Hedge funds profit from return of M&A

August 7, 2013 5:17 pm

Hedge funds profit from return of M&A

By Sam Jones

As developed world stock markets have surged this year, the corporate world has likewise seen a revival of deal-making, capital raisings and restructurings. And hedge funds – in particular, so-called event arbitrageurs – are looking for rich pickings from that trend. Event arbitrage is a catch-all term for the strategies by which hedge funds look to capitalise on corporate announcements. In a merger, a simplistic event arbitrageur bet would entail wagering on the price of the acquisition target rising, while shorting the acquirer in expectation of its price falling. Such strategies have outperformed all other hedge fund trading styles so far this year. Proof positive, say event arb traders, that their strategy is bearing fruit. According to HFR, the average event arbitrageur is up 5.7 per cent, compared with an industry-wide average of 3.6 per cent. Many individual managers have fared better.Davidson Kempner, one of the largest merger arbitrage and event-driven hedge funds in the US, with $19bn under management, has seen its flagship fund rise 6 per cent this year.

And the flagship $22.7bn master fund of Och-Ziff, the largest listed US hedge fund, rose 6.5 per cent in the first half, thanks primarily to returns from equity special situations and mergers.

While such numbers are not stellar – particularly set against the 18 per cent rally in the S&P 500 this year – they are better than they have been, and conditions driving them point to better things to come.

Hedge fund investors seem to think so too. In the first half of this year, about $10bn came into event-driven hedge funds compared with just $12bn in the preceding three years, HFR data show.

Event-driven equity strategies currently make up more than 26 per cent of investments at SkyBridge Capital, the $8bn hedge fund investor. “Event-driven is now hugely compelling,” says Troy Gayeski, senior portfolio manager at the firm. “It has a very attractive risk/reward profile in the current environment.

“Even if equities trade flat for the next year . . . managers should still be able to outperform,” he adds, based on expectations of corporate activity in the coming months.

If there is any event arbitrage renaissance – and it remains a big if – it has been a long time coming. Managers and investors have prophesied the strategy’s success at the beginning of almost every year since 2009, though it has failed to materialise.

Where event arbs have made money, it has been largely in activist positions or through experiments with distressed debt or restructurings, rather than through bread-and-butter merger plays. Dan Loeb’s big gains at Third Point – up 20 per cent this year – have come from shorting the yen and agitating for change at Sony rather than through grinding out gains from takeovers.

For pure plays on mergers, the part of the puzzle that has been missing is macroeconomic stability, and with it the confidence of chief executives.

Few corporate leaders have been willing to risk their jobs with big deals, even if corporate cash balances are touching new highs – $1.45tn in the US alone, according to Moody’s – and prospects for growth through acquisitions look attractive.

And while that is changing, as the recent flurry of multibillion-dollar announcements seems to indicate, not every merger situation makes for a profitable opportunity from an arb’s point of view.

“The year started terribly with TNT,” says Mark Kelly at Olivetree Securities – referring to the unexpected collapse of the Dutch logistics company’s takeover by UPS after an EU competition ruling. The fallout of the deal was felt widely.

Many event arbitrageurs lost millions, including some big US players. “Everyone has been very defensive in the way they have traded Europe since,” says Mr Kelly.

You can always tell when the good years start coming back because people start taking directional risks

– Mark Kelly, Olivetree Securities

If there is a market for event arb to prove its worth in the coming months, it will almost certainly be in the US.

“In the US they are going great guns,” says Mr Kelly. “You can always tell when the good years start coming back because people start taking directional risks.”

One such example was Liberty Global’s $23.3bn takeover of Virgin Media. Many managers eschewed aggressively hedging their positions, and thereby collected bigger profits when they deal went through.

Just how much risk managers are willing to take in the coming months – whether they scale it up cannily or remain cautious – will be decisive.

As yet they are still taking incremental steps. With such mediocre performance since 2008, they have little to fall back on. And plenty to lose.

“What matters is not the situations where you make money – there are loads of those,” says one merger arbitrage trader. “What is the killer is the one trade that loses you everything.”

About bambooinnovator
Kee Koon Boon (“KB”) is the co-founder and director of HERO Investment Management which provides specialized fund management and investment advisory services to the ARCHEA Asia HERO Innovators Fund (www.heroinnovator.com), the only Asian SMID-cap tech-focused fund in the industry. KB is an internationally featured investor rooted in the principles of value investing for over a decade as a fund manager and analyst in the Asian capital markets who started his career at a boutique hedge fund in Singapore where he was with the firm since 2002 and was also part of the core investment committee in significantly outperforming the index in the 10-year-plus-old flagship Asian fund. He was also the portfolio manager for Asia-Pacific equities at Korea’s largest mutual fund company. Prior to setting up the H.E.R.O. Innovators Fund, KB was the Chief Investment Officer & CEO of a Singapore Registered Fund Management Company (RFMC) where he is responsible for listed Asian equity investments. KB had taught accounting at the Singapore Management University (SMU) as a faculty member and also pioneered the 15-week course on Accounting Fraud in Asia as an official module at SMU. KB remains grateful and honored to be invited by Singapore’s financial regulator Monetary Authority of Singapore (MAS) to present to their top management team about implementing a world’s first fact-based forward-looking fraud detection framework to bring about benefits for the capital markets in Singapore and for the public and investment community. KB also served the community in sharing his insights in writing articles about value investing and corporate governance in the media that include Business Times, Straits Times, Jakarta Post, Manual of Ideas, Investopedia, TedXWallStreet. He had also presented in top investment, banking and finance conferences in America, Italy, Sydney, Cape Town, HK, China. He has trained CEOs, entrepreneurs, CFOs, management executives in business strategy & business model innovation in Singapore, HK and China.

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