Professionals use the fairly conservative strategy of merger
arbitrage — buying the stock of the firm about to be acquired and
sometimes betting against the stock of the buyer. The strategy tends to yield
steady, if unspectacular, returns-a nice way to
diversify your portfolio away from the manic depressive stock market. In 2008,
the $1.8 billion Merger Fund (MERFX)
lost a bit more than 2 percent, beating the Standard &Poor’s 500 index by about 35 percentage points. The fund is up 6.5 percent so far
this year, compared with the S&P’s 17 percent rise. CBS
MoneyWatch checked in with co-portfolio managers Roy Behren and Michael Shannon
to get their take on headline-grabbing merger announcements and how they plan
to profit from the gobbling trend.
What’s behind this recent flurry of merger activity?
Michael Shannon: The number of deals has really
picked up in the past few weeks, largely because the market has recovered so
significantly from its lows in March. Early in the year, buyers
were offering to pay about 25 percent more than the target’s share
price, which is a pretty typical premium. But that premium didn’t
look that great when the shares of both the acquirer and the target were so
beaten down. Many of the deals discussed earlier in the year were good strategic
fits, but the firms couldn’t agree on price. As the market rebounded,
the target companies have been more willing to sit down.
Will it continue?
Roy Behren: Yes. It’s partly that time in
the economic cycle. We’ve had four, five, six quarters of slowing revenue
growth. Companies have been cutting costs to meet their numbers. There’s
not much more in the way of cost cutting they can do. Their balance sheets look
pretty good, and they’re flush with
cash. So the natural next step is to grow by acquisition, either adding new
product lines or services or expanding their share of the market.
There have been a lot of hostile bids in the news. Why such hostility?
RB: Hostile really just means unsolicited. It doesn’t
necessarily mean unwelcome.
MS: A company usually “goes hostile”
over a disagreement on price, not the merger itself. When