Institutional Investor's Alpha Magazine - December 2007/January 2008 - (Page 59)

Merger Arbitrage dex, but there is generally little correlation between the index and the price of a takeover target when a deal blows up. Today, Ho says, arbitrageurs look at the entire capital structure — equity, debt and convertible securities, as well as credit derivatives. Rather than buy stock in an LBO target, arbitrageurs may trade credit default swaps, expecting the credit spread over Treasuries to widen if a deal is completed. A credit default swap is a form of insurance against default — one party agrees to take delivery of bonds in the event of default in exchange for annual payments, calculated as a percentage of principal, that reﬂect interest rates on Treasuries plus a credit risk premium. The spread over Treasuries is ﬁ xed when the swap is initiated, so if the credit quality improves, the price of an existing swap will rise and new swaps will incorporate a lower spread. In the case of an LBO, which reduces the target company’s credit quality by piling debt on its balance sheet, existing credit default swaps typically tumble in price and new swaps must carry a wider spread. Swap spreads can raise an early warning ﬂag that a deal is in trouble. Although the proposed acquisition of San Antonio, Texas–based media conglomerate Clear Channel Communications by Boston-based private equity shops Thomas H. Lee Partners and Bain Capital is not contingent on selling the group’s television stations to Providence, Rhode Island’s Providence Equity Partners, the stock price dropped more than $2, to $35, after the early-November 2007 announcement that Providence might pull out. Investors feared the entire deal would fall apart. Arbitrageurs who monitor credit default swaps had a chance to avoid damage, as swaps narrowed from 300 basis points over Treasuries to 200 basis points ahead of the news. The tighter spread signaled an improvement in Clear Channel’s perceived credit quality, indicating that the market thought the deal was less likely to be completed. Ho also uses swaps as a hedge. “Sometimes we buy the stock and go long the credit through the credit default swaps,” he says. “If the deal doesn’t happen, the credit spread will revert to normal.” A gain on the trade helps offset any loss on the equity position in a busted deal. It’s a riskier trade now that credit spreads have become so volatile, so Ho has added another dimension: He offsets the single-name credit default swap with an opposite position in a credit default swap index. Ho is currently hedging his portfolio with a combination of short equity indexes, short credit instruments and a short basket of ﬁnancial stocks. “Takeover stocks are correlating more closely with ﬁnancials than they are with industrials,” he says. “The health of ﬁnancials is inﬂuencing deal completion risk.” Judy Posnikoff, a co-founder and managing director at Irvine, California–based Paciﬁc Alternative Asset Management Co., a $10.5 billion fund-of-hedge-funds manager, says the volatility of merger arbitrage returns has risen as mandates have broadened and managers hedge less. She says unlevered returns have averaged 300 to 400 basis points above LIBOR in the recent past, but she expects future returns to be lower. “Traditional merger arbitrage is not going to pay as well as it has the last couple of years,” says Posnikoff, adding that too much money is chasing fewer deals. As a result, managers are scouring the world for opportunities. Even new funds headquartered in New York are setting up ofﬁces in London and in some cases Asia. Posnikoff expects corporate consolidation to continue to drive deal ﬂow in Europe. And though the environment may not be strong, she still expects decent returns from merger arbitrage funds. “If the equity markets sell off hard, that could throw a spanner into it,” she says. “But barring that, in the U.S. the weak dollar will make cross-border deals more attractive.” EACM’s Crerend expects to see fewer large-capitalization LBOs in the coming months, — JUDY POSNIKOFF, MANAGING but he too is optimistic about DIRECTOR, PACIFIC ALTERNATIVE the prospects for merger arbiASSET MANAGEMENT CO. trage. He says strategic motivations for corporate buyers haven’t disappeared. Private equity funds also have plenty of dry powder, although Crerend foresees a shift toward middle-market targets while the credit crunch persists. In normal market conditions, the returns on classic merger arbitrage trades have become so tight that it has all but vanished as a stand-alone strategy. Crerend says event-driven merger arbitrage mandates can still deliver returns of 500 basis points over LIBOR, but those returns will come with higher volatility — a conﬂict most investors haven’t acknowledged. “People want higher returns, but they really like the low historical annualized standard deviation,” says Crerend. “That’s not going to be the environment going forward.” Even a traditional merger arbitrageur like Robeco’s Sweat expects to eke out acceptable returns in the current market. He too has written off the big $15 billion–plus private equity club deals for now. But he predicts a ﬂow of smaller transactions subject to ﬁnancing in which the banks fund the senior debt, the high-yield market takes the junior debt, and interest coverage ratios drop back to where they were a couple of years ago. “You won’t see the merger premiums you have seen in the past in the LBOs,” says Sweat. “The strategic buyers can now come back into the game, and from a capital structure standpoint, you should see more stock transactions.” Like many arbitrageurs, Sweat prefers all-share deals because they offer a natural hedge against market movements. As long as there is some merger activity, he and his fellow arbitrageurs will ﬁnd ways to make money. “ Traditional merger arbitrage is not going to pay as well as it has the last couple of years.” DECEMBER 2007/JANUARY 2008 • INSTITUTIONAL INVESTOR’S ALPHA • 59

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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