By Josh Friedlander
For merger arbitrageurs, deals don’t get any better than pharmaceutical giant Pfizer’s proposed acquisition of competitor Wyeth. Were the deal to close at the end of this month, hedge funds that entered the trade as late as August could realize gains of nearly 4% in eight weeks—an annualized return of more than 20%. Depending on an investor’s entry date, the transaction is poised to produce annualized returns of 14% to 25%, reflecting the perceived riskiness of the deal at any given time.
Merger arbitrage has been kind to hedge funds in recent months, in sharp contrast to 2008. The Absolute Return Convertible & Equity Arbitrage Index is this year’s top performer, up 29.85% through July 31, more than 20 percentage points more than the Absolute Return Composite, which has gained 8.08%. In 2008, the Convertible & Equity Arbitrage Index finished with the worst return of any strategy, losing 26.03% as merger and acquisition deals imploded for lack of financing.
Valued at $68 billion, the Pfizer-Wyeth combination represents about 30% of the market capitalization of all current m&a activity, and its large size makes it an easy and liquid target for merger arbitrageurs. Despite the deal’s mass, or perhaps because of it, there was, from the time of the January 26 announcement, a large spread between the price of Wyeth stock and its expected value at the close of the deal.
That incentive lured such heavyweights as Paulson & Co., Taconic Capital Advisors, SAC Capital Advisors and Maverick Capital, all of which were big holders of Wyeth as of June 30, according to filings with the U.S. Securities and Exchange Commission. Paulson, which held 30 million shares in March, increased its stake 59% by June. Other hedge funds lightened their holdings in the second quarter. Of the hundreds of large investment houses that disclosed ownership in Wyeth to the SEC at the end of the first quarter, about 10% had dumped their holdings by June. The remaining owners held 7% fewer shares. On the other hand, more than 100 funds first reported Wyeth holdings in June.
One reason for the deal’s big spread and potential double-digit returns is that the merger’s size may have actually worked in favor of hedge funds. For fund managers investing in a representative sampling of current m&a transactions, concentrating as much as 30% of their merger arb portfolios in a single deal may have seemed an unduly risky bet. Arguably, the market for Wyeth stock required a larger spread to lure buyers.
Among merger arb traders, the more popular theory for the rich spread is the lack of competition. These traders say there has been less interest in the deal than there might have been in previous years because some players pulled out of the strategy as it lost money in 2008, when the global financial crises severed funding lines, and more than 1,100 proposed deals fell apart. Those firms still in business with merger arbitrage expertise, including several large investment banks, have since reduced the amount of capital allocated to the strategy.
Large hedge funds, such as Citadel Investment Group, shut down their merger arbitrage strategies last year. Bank prop desks at Credit Suisse, Deutsche Bank, Morgan Stanley and UBS have curtailed their proprietary trading operations, while JPMorgan closed its prop desk altogether. “If you look at the universe that invests in situations like this today as opposed to a year and a half ago, it’s very different,” says Matt Halbower, founder of Pentwater Capital Management, a $650 million event-driven fund with exposure to the Pfizer-Wyeth deal. “Investment banks have pulled their proprietary trading desks. A year and a half ago, event-driven or merger arb desks at multistrategy funds would have been involved, but many of those desks have been disbanded.” Given the success of merger arbitrage so far this year, there is almost certain to be a return-chasing reallocation of capital to the strategy, which may then, in turn, limit its attractiveness.
In a merger arbitrage strategy, a fund generally sells short the stock of the acquiring company and uses those proceeds to defray the cost of buying shares of the company that’s being acquired. If the stock of the acquiree trades at a discount to its closing price under the terms of the deal, the arbitrageur will profit as the stock prices converge upon completion. With fewer players chasing Wyeth and, on the other leg of the trade, shorting the shares of Pfizer, the spread between the share prices has remained wider than usual.
The acquisition of Wyeth will enable Pfizer to expand its product line. By 2011, Pfizer will lose the patent rights to Lipitor, its current blockbuster drug. That loss means the company will face a significant decline in revenues. Lipitor, one of the best-selling drugs in history, generated revenue of $13.6 billion in 2008, according to IMS Health, a drug research firm. That’s 28% of Pfizer’s total 2008 revenues, which were $48.3 billion. Wyeth, which is expected to bring Pfizer a number of near-to-market products, was an obvious target. By the time the deal was announced in January, Wyeth’s stock had been trading up for months, recovering from its 12-year low of $29.89 on October 10, possibly in anticipation of a takeover. Pfizer stock, which traded at $15.65 on the day of the announcement, had been on a long-term descent from its peak price (adjusted for reverse splits) of $37.12 in April 1999. On August 19, Pfizer shares closed at $16.37; Wyeth shares closed at $47.86.
Pfizer offered to buy Wyeth shares at a ratio of 0.985 of Pfizer stock plus $33 in cash. If the deal had closed on the day it was announced, when the stock was trading at $15.65, shares of Wyeth would have been worth $48.42. Instead, Wyeth shares closed at $43.39, a 10.38% discount. Given the uncertainty attending any deal of this size, such a discount presented an incentive for those willing to take the risk. Although the Wyeth discount has steadily declined, and there is arguably less capital from hedge funds or prop desks, merger arb traders disagree as to whether that spread has been uncommonly wide or simply an obvious bargain given the deal’s size.
AQR Capital Management, the $21 billion quantitative trading shop ($7.8 billion in hedge fund assets), tracks merger arbitrage activity and recently compared the expected annualized returns over time from the Pfizer-Wyeth trade to the expected returns of applying a standard merger arbitrage strategy to all U.S. stock-for-stock deals. The research (see chart below) indicates that the deal’s spread has exceeded the median expected returns for all other deals by as much as 17.5 percentage points. Yet it has remained, for the most part, within one standard deviation of the expected annualized return.
The spread between the Pfizer-Wyeth trade and other U.S. merger arbitrage opportunities reached a low of -1.39% on February 24 and rose, with large swings, into a double-digit expected outperformance relative to other trades, reaching a peak on May 4.
Because the spread is a function of the market relative to the Pfizer-Wyeth deal, it’s difficult to pinpoint a precise reason for the spread’s peak that day. The richest day for investors in the deal came on April 28, a few weeks after the Federal Trade Commission requested additional information from Pfizer about the merger. Those who invested then stand to make an annualized return of 25.04%. The deal’s lowest expected annualized return to date of 14.09% came on July 16, a day before the European Commission approved the merger.
