For many years, the Merger Fund was the only mutual fund to focus exclusively on merger arbitrage. Such a strategy capitalizes on the disparity in price between two companies planning to merge. The returns are not great, but they are fairly steady. Merger Fund's best year was 1993, when it was up 17.7%. That explains, perhaps, why the Merger Fund had a de facto monopoly for so long.
No more. The Arbitrage Fund opened last year, and both the Lipper Merger Fund and the Enterprise Mergers & Acquisitions Fund came along this year. In a period when most funds are posting negative returns, the arb funds' small but positive results look mighty good. What really makes them glow is their low risk. Over the last 10 years, the Merger Fund had only 28% of the volatility of Standard & Poor's 500-stock index but produced 90% of the return.
How do merger arb funds stay so steady? "The driving force behind our performance is whether or not merger deals get done," says Edward Strafaci, portfolio manager of Lipper Merger Fund. Mergers take place in good times and bad. "In a difficult business climate, companies have as much or greater need to make acquisitions because they need scale to stay afloat," Strafaci adds. Those acquisitions are cheaper when stock prices are down.
"SPREAD." Merger arbitrage portfolios have long been available to institutional investors, yet access in the mutual-fund world has been limited. Though open now, Merger Fund often closes its doors to new investors to keep its asset size manageable (it's now $1.1 billion). Recently, its management firm, Westchester Capital Management, sued Lipper & Co., parent of the Lipper Merger Fund, for trademark infringement. Citing the suit, Westchester Capital declined to comment.
Here's how merger arbitrage works: When one company acquires another, it agrees to pay a premium above the target company's current stock price. The arbitrageur tries to capture the difference, or "spread," between the target's current price and its acquisition price. The reason for the difference is that the deal could fall apart.
In cash deals, the arbs often just buy the target. With Ralston Purina, which Nestle plans to acquire for $33.50 a share, an arb buys Purina, at its current price of $33, and waits for the deal to close. If it does, he has made a 50 cents spread, a 1.5% return. If the deal closes in one month, it's the equivalent of an 18% annualized return. If the deal falls apart, Purina's stock will likely tank--which is why arbs' success depends on smart analysis. Sometimes regulators block deals or buyers can't raise the cash.
Many deals are exchanges of stock. For instance, last spring Tyco International agreed to acquire medical-equipment maker C.R. Bard, paying 1.13 shares of Tyco for every share of Bard. Here arbs take a different tack, selling short 1.13 shares of Tyco for every share of Bard held.
Since Bard shareholders will be getting paid in Tyco stock, shorting protects them from a drop in Tyco, which will make the exchange less valuable. But this is not a riskless transaction. "If the Bard-Tyco deal breaks up, I have two potential losses on my hand," says John Orrico, portfolio manager of the Arbitrage Fund. Both his long and short bets would probably lose money.
Still, botched deals usually have a minimal impact on well-diversified funds. "About five out of every hundred deals we do don't close," says Mario Gabelli, manager of Enterprise Mergers & Acquisitions. Gabelli, who also runs the arb-driven Gabelli ABC Fund, further dampens his risk by sticking to cash deals.
None of these funds will ever be the stars in a bull market. That's not their goal. "Our target return is 10% to 14% a year," says Strafaci. That's a far cry from the halycon days of the '90s. But now, 10% to 14% looks pretty good.
By Lewis Braham