Merger arbitrage strategy update

The Reformed Broker cites a very interesting study put out by The Boston Consulting Group (BCG) that suggests that M&A activity is expected to materially increase (they’re looking at European companies, but there are few reasons why the US won’t behave similarly, like FX rates). Bottom line: merger arb strategies need deals to invest in, and more deals means more potential investment opportunities in the merger arb space. The more opportunities, the better the prospects for solid returns, as a low-deal environment forces more crowded trades in the merger arb space which historically is negatively correlated with spreads/discounts to takeover prices. More activity is good for the merger arb funds. There are a number that I’ve discussed previously, including ARBFX, MERFX, GABCX, and GDL.

Their post: http://thereformedbroker.com/2009/12/23/a-european-buyout-frenzy/

They state: “It was only a matter of time.

The recent rally notwithstanding, corporations and their assets denominated in US dollars are lookin’ like lunch meat to the European business world and according to a recent study, a wave of mega-mergers is on the way.

The Boston Consultant Group is out with a survey that indicates 1 in 5 European companies is planning to do a deal in 2010, and that percentage jumps to 1 in 2 companies with market caps in excess of €20 billion.

68% of the companies surveyed were pondering “horizontal” deals, meaning mergers within their own industry segment for the purpose of scale and the easing of competition.

BCG broke the results down by industry group (see chart below):

While to be sure, a great many of these deals will take place on the European continent, something tells me that the Kraft/Cadbury game of footsie we’re witnessing is only the canary in the coalmine in terms of Transatlantic mergers (although in this case, it’s an American company bidding for Euro assets vs Nestle, another European company).

One bright spot for the global economy is the fact that 44% of chemical companies have the urge to merge, as the chemical industry is often seen as a harbinger of economic activity.

Research Recap has the rest of the stats as well as a link to the full report.

Sources:

1 in 5 European Companies Planning M&A Deal in 2010  (Research Recap)“

Strategies For Uncertain Times: Merger Arbitrage (and Special Situations)

Overview: Merger arbitrage involves long/short equity positions in an attempt to exploit M&A takeover mispricings. In some ways the merger arbitrate strategy can’t be divorced from general “special situations” strategies like spin-offs and corporate reorganizations.

Merger Arbitrage/Special Situations

Overview: Low correlation with S&P. Current historically high levels of corporate balance sheet cash balances combined with unfreezing of credit markets should lead to more M&A activity and benefit merger arb strategies. Merger arb strategies throw off lots of cap gains b/c of high turnover on deals so it’s best to hold it in a tax advantaged account.

• Open-end mutual funds:
  • ARBFX: Arbitrage Fund
    • ¼ the size of MERFX, might mean they can get out of blown deals easier
    • Mgmt focuses on strategic deals, not LBOs, and is focused on vol-adjusted returns
    • 1.9% annual expense
    • 5.28% std dev on 3 year basis, has roughly 0.40 beta w/ S&P
    • 5 year annualized return of 4.7%
    • 65 positions with high turnover
    • Down 1% in 2008
  • MERFX: The Merger Fund
    • 1.5% annual expense
    • 4.96% std dev on 3 year basis
    • 5 year annualized return of 4.4%
    • 42 positions with high turnover
    • Down 2% in 2008
  • GABCX: Gabelli ABC Fund
    • 0.64% annual fee, no load
    • 4.6% std dev on 3 year basis, beta of 0.20 vs. S&P
    • 5 year annualized return of 5.3%
    • 140 positions with high turnover, very diversified, currently 100% long
    • Merger arb, special sits, value oriented common stocks, convertible bonds
    • Down 2.6% in 2008
    • Morningstar 5 star fund
    • Almost entirely US although is global in focus
• CEFs:
  • GDL: Gabelli Global Deal Fund    
    • VERY diversified
    • All special situations: merger arbitrage, spins, reorgs
    • Global, but almost all US at the moment
    • Existing holders are buying at the moment
    • 90 positions with high turnover
    • Low annual fees of only 0.66%
    • Only 3 year history, but has a 0.65 beta w/ S&P
    • Down 8% in 2008
• ETFs:
  • MNA: IQ ARB Merger Arbitrage ETF
    • Does NOT actually short shares of the acquirer, only indexes, so it’s not real arbitrage
    • Just started
    • 0.75% annual fee

Strategies For Uncertain Times: THE OVERVIEW

I believe that tremendous uncertainty supports the adoption of hedge fund replication strategies.

