Institutional Investor's Alpha Magazine - December 2007/January 2008 - (Page 58)

“For no-brainer deals like First Data and TXU, spreads yawned and then came back,” says William Crerend, CEO of EACM Advisors. Corp. and $29 billion for credit card processor First Data Corp.; and J.C. Flowers & Co. made an ill-fated $26 billion offer for SLM Corp., the parent of studentloan provider Sallie Mae. Of the total $4.7 trillion in global M&A deals announced in 2007, a record $2.7 trillion took place in the ﬁrst half of the year, according to London-based data provider Dealogic. When the credit crunch hit last summer, merger arbs got caught in the backwash. The collapse of several hedge funds, as a result of losses in the credit markets, prompted prime brokers to tighten margin requirements as prices for structured debt tied to subprime mortgages plummeted. To meet margin calls, leveraged hedge funds and proprietary trading desks were forced to raise cash quickly — and merger arbitrage positions were among the ﬁrst to be sold. Sweat, who has worked in merger arbitrage since 1997, when he received his MBA from Nashville’s Vanderbilt University and immediately joined a team at privately held commodities conglomerate Koch Industries in Wichita, Kansas, knew that turbulent market conditions can often create investment opportunities. He invested in a handful of deals likely to close that had extremely wide spreads — such as the $6.9 billion merger between regional brokerage ﬁrm A.G. Edwards and Charlotte, North Carolina–based bank Wachovia Corp. But such opportunities were short-lived. After the Federal Reserve Board cut the discount rate on August 17 — to 5.75 percent from 6.25 percent — the credit markets temporarily stabilized. Equities soared and merger spreads snapped back on deals where ﬁnancing commitments were ironclad and agreements left little room for buyers to wriggle out. “A lot of the potential was realized quickly,” says William Crerend, CEO of Norwalk, Connecticut–based fundof-hedge-funds firm EACM Advisors. “For no-brainer deals like First Data and TXU, spreads yawned and then came back by early September.” Despite the huge drop-off in LBOs — private equity M&A volume fell to $71.8 billion in the fourth quarter of 2007, from $378 billion in the second quarter, according to Dealogic — strategic buyers are still busy doing deals. Preliminary fourth-quarter data pegs corporate M&A activity at $911 billion, the second-highest quarterly ﬁgure ever. But traditional merger arbitrageurs are not the only ones chasing those deals. The wide spreads this past summer attracted new participants — hedge funds that don’t specialize in merger arbitrage, along with several multistrategy managers that set up special-purpose funds to take advantage of the opportunity. Now all that new capital is looking for a place to go. “Merger arbitrage is a very popular strategy,” says Sweat, who manages about $170 million in unleveraged capital at Robeco. “It is short duration, low volatility and one of the most liquid strategies.” Hostile takeovers can offset the pressure on spreads that comes from lower deal volume. In volatile markets individual share prices can get beaten down to distressed levels that attract opportunistic buyers and generate more hostile acquisitions. EACM’s Crerend says his eventdriven managers would not be surprised to see an uptick in unfriendly deals. Jesse Ho, a merger arbitrage portfolio manager in the London ofﬁce of Dallas-based hedge fund Carlson Capital, welcomes the shift away from LBOs because he says it lowers the risk of deals’ not closing. Corporate buyers, which have strategic objectives as well as a ﬁnancial interest in proposed mergers, are less likely to walk away. Ho believes the weak dollar will attract non-U.S. companies. “A corporate buyer is still able to get a bank to lend money,” says Ho. He expects to see more share-exchange deals if spreads for corporate credit over Treasuries widen enough to equalize the cost of debt and equity capital. With banks no longer willing to fund buyouts, private equity ﬁrms have had to look for alternative sources of ﬁnancing. Ho says some hedge funds have stepped forward to ﬁ ll the gap by providing leveraged loans, much the way they began making direct loans several years ago to corporations too small to access the public debt markets. That’s good news for merger arbitrageurs, as it ensures LBO activity will not disappear. Developments in financial technology give hedge funds more ways to play the arbitrage game. In the past it was difﬁcult for arbitrageurs to hedge a cash merger. They could buy puts on the Standard & Poor’s 500 in- 58 • INSTITUTIONAL INVESTOR’S ALPHA • DECEMBER 2007/JANUARY 2008

Table of Contents Feed for the Digital Edition of Institutional Investor's Alpha Magazine - December 2007/January 2008

Institutional Investor's Alpha Magazine - December 2007/January 2008 Contents Letter from the Editor Longs & Shorts Pension Corner: Liberal Returns The Good Guy: Inner-city MVP Cover Story: Marathon Men Interview: Rizk Management Profile: Living on Hostile Ground Profile: Buy and Hold In Theory: The Fallacy of Portable Alpha Strategies: Changing Course Alpha Bytes: Behind the Scenes Unhedged: Commentary: An Activist Alternative

Institutional Investor's Alpha Magazine - December 2007/January 2008

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