Paulson Leads Deal Magicians Amid Tight Spreads: Real M&A
Amid a bumpy recovery in mergers and acquisitions this year, a handful of hedge-fund managers are finding a way to make money betting on deals.
John Paulson, Drew Figdor and Peter Schoenfeld are outperforming funds that seek to profit from corporate mergers -- a strategy that has trailed broader hedge-fund returns since the financial crisis. Paulson & Co. posted an 11 percent gain in its merger fund this year through August. Figdor, who runs TIG Advisors LLC’s merger fund, returned 9.6 percent, and P. Schoenfeld Asset Management LP’s fund rose 8.8 percent through July, according to investors who asked not to be named.
While deal spreads remain tight, the managers have benefited by wagering on telecommunications and technology takeover battles, including the $21.6 billion purchase of Sprint Corp. and the $24.9 billion buyout of Dell Inc. (DELL) Their gains, helped by a resurgence in activist investing and an improving economy, are a ray of light for a strategy that clients have pulled money from for five of the past seven years as global deal volume remains stuck below the 2007 peak.
“We’ve got some good ingredients” to spark deals and fuel a rebound for merger arbitrage, said John Orrico, co-portfolio manager of the $2.9 billion Arbitrage Fund (ARBFX) at Water Island Capital LLC in New York. Takeover activity “is hefty enough to keep us fully invested, but it’s not this crazy robust deal environment that a lot of bankers and investors have been predicting.”
Global deal volume this year, at $1.6 trillion, is on pace to top last year’s, though it’s still trailing the post-crisis high of $2.4 trillion reached in 2011, according to data compiled by Bloomberg. This year has been helped by Vodafone Group Plc’s $130 billion sale of its Verizon Wireless stake, the biggest transaction in more than a decade, the data show.
Merger arbitragers seek to profit from the difference between the stock price of a target company when a deal is announced and the price when the transaction is completed. The larger the difference, or spread, the greater the potential profit for the arbitrager. The funds sometimes bet against the buyer while taking a long position in the company being bought.
Spreads have narrowed in the past years as investors chased fewer deals and as interest rates fell to a record low, eroding returns and prompting investors to pull money from the strategy. Merger-arbitrage hedge funds returned an average 4.9 percent a year since the end of 2008 through August, compared with 7.2 percent for hedge funds overall and 16 percent for U.S. stocks, according to data compiled by Bloomberg and Chicago-based Hedge Fund Research Inc. That’s a reversal from the previous four years, when merger arbitragers on average outperformed both hedge funds and the broader stock market.
Merger arbitrage in its modern form started after World War II and was initially called risk arbitrage, according to Ganapathy Vidyamurthy’s 2004 book “Pairs Trading: Quantitative Methods and Analysis.” Joseph Gruss of Gruss & Co. and Eugene Wyser-Pratte of Bache & Co. were among the famed arbitragers of that time. Paulson had worked at Gruss & Co., a pioneer of the strategy, before starting his own firm.
Today, merger-arbitrage funds manage $17 billion of the $2.4 trillion in hedge-fund industry assets, according to data from Hedge Fund Research. A net $482 million was pulled from such funds in the first half of the year after a net $1.07 billion was removed in 2012, according to the research firm. The strategy received a record $5.49 billion in 2006.
Some merger-arbitrage funds benefited from an increase in deals this year fueled by the telecommunications industry. Apart from Vodafone’s deal with Verizon Communications Inc., SoftBank Corp. (9984) purchased Sprint, Deutsche Telekom AG merged its T-Mobile USA unit with MetroPCS Communications Inc., and AT&T Inc. announced a $4.1 billion takeover of Leap Wireless International Inc.
Paulson, 57, profited from several of the deals, including MetroPCS, where his fund joined Schoenfeld’s $2.2 billion firm in February to oppose the wireless carrier’s original plan to merge with T-Mobile USA. Deutsche Telekom then sweetened the terms of the proposal and cut the amount of debt it imposed on the combined company to appease shareholders.
Schoenfeld, 68, also made money on MetroPCS, according to a person familiar with the matter, who asked not to be named because the information is private. Schoenfeld founded New York-based PSAM in 1997 and runs the PSAM WorldArb Master Fund.
Sprint, the largest holding in Paulson’s merger funds as of the second quarter, was the biggest contributor to gains this year after SoftBank and Dish Network Corp. engaged in a bidding war. SoftBank completed the acquisition in July. Paulson also made money from Life Technologies Corp. after Thermo Fisher Scientific Inc. agreed to buy the company.
“While spreads remain tight, competitive bids and pre-announced deals were the primary drivers of our returns this year,” New York-based Paulson & Co., which oversees $18 billion, said in its second-quarter letter to investors. Anticipating which announced deals may result in topping bids has historically been a key driver of profitability in the firm’s merger strategy, according to the letter.
