Hedge Funds Winning in M&A Arbitrage as Banks Cut Prop Desks

  • Merger-arbitrage hedge funds make money as peers suffer losses
  • Abrax and Lutetia among profitable deal-focused hedge funds

Hedge funds betting on the success or failure of mergers and acquisitions are taking advantage of a record volume of deals and a lack of competition from banks to score the best returns among peers looking to profit from corporate actions.

Banks have shrunk or shuttered trading desks under pressure from regulators to take fewer risks, and some event-driven funds have closed. That helped merger-arbitrage money pools return 3.4 percent in the 13 months through January, compared with a 5 percent loss for other hedge funds focused on equities, according to data compiled by Hedge Fund Research Inc.

"The opportunity set at the moment is as good as I have witnessed over the past decade,” said Simon Freeman, a money manager at GLG Partners LP, a unit of Man Group Plc. “You have got wide spreads in big liquid deals." Man Group is the world’s biggest publicly traded hedge-fund firm.

Companies spent a record $4.3 trillion on acquisitions in 2015, according to data compiled by Bloomberg, adding to the funds’ opportunities to bet that a target company will rise toward the offer price as a deal nears and that the bidder’s share price will fall. The strategy is largely immune from stock-market fluctuations unless the deal falls apart, making it attractive to investors as financial-market turmoil whipsaws share values.

Abrax Merger Arbitrage Fund, managed by Xavier Robinson at French money manager Puzzle Capital, gained 22.7 percent last year; KL Special Opportunities Fund, run by London-based Kite Lake Capital Management, returned 9 percent; and the Lyxor Lutetia Merger Arbitrage fund of Paris-based Lutetia Capital increased by 5.5 percent, their fund managers said.

Deals such as Salix Pharmaceuticals Ltd.’s takeover by Valeant Pharmaceuticals International Inc., Intel Corp. buying Altera Corp. and Actavis Plc taking over Allergan Inc. were some of the most profitable trades for merger arbitrage hedge funds last year, according to Philippe Ferreira, a strategist at Lyxor Asset Management.

M&A spreads are around 14 percent on an annualized basis, well above their 6 percent average over the past 10 years, according to money manager Unigestion.

Drugmaker Baxalta Inc., a target of Shire Plc in a $32 billion deal announced last month, trades at a gross spread of 5.4 percent, meaning investors could earn an annualized 15.6 percent return if the deal closes as expected by the end of June. EMC, which is being acquired by Dell Plc, trades at a gross spread of 16.5 percent in a deal that’s due to be completed in October.

"There’s not enough merger-arbitrage capital to keep these spreads tight, given that the prop desks have shut down and event funds are closing or de-risking," said Ben Watson, a senior investment manager at Aberdeen Asset Management Plc. "It means that spreads in some of these huge deals are trading quite wide right up until they close."

Pending and completed M&A deals worth about $424 billion have been announced this year, a 19 percent increase on the same period in 2015, according to data compiled by Bloomberg.

Merger-arbitrage hedge funds manage about $52 billion, according to Eurekahedge. They continued making money in January when a global equity-market sell-off led to an average 4.2 percent loss in equity hedge funds, according to HFR. Abrax and KL funds rose more than 2 percent each, according to the managers.

“Most companies are still struggling for organic growth, and balance sheets are healthier than they have been for a long time,” making deal-making attractive, said John Melsom, chief investment officer of Omni Event Fund. “The recent sell-off in equity markets may encourage more deals as many valuations have become more attractive.”

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