| Peter Schoenfeld |
Last week John Paulson and other merger arbitrage fund managers were shaking off the doomsday price drops that came in August and were envisioning double-digit earnings from some of the merger and acquisition deals that have made front-page news since the summer. Then, on Monday, President Barack Obama announced that the Department of the Treasury was going to crack down on inversion, the practice of letting U.S. corporations buy foreign companies and move their own headquarters abroad so that they can pay lower taxes. The new tax rules are likely to complicate such deals as Minneapolis-based medical device maker Medtronic’s $43 billion purchase of Dublin-based surgical equipment maker Covidien and Delaware-incorporated AbbVie’s $54.5 billion purchase of Shire, also in Dublin. Though it’s now uncertain whether the deals will go through, if they do, merger arbitrage managers with stakes in these deals stand to make more money than ever.
Fund managers who have been arbitraging these big inversion-related mergers might have to look for deals with other kinds of complexities in the future. But the rules are unlikely to put much of a crimp in a strategy that has for the most part begun to recover from a rocky summer and have a good year. Merger arbitrageurs, a substratum of event-driven traders, make money trading on the spread, or price difference, between a target company and the stock price of the combined company when the merger becomes a done deed. And they have plenty of places to play: M&A deals have been abundant this year. The total value of worldwide announced M&A deals between January 1 and September 18 was just under $2.6 trillion, according to Thomson Reuters, a 59 percent increase over the same period in 2013.
Peter Schoenfeld, CEO of P. Schoenfeld Asset Management in New York, is optimistic that whether the inversion-related deals go through or not, the rise in global M&A deals over the past year will allow a manager investing in a merger arb strategy to be well diversified.
“In addition to the U.S., deal flows in Europe and Asia are heating up, and there’s been some pickup in Latin America,” he says. “I don’t believe there will be a major slowdown in M&A, but the subclass of inversion-related deals might be impacted.”
Still, the key to winning big in merger arb today appears to be investing in the riskiest, most complex deals. Spreads are wide only when deals are complex, subject to political change, bidding wars, antitrust scrutiny, hostile resistance on the part of the target company or other problems that create the risk that the deal won’t go through.
Just ask Paulson, founder of New York-based Paulson & Co., which is invested in at least six high-profile merger deals. Paulson’s merger arb funds have holdings in the Allergan–Valeant Pharmaceuticals International, DirecTV–AT&T, Time Warner Cable–Comcast, Covidien–Medtronic, Questcor Pharmaceuticals–Mallinkrodt and AbbVie–Shire deals. Paulson sees a promise of big earnings at the end of these large-cap deals.
“With these larger transactions, arbitrage capital may be insufficient to tighten the spreads, therefore spreads may remain wide until the deal closes,” he writes in a second-quarter investor report obtained by Alpha.
“Spreads in the riskier deals — those with political, regulatory or deal risks — are high by historic standards,” says Schoenfeld. With a strong M&A deal flow, there is more capital chasing the simpler deals and less in the complex ones, all of which is manna to managers like Schoenfeld. His firm has clawed back from a post-financial crisis slump; PSAM’s assets dropped from $3.5 billion in 2008 to just over $1 billion at the start of 2009. But the event-driven/merger arb funds earned slightly upward of 18 percent last year and 6.6 percent this year through August, and the firm now manages $4.3 billion. “On Monday spreads widened somewhat, as the rules are designed to dampen inversion activity and force boards to adjust the premium they are willing to pay.”
Annual spreads in some of the deals in which inversion comes into play had been as high as 20 percent since the summer, generally because the deals carry a lot of risk. Schoenfeld’s merger arb funds have holdings in both the Medtronic–Covidien deal and the AbbVie–Shire deal, according to people familiar with the firm, but in both cases Schoenfeld and the portfolio managers think there are good strategic reasons, beyond tax considerations, for the companies to merge.
Covidien’s stock is still trading above where it was in June, when Medtronic announced the acquisition. In June it was trading at about $86 a share. On Monday of this week, it crashed from about $90 to a low of $87.33, but on Tuesday it rose to over $88. The bounce-back might mean that the market is pricing the odds of the deal consummating at about 50-50, says a merger arb fund manager who requested anonymity because he’s invested in the trade. The deal has other sticking points; a group of Covidien investors filed suit in August, saying the purchase price is too low, while Medtronic investors have complained that the price is too high. But Medtronic, according to the terms of the agreement, would have to pay a substantial breakup fee to walk away. All of this means the deal is still a potentially highly profitable arbitrage.
