (SASY.PA: ) for Genzyme Corp (GENZ.O: ).

SHAKY OPTIMISM

Over the last few years, there has been less money chasing merger arbitrage, said Chicago Capital’s Gerbel.

Still, traders took comfort from the fact a number of funds did not collapse, as seen in the prior two years.

There are now about 30 to 50 funds that offer risk arbitrage as a strategy, said the two arbitrageurs. However, with a shaky capital raising environment, the majority of those funds are below $1 billion in total assets.

Fund raising remains very difficult, said a third arbitrageur, who preferred anonymity. Even risk arbitrage funds with a decent track record in the range of below $300 million to $400 million are finding it hard to attract more capital, that arbitrageur said.

But capital could flow back quickly, said Gerbel, adding that risk arbitrage as a strategy has gained momentum in the last 3 or 4 months.

The total global hedge fund capital that was deployed into event driven investing was just over $460 billion at the end of the third quarter, said Ken Heinz, president at Hedge Fund Research Inc. That number at the end of 2008 had fallen to $335 billion, Heinz said.

In April, Gerbel and his staff moved into an office that is “800 percent larger in square footage,” anticipating a rush of new deals.

With 2011 widely expected to see a wave of consolidation, according to bankers and lawyers, the level of deal making will rebound, said Glenn Callen, a managing director at Knight Capital Group.

At some point shareholders are going to demand cash-rich companies to put money to work, either through a share buyback, dividend or acquisition, said Gerbel.

Deal-flow is also expected to be boosted by more clarity on regulation and policy in Washington, D.C. — including healthcare, energy and financial reform bills — and the extension of Bush-era income tax cuts, said Jason Orchard, head of the hedge fund analysis group at Spring Mountain Capital.

As a result, there is expected to be an uptick in activism.

“We are looking at 2011 as the year of reckoning,” Orchard added.

(Editing by Andre Grenon)

Risk arb funds seek M&A rebound to spur returns