At the end of 2008 I felt very certain that, given the oversold levels of various equity markets around the world, a basket of China, India, and LatAm (Brazil) were extremely likely to experience very solid price appreciation. Multiples for their respective indexes were lower than they were in the US (which is rare) and I knew that emerging market economies will precede the US coming out of the trough of the macro cycle. Additionally, their macroeconomic situations were comparatively healthy versus the US. In retrospect, it was a no-brainer and a huge winner. I nearly bottom-ticked those equity markets and ended up doing extremely well on a percentage/relative basis as their TTM performance has been stellar.

This year I have the entirely opposite mindset: I have ZERO idea what will happen to equities over the next two years and I think anyone who says they do is selling a theory that they can’t realistically support as actually PROBABLE. Hence, I’ve put together a list of strategies/asset classes that, in aggregate, satisfy my desire to make money over the next year or two. Some ideas are targeted at generating current income, some ideas are targeted at capturing potential equity market appreciation, and some ideas are just uncorrelated strategies or asset classes that offer non-equity means of potentially increasing in value (income plus price appreciation).

Some people refer to compiling these strategies and/or adding non-equity  asset classes  as “hedge fund replication” whereas I just call it considering your alternatives (zing). I believe that, while unlikely to repeat the huge outperformance of my portfolio this over past 12 months, this strategy should produce sold tax-managed returns with favorable volatility over the next one to two years. This is really just a study I prepared for myself (AKA The Dan-Don’t-Be-Broke-Portfolio), but you might find some interesting info for yourself.

There is a considerable amount of disagreement about the definition of the term “hedge fund replication” but, to me at least, it means any combination of three things: 1) not being exclusively long equities (long only), 2) maintaining short exposure as a hedge against bearish moves in equities or the economy overall, and 3) looking at various asset classes and strategies that seek to generate uncorrelated or low-correlation returns with equities.

Clearly 2008 demonstrated that many “hedge funds” were not appropriately hedged, if at all. If the S&P was down 30%+ in 2008 and hedge fund XYZ was down roughly the same amount, then they did not come close to producing returns for their investors that were either 1) positive on an absolute basis (greater value at end-of-period than at beginning-of-period), or 2) positive on a relative basis (lost less value on a percentage basis than the S&P, which is admirable but still fails to increase investor wealth), and 3) most likely generated a return that was highly correlated with the performance of the S&P, which is not acceptable given that investors pay high fees to hedge funds in the expectation that they do NOT produce results similar to what the overall equity market does.

This list is not inherently “fully hedged” or “market neutral” but the list (when aggregated as a portfolio) has a correlation with the S&P of less than 1.0 and potentially has the ability to increase in value even if the S&P falls.  Obviously, my allocation to each of these strategies will vary greatly depending on changes in value, and I might not even currently employ any one of them at all.

Non equity asset classes:

-Commodities

-Debt (emerging market)

-Debt (floating or variable corporate)

-Muni bonds

-Closed end fund (CEFs) arbitrage

-Private equity and/or venture capital (PE and VC)

-Currencies

-Convertible bond arbitrage

Equity-based strategies:

-Merger arbitrage and special situations

-Closed end fund Fund-of-Funds (CEF FoF)

-Biotechnology

-Stock buyback funds

Covered call funds (buy-write strategy)

Real estate (US and/or international)

Long/short equity (partially hedged or market neutral equity)

Managed futures (this can mean several things)

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I have prepared my own investment guide that spans all of these strategies. You can download it by clicking here.

Strategies For Uncertain Times

I prepared it awhile back, so it may not reflect current market conditions, valuations, or discounts. It is based on my own financial situation, goals and objectives, risk profile, and tax considerations. My picks/selections are bolded, there may be two per strategy/asset class. In many cases I prefer closed-end mutual funds (CEFs) b/c they trade on an exchange like stocks, and frequently trade at discounts to their “net assets” per-share, which occasionally creates a built-in margin of safety. I will continue to hold a good portion of emerging market equities, which I trade in and out of depending on valuation on price changes. I hold HAO for China, GML for Latin America, RSX for Russia, and EPI for India. I just typed up my handwritten notes, so there are plenty of abbreviations, typos, and short-hand notes. The format isn’t meant to be anything more than acceptable, so just call me if you have a question about what something means or what I’m thinking.