Paulson Partners Enhanced, the leveraged version of the firm’s merger-arbitrage fund, Paulson Partners, rose 21 percent this year through August, second-best of his main strategies. Gains in the strategy helped Paulson rebound from losses in previous years tied to gold investments and ill-timed bets on the U.S. economy and a breakup of the euro.
Merger-arbitrage funds vary in investment mandate. Some focus only on announced deals. Paulson & Co. and PSAM can invest in companies they expect to consolidate, before there is an announcement. TIG does not.
Another profitable trade for Paulson, Schoenfeld and Figdor was Irish drugmaker Elan Corp., according to people familiar with the firms. Royalty Pharma, an investor in royalty streams from pharmaceuticals, made four bids before withdrawing its offer in June. Perrigo Co. (PRGO), an Allegan, Michigan-based maker of over-the-counter medicines, stepped in with a superior cash-and-stock offer in July. The deal is slated to close by year end.
TIG’s Figdor, whose merger fund has about $900 million in assets, profited this year on deals including Constellation Brands Inc. (STZ)’s purchase of Grupo Modelo’s U.S. beer business for about $4.75 billion, as well as Sprint, two people with knowledge of his investments said.
Figdor, 52, bought the stock of Grupo Modelo after Anheuser-Busch InBev NV in June 2012 sought to buy the rest of the company that it didn’t already own, the people said. After the U.S. sued to block the AB InBev-Grupo Modelo deal, he also bought shares of Constellation. Figdor, who joined New York-based TIG in 1993, anticipated that AB InBev would eventually win antitrust approval and that Constellation would buy out Grupo Modelo’s stake in their joint U.S. beer distributor, the people said.
Representatives for Paulson & Co., PSAM and TIG declined to comment on their merger funds’ performance and trades.
Both TIG and Schoenfeld also took stakes in Dell, the computer maker that won shareholder approval last week for a buyout by founder Michael Dell and Silver Lake Management LLC after a seven-month standoff with investors. The stock jumped 13 percent to $12.29 on Jan. 14 after Bloomberg News reported the buyout talks. On Feb. 5, Dell and Silver Lake offered $13.65 a share, before boosting it to $13.75 plus a 13-cent dividend.
Schoenfeld bought 1.25 million shares in the first quarter and raised its stake to 4.26 million shares in the second quarter, according to data compiled by Bloomberg. TIG owned 2.16 million shares at the end of the first quarter and 3.55 million shares by June 30, the data show. Paulson hasn’t disclosed owning any Dell stock this year.
Dell also showed that profiting from merger arbitrage investments is a question of timing. The stock rose as high as $14.64 on March 25 on speculation that activist investor Carl Icahn’s counterbid would either succeed or further fuel the bidding war. Icahn this month surrendered the fight, and Dell’s stock closed last week at $13.85, leaving investors who bought at the peak with a loss of 79 cents a share.
A recent surge in activist investing by hedge-fund managers such as Icahn, who invest in companies to push for change, has benefited event-driven funds this year, which often engage in merger arbitrage, said Sam Sussman, partner and investment committee member at Alternative Investment Group LLC. The $1.4 billion Southport, Connecticut-based firm invests in hedge funds.
That’s helped to offset tight merger spreads. Global deals that are still pending completion are trading at a median of 1.7 percent below their respective offer prices, data compiled by Bloomberg show. That’s a narrower spread than what arbitragers typically seek, said Kathleen Renck, New York-based head of event-driven research at FBN Securities Inc. The data exclude negative spreads, which occur when the target company trades higher than the acquirer’s offer price in anticipation of competing bids.
“A spread of 5.5 percent would be phenomenal,” she said, adding that the “golden age” of merger arbitrage was in the 1980s when hostile deals pushed spreads into the double digits.
A more robust deal environment should help alleviate the tight spreads because there will be more transactions to choose from, said Water Island’s Orrico. Higher interest rates will also benefit funds focused on the strategy because spreads are determined in part by the risk-free interest rate, usually the rate on short-term Treasury bills, Orrico said.
Orrico’s Arbitrage Fund, a mutual fund, returned 0.3 percent this year in the retail share class, trailing 96 percent of similarly managed funds, according to data compiled by Bloomberg. His firm’s Arbitrage Event Driven Fund (AEDFX) has gained 3.1 percent this year, topping 47 percent of peers, the data show.
There may be more opportunities on the way for merger arbitragers to make money, said Matias Ringel, the New York-based head of fund research at EFG Asset Management Ltd., which has about $1.5 billion invested in hedge funds.
“Given that many companies may have gone through cost reductions and are sitting on a lot of cash, the environment can be ripe for competitive bidding, which together with what seems to be favorable equity markets should help to offset the low spreads,” Ringel said. “Funds could benefit from that.”