How to Make Money on Mergers

Funds that specialize in deal stocks can deliver steady returns without taking huge risks.

Investing in mergers is one of the safest ways to tiptoe into the stock market. We’re not kidding. Consider this case: Software giant Oracle plans to buy Sun Microsystems in a friendly, all-cash deal. Oracle will pay $9.50 for each share of the Silicon Valley computer-hardware firm. Yet Sun shares recently traded for about $8.60, or 10% below Oracle’s offer. Is this a free lunch just waiting to be served?

Sure looks that way. Say you were to buy Sun at the recent price, and the transaction, which awaits approval from European regulators, closes in four months. On an annualized basis, that 10% gap becomes a juicy 33% return, before trading commissions. But while nothing is stopping amateur investors from getting in on a deal like this, there are a lot of potential pitfalls. That’s why it’s a good idea to leave merger investing to specialists known as risk arbitrageurs. They sort through hundreds of deals like this one, investing in some and avoiding others. A handful of mutual funds that specialize in deals are known for providing steady returns and holding up well in bear markets.

Deal shortage. U.S. merger activity slumped after the 2008 meltdown. In the first 11 months of 2009, merger volume (in dollar amounts) was down 30% from the same period a year ago, according to Dealogic, a research firm. But a slew of recent transactions may be signaling that corporate executives are ready to dust off their deal-making skills. Given the uncertain outlook for the economy, buying another company may be their quickest route to increased profits.

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Meanwhile, the average gap between a target company’s share price and the announced deal price has been growing wider and staying that way longer. One reason is that big institutional investors are now inclined to dump their stakes in a target company quickly once a deal is announced. A few years ago, when credit was easy, they would have hung on to their shares, hoping for a higher bid to emerge. But in recent years, many were burned by deals that fell through.

What can scuttle an announced deal? Plenty. Lenders can refuse to finance it, regulators can intervene, influential shareholders can balk at the terms, or the target might fail to perform up to expectations.

We found five no-load funds and one exchange-traded fund that specialize in merger arbitrage. Our favorites are the first two -- Merger Fund and Arbitrage Fund -- because each offers experienced managers and a relatively pure focus on merger arbitrage. (All performance figures are through December 4.)

As befits a fund with its name, Merger Fund (symbol MERFX) is the most senior member of this group. It has been skillfully navigating the deal market since 1989. With $2 billion in assets, though, it must focus on larger deals -- typically those involving target companies with a market value of at least $300 million. And when deal making hits a lull, the fund might hold a big cash stake or engage in related types of arbitrage investing. One example: As Citigroup converted preferred shares to common stock to boost its capital levels, Merger Fund bought the Citi preferred and shorted the common stock to profit from price discrepancies. The fund will also invest in hostile deals, which are riskier than friendly ones, and in companies that are looking for a buyer but haven’t yet found one.

Over the long term, managers Fred Green, Roy Behren and Michael Shannon aim for an 8% to 12% annual return, a target they haven’t hit recently. Over the past decade, the fund returned an annualized 4.6%. That’s well ahead of the gain of Standard & Poor’s 500-stock index, which was flat over the period. In 2009, the fund gained 7.9%, trailing the S&P 500 by 17 percentage points. But amid 2008’s tumult, Merger lost just 2.3% -- a terrific result considering that the S&P sank 37%. The fund has lost money in only one other calendar year (in 2002, when it surrendered 5.7%). Its annual expense ratio is 1.47%.

Approaching its tenth anniversary, Arbitrage Fund (ARBFX) is still small enough ($591 million in assets) to get into deals that Merger Fund won’t touch. It will buy shares of companies with market values as low as $40 million. That gives manager John Orrico more options to choose from, although he picks his spots carefully. He avoids most hostile deals and leveraged buyouts (deals financed through heavy borrowing). He also calls his fund the only pure play in the field because he shuns other types of arbitrage strategies.

From its inception in September 2000, the fund returned an annualized 9.1%, beating the S&P 500 by an average of nearly 14 percentage points per year. It earned 9.5% in 2009 and lost just 0.6% in 2008. Arbitrage’s only other down year came in 2005, when it lost 0.2%. Fees total 1.69% annually.

Gabelli ABC (GABCX) is a freewheeling fund that engages in merger arbitrage. But it also buys value stocks and convertible securities, and it sometimes holds big cash stakes. Value maven Mario Gabelli has managed the fund since its 1993 inception. Because of ABC’s tendency to hold a lot of cash (74% of assets at last report), this fund will make you squirm during bull markets (it was up just 5.2% in 2009). But the fund has a good record of protecting capital during tough times. It returned an annualized 4.9% over the past decade, beating the S&P 500 by nearly six percentage points per year. At 0.63% annually, expenses are less than half those of the Merger and Arbitrage funds. But you’ll need at least $10,000 to become a shareholder.

Pennsylvania Avenue Event-Driven Fund (PAEDX) uses a blend of strategies, all triggered by corporate “events,” such as mergers, reorganizations and restructurings. Each of these situations can cause uncertainty about the value of a company’s stock and bonds, opening the door to skilled players. Thomas Kirchner, who launched Pennsylvania Avenue six years ago, buys traditional merger-arbitrage stocks but also engages in riskier strategies, including purchasing undervalued bonds issued by companies in or near bankruptcy, and investing in companies involved in proxy fights.

Yet it was bread-and-butter merger plays that burned the fund in 2008, when it took stakes in mortgage servicer PHH, footwear maker Genesco and video distributor Image Entertainment, among other takeover targets that saw deals fall through. As a result, Pennsylvania Avenue lost 26% in 2008. Over the past five years, the fund gained an annualized 4.2% but with twice the volatility of other merger funds. It rebounded strongly in 2009, with a 29.7% gain. Expense ratio: 1.5%.

AQR Diversified Arbitrage (ADANX), launched in January 2009, is the new kid on the block. Managed by a team of four, the fund uses a mix of merger investments and other arbitrage strategies intended to profit from temporary price discrepancies among different types of securities issued by a company or by a parent company and subsidiary. Although the managers ran private arbitrage funds long before they launched the mutual fund, we’d still give AQR more time to season. The fund charges 1.5% in annual fees.

You can also invest in deals through an ETF, IQ ARB Merger Arbitrage (MNA), which launched in late 2009. The ETF tracks an index of companies worldwide that are targets of already-announced acquisitions. The expense ratio is a relatively low 0.75%. But we’re skeptical that a merger index strategy will work as well as sound active management. Because merger arbitrage requires skilled managers, this is one area in which it probably pays to pay a little extra.

Contributing Editor, Kiplinger's Personal Finance