Hedge Fund Tales – Or What Is Wrong With Merger Arbitrage


November 13, 2014 | By Alex Gavrish, Etalon Investment Research; author of "Wall Street Back To Basics"



Hedge funds lose after Shire plc deal is cancelled

On October 20th, 2014, AbbVie Inc and Shire PLC announced that they have agreed to terminate their proposed merger. The main reasons for cancellation are the adverse tax changes that would destroy the financial benefits of the transaction. According to agreement between companies, AbbVie will have to pay Shire a break-up fee of $1.64 billion. As widely reported in the financial media, investors gasped at the estimated losses few hedge funds experienced, Paulson & Co the main among them. According to media reports, his funds held a 4.7% stake in Shire, and suffered losses of about $783 million as of October 15th, 2014. Without blink of an eye, on October 20th, 2014, Paulson’s hedge fund announced its proposal that Allergan should buy Shire if AbbVie no longer wants it. As simple as this, not more. Paul Singer, manager of hedge fund firm Elliott Management and who is also believed to own a large stake, considers suing AbbVie for killing the merger with Shire. And just in case this will not work, some hedge funds have been increasing their Medtronic/Covidien position in order to make back what they lost in Shire, betting that this time, the deal will, in fact, close.

To put things into perspective, let's see what has lured Paulson and other hedge fund managers into taking such large positions in this merger arbitrage situation? Based on prices the day before negative news broke, merger arbitrage spread that could have been earned was about 5.4%. Certainly an attractive spread, given the fact that merger arbitrage spreads are at historical lows and the strategy does not offer as many interesting investment opportunities as it used to offer in the past. But to bet the farm on one deal? The minimal amount of common sense is enough to understand that it is wrong.

Where does risk management starts and greed ends?

Trying to comprehend the situation, I thought about one of short stories by Isaac Babel, a Russian language journalist, playwright, literary translator, and short story writer. He is best known as the author of Red Cavalry, Story of My Dovecote, and Tales of Odessa, all of which are considered masterpieces of Russian literature. Odessa Tales is a series of short stories set in the Odessan ghetto of Moldavanka. At their core, the stories describe the life of Jewish gangsters, both before and after the October Revolution. Many of them directly feature the fictional mob boss Benya Krik, who remains one of the great anti-heroes of Russian literature. One of the characters, in the story, screams: “Where does police starts, and Benya ends? – To which reasonable people replied: police ends where Benya starts”.

To paraphrase the question for our context, "Where does sound risk management starts and greed ends?" What prompted these hedge funds to take such risks? After Shire PLC deal cancellation the answer seems clear – that sound risk management ends where greed begins.

Warren Buffet and merger arbitrage

One can get a valuable insight on the topic of merger arbitrage from Warren Buffett. Although known mainly for conservative, long-term value investments, he made some handsome profits in the past doing merger arbitrage deals. In his 1988 annual letter to shareholders Warren Buffett explained that Berkshire Hathaway Inc's arbitrage activities are different than those of many other arbitrageurs. First, the firm participates in only a few, and usually very large, transactions each year. Second, it participates only in transactions that have been publicly announced and do not trade on rumors or tries to guess takeover candidates. Dedicated merger arbitrage investors and fund managers therefore face a trade-off between managing a diversified portfolio of merger arbitrage deals and remain with mediocre and pathetic returns. Or, investing more selectively, taking larger positions, and as a result increasing overall risk of the portfolio. It is exactly this trade-off that lead many hedge funds to take such disproportionate risks in Shire PLC transaction. What are the alternative approaches, if any?

Add-on to equities portfolio

The first alternative approach is to give-up on merger arbitrage as a dedicated portfolio strategy. Similar to Warren Buffett's strategy of participating in only few deals, you can employ the same approach and look for attractive opportunities in merger arbitrage space, but only as an add-on to your main equities portfolio or as a partial replacement for cash holdings. The reason Warren Buffett focuses on a few large deals is not only because of his size limitations but also because he prefers to spend the bulk of his time on more promising fundamental research. One area where investors can find interesting opportunities is foreign market. In April 2012, I recommended a deal that offered very attractive rate of return: Oridion Systems Ltd, a small-cap medical device company was acquired by Covidien, in an all-cash, strategic transaction. Oridion Systems is an Israeli company that was listed on Swiss Stock Exchange, quoted in Swiss francs while the acquisition price was specified in US dollars. Due to these circumstances, clear market inefficiency arose: fully approved, all-cash, strategic deal offered a spread of 4.8% with an estimated 2-4 months to completion or a 14%-29% annualized rate of return.

Broader event-driven approach

The second alternative is to adapt a broader approach. Merger arbitrage is only a subset of a broad category of event-driven situations. This broader event-driven space includes any cases where one seeks to exploit pricing inefficiencies that may occur before or after a corporate event, such as a merger, spin-off, asset sale, buyback, or other significant transaction. Among the most important attractions of the event-driven approach is the ability to find specific corporate events and target certain returns irrespective of the direction of the broader market. As a result, event-driven funds often have lower correlation with equity markets and provide more consistent returns. Apart from merger arbitrage, there is a plethora of other events that exist in abundance. With a broader focus, event-driven approach can be combined with a strong emphasis on value investing principles. Such combination can provide the best of both worlds: it can unite opportunism and bargain hunting with specific, idiosyncratic corporate events, providing more balanced and consistent risk-adjusted returns. A broader event-driven strategy can therefore take advantage of current market environment and provide a good long-term approach to portfolio management and alpha generation.