End of the party for merger arb funds?

End of the party for merger arb funds?
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First Published: Mon, Aug 13 2007. 12 44 AM IST
Updated: Mon, Aug 13 2007. 12 44 AM IST
Merger arbitrage hedge funds had quite a couple of years thanks to a record number of deals. But now it appears their run may be coming to an end. Stock and credit market turmoil has roiled mergers and buyouts. Spreads between the prices offered by acquirers and their targets’ public share prices have widened sharply over the past month. This can cause serious problems for merger arb funds, which typically bet on those prices converging.
Closing deals has recently gotten much harder. Sallie Mae, TXU and ABN Amro are all reportedly having problems. This has caused their stock prices to drop significantly. Since late June, TXU has fallen 6%, Sallie Mae is off a whopping 17% and ABN Amro, which was trading at its offer price just a month ago, is down 2%. Other takeover subjects, such as Clear Channel, have also been dragged down.
Arbs’ problems are magnified by the fact that they are often leveraged up. Because the incremental payoff on each deal is quite small, they increase returns by taking on debt. But when stock prices fall, their losses are much steeper. Take a hypothetical fund that invested equal amounts in the above companies a month ago. Today, its net asset value would be down 12%. But if it were leveraged up, say, five times, its investors would have lost over half of their money.
The blow-up of a single arb fund can have a domino effect. Most arb funds plough into the same stocks. If one has to sell positions quickly at a loss, say, to meet margin calls, the stocks in its portfolio could be dragged down. Other funds with similar exposures would get hammered. Of course, there is always a chance that these buyouts will be able to close. But with the recent sharp downturn in their investments, some arb funds might not be around to see that day.
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First Published: Mon, Aug 13 2007. 12 44 AM IST