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Gambling on M&A: Risk Arbitrage on the Decline? Navigation: Main page Amazing Sports Betting System - Win 97% Of Your Bets!!! Author: Weekly Corporate Growth Report When big money mergers and acquisitions occur, everyone wants to get in on the profits. One strategy for capitalizing on M&A activity is risk arbitrage, an investment gamble in the target company's stock. In the past, risk arbitrage has been a largely profitable technique enjoyed by hedge funds and Wall Street traders. In today's market, however, the returns from risk arbitraging have declined. Merger arbitrage is a stock-buying practice that seeks to capitalize on the price difference between the current market value of a security and its value following a successful takeover, merger, spinoff, or other form of corporate reorganization. Risk arbitrage is a merger arbitrage strategy that seeks to profit from acquisitions. Most acquirers offer to buy the target's stock at a premium over its current value. The risk arbitrager buys stock of the target company before the merger takes place, hoping that the merger will increase its value. The gamble is on whether the merger will actually occur. Risk arbitrage is nearly always profitable if the merger goes through, but the arbitrager almost always takes a loss if the merger fails. To help cover this bet, arbitragers often simultaneously sell the stock of the potential acquirer, since shares of buying companies commonly decline in price, especially if their takeover bid is hostile. This way, at least half of the deal is likely to provide value.
Risk arbitrage is a popular tactic for hedge funds, small but wealthy investment pools that generally seek short-term profits. When a company is up for auction, hedge funds often buy up stock, gambling that multiple bidders will drive up the auctioned company's value. But the returns from risk arbitrage are on the decline. So far this year, hedge funds that do risk arbitrage have seen a return of barely two percent on an annualized basis, according to Credit Suisse First Boston Tremont Index LLC. In 2003, the strategy returned almost nine percent, an improvement over this year but unimpressive compared to the 14.7 percent average return in 2000. There are a number of reasons for this decline in value. Corporate acquirers are bidding more cautiously, unwilling to make large bids that could seriously impact their balance sheets. These cautious bids mean that the gap between a target's stock price and the offer price is smaller - and that gap is the arbitragers' profit. And although mergers and acquisitions activity is on the rise, there are still relatively few of the large, straightforward deals that arbitragers favor. Another problem is deals that either fail outright or suffer serious challenges that cause costly delays. Comcast's bid for Disney, which could have been one of the largest deals of the year, did not go through. California insurance regulators have challenged the $16 billion merger between Anthem Inc. and WellPoint Health Networks because WellPoint has a small insurance operation in that state. General Electric's $900 million acquisition of In Vision Technologies Inc., a deal popular with merger arbitrage investors, may be delayed as federal prosecutors meet with In Vision regarding possible improper business tactics. There are also more arbitrage players competing for the potential profits. Hedge funds have grown in the past few years, attracting substantial new money from investors that have become disappointed with the poor returns on conventional investments. But the proliferation of hedge funds makes it harder for their managers to profit from the exotic investment techniques they employ. And hedge funds aren't the only arbitragers in the game. Risk arbitrage has traditionally been popular with Wall Street trading firms such as Bear Stearns and Goldman Sachs. The declining returns from risk arbitrage can also be attributed, at least in part, to the arbitragers themselves. A study by Citigroup Asset Management suggests that while the number of hedge funds has increased, the quality of the average fund manager has fallen. The study examined a number of common hedge fund strategies and found a "significant reduction" from one period to the next in the fund's "alpha" - the component of performance attributable to the manager's skill rather than market-related factors. So while risk arbitrage sounds like a good deal on paper - buying a stock and then selling it at the premium generated by a potential acquirer - the value of the strategy has clearly been impacted by a wide range of factors. The strategy remains a gamble, as not all announced deals are closed at the original bid price, or even closed at all. While the risk factors remain and the potential returns decrease, risk arbitrage will remain a strategy to be exercised cautiously.
Sources: Quarterly Journal of Business and Economics, New York Times, Wall Street Journal By Andrew Dolbeck Editor Copyright NVST, Inc. Aug 9, 2004 |
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