Merger Fund Treads Water
The past year has seen Merger Fund (symbol MERFX) at its best (when it lost money) and its worst (when it made money). During last year's April-October correction, during which the stock market sank 18.6%, Merger lost only 4.6%. But so far in 2012 (through April 24), it has earned just 1.0% as the market gained 9.8%. And over the past 12 months, Merger, a member of the Kiplinger 25, made zilch.
Co-managers Roy Behren and Mike Shannon invest in takeover targets after a buyout is announced to cash in on the difference between the post-announcement price and the deal price -- the so-called arbitrage spread. Once a transaction is completed, the pair step out of the takeover-target stock and pocket their gains. Some of the fund's best investments over the past year included Petrohawk Energy, which was acquired by BHP Billiton; Motorola Mobility Holdings, which was bought by Google; and Synthes, the Swiss medical- device company that is being bought by Johnson & Johnson. Most recently, the $5 billion fund pocketed a $13 million profit following the April 2 closure of the merger between Medco Health Solutions and Express Scripts. (Because Express Scripts paid for the acquisition with both cash and its own stock, Merger purchased Medco shares and shorted Express Scripts shares after the deal was announced in July 2011. This is a common technique used by merger arbitrageurs when a buyer uses stock for all or part of the transaction.)
But there's always a chance that a deal will be broken, which is one of the big risks for merger investors. Last July, in the wake of News Corp.'s involvement in a phone-hacking scandal, Rupert Murdoch's company pulled out of a deal to buy the 61% of British Sky Broadcasting that it didn't already own. Merger Fund was caught holding stock in BSkyB, as the European network is better known, while the share price dropped 30% from July to October.
Low interest rates curbed the fund's returns over the past year, says Behren: "Because rates are down, arbitrage spreads are as well." Concerns about European government debt dampened deal activity, too.
Are double-digit annual returns a thing of the past in merger arbitrage? In the 1990s, Merger posted double-digit returns in five years out of ten; its most recent double-digit return year was 2006. Market conditions were different in the 1990s. Interest rates were higher, and fewer players engaged in merger arbitrage.
Moreover, says Behren, the decade was marked by "a preponderance" of hostile deals. In a hostile takeover, the risk and, thus, the premium are higher; plus, there can be multiple bidders, which can also raise the stakes. "We went through a couple of cycles," Behren says, "when there was an upturn in deal activity and higher rates of returns -- the days of Ivan Boesky. Back then, it was an untrammeled field." As more investors entered the arbitrage space, including hedge funds, the arbitrage spread narrowed. But following the carnage of 2008, the field is "less crowded…and that opens up the potential for the spread to widen."
Because the U.S. economy is improving and because many companies are cash rich, Behren says he's optimistic about an increase in deal activity. Nonfinancial companies are sitting on $2 trillion in cash, he says. Many such companies are also looking for ways to boost profits, and they may do so by making acquisitions. "Put those altogether and it means that the stage is set for increased deal activity," says Behren. That would be bullish for Merger Fund, which is now invested in 56 deals.
In recent months, Behren and Shannon have seen merger activity in sectors such as biotechnology, technology, natural resources and mining, as well as a rise in cross-border deals. In late 2011, Caterpillar announced plans to buy Hong Kong-based ERA Mining Machinery; and a leading Japanese insurer, Tokio Marine Holdings, agreed to acquire Delphi Financial Group, a U.S. insurance company.
Merger's net assets have doubled since 2009, but Behren says that has helped the fund. Revenues from the additional assets have enabled the fund to beef up its research desk. And "the strategy is scalable -- it's easy to manage a lot of money because you just buy more shares" of the same company. In addition, being bigger makes it easier for Behren and his colleagues to get through to company managements. Access is important -- a big part of the managers' research process involves figuring out how motivated the buyer and seller are to close the deal. And, of course, the deal has to make strategic long-term sense as well. "Mike and I have been doing this since 1994," says Behren. "It can be complicated, and a lot of it is learned only by doing and experiencing. It's not a textbook style of investing."
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