The strategy is not without risks, of course. The entire merger arb strategy suffered a big performance setback on August 6, a day traders dubbed “Arbegeddon,” when two hot deals blew up — the 21st Century Fox acquisition of Time Warner and Sprint Corp.’s acquisition of T-Mobile U.S. The demise of those deals, combined with government scrutiny of inversion, sent the share prices of a number of prominent targets hurtling downward. Two of Paulson & Co.’s biggest arbitrage portfolios had a flat month in August. The Paulson International fund was down 0.1 percent for the month but up 5.24 percent for the year through the end of August, while the Paulson Enhanced fund was down 0.06 percent in August but up 8.91 percent year to date.
Overall, those in the difficult deals are performing like a different breed from merger arb funds that stick to easy M&As, where both parties agree to the deal and it happens painlessly. Plain vanilla M&As are showing annualized spreads of about 3 percent, while the more complex ones across the board have annualized spreads of 8 percent to 10 percent or more, says Philippe Ferreira, head of research for managed account platforms at Lyxor Asset Management in Paris.
Lyxor is investing selectively in merger arb funds — only those that are going for the more fraught deals; as a result, merger arb has been one of the best-performing strategies in the Lyxor index, up 4.5 percent year to date through early September. That’s an index of funds in the Lyxor portfolios only. By contrast, the much broader Hedge Fund Research merger arb index, which includes all funds that report to HFR, was up only 2.3 percent through August, while the overall event-driven index rose 4.21 percent for the same period.
Drew Figdor, manager of the arbitrage strategies at TIG Advisors in New York, says that in a strong deal flow environment, capital inflows to friendly deals can increase due to allocations from ETFs, mutual funds, non-actively researched quantitative-type funds and other equity hedge funds. The conventional way to play such deals is by taking a long position in the target company and hedging with a short position in the acquirer.
But there’s plenty of opportunity, says Figdor, in the deals that require deep research and sometimes figuring out unconventional ways to capitalize on potential outcomes. In these more complicated deals, a portfolio manager might go long both companies, or long the acquirer and short the target. Nor is it particularly unusual these days to see merger arb fund managers taking an approach that resembles activism to influence their complex deals.
For example, earlier this year Figdor had a play on the Signet Jewelers takeover of Zale Corp.; now, according to people familiar with TIG, he has filed an appraisal suit against the price that Signet paid. TIG, a $3.2 billion firm that Michael and Carl Tiedemann founded in 1980, with about $2.4 billion in its event-driven/merger arbitrage strategy, had a 5 percent position in Covidien as of June 30, according to 13F filings. Its top holdings also included long positions in both Allergan and Valeant, plus call options on Valeant and positions in the merger-bound stocks Hillshire Brands, Questcor Pharmaceuticals and the Men’s Wearhouse.
Fortunately for those looking for complications, there is still the Canadian pharmaceutical company Valeant’s hostile bid, in partnership with William Ackman’s Pershing Square Capital Management, for Botox maker Allergan in Irvine, California. Paulson’s merger arb funds are holding both Valeant and Allergan stock. At Institutional Investor’s Delivering Alpha conference in July, Paulson said it was a deal in which “you can make more money by holding onto the acquirer’s stock than by trading the spread.” He said he was holding out for the possibility of Allergan’s stock trading at $222 per share, the value if it appreciated as much as Valeant’s earnings per share.
Allergan has been a volatile stock, trading at $169 this week — and it rose right after the announcement about the tax inversion rules. (In this case, it’s a Canadian company attempting to buy a U.S. one, so inversion isn’t an issue.) Paulson thinks the deal will go through, even if it morphs into something other than Valeant taking over Allergan.
“We believe there are three ways to win in Allergan,” he writes in the second-quarter investor report. “(1) The Valeant offer is successful. (2) Another bidder surfaces. (3) Allergan cuts costs and/or takes its own steps to substantially increase shareholder value, such as making an accretive acquisition.”
Schoenfeld’s PSAM is long Allergan and short Valeant based on its view of company fundamentals, according to people familiar with the firm. Douglas Polley, who manages the merger arb portfolios for PSAM, confirms that he and others at the firm have some reservations about Valeant’s own business model.
“We’re concerned that Valeant has to get bigger and bigger by consolidating. It’s the rule of large numbers,” says Polley.
On the other hand, PSAM thinks Allergan has to take some measures to boost its price, deal or no deal. People familiar with PSAM say its managers have had discussions with Allergan’s senior managers, urging them to cut the research and development budget as well as the cash flow. PSAM’s managers think Allergan is now doing a better job of addressing its spending problems — and they wouldn’t mind seeing Paulson’s No. 2 scenario come about, with a better bidding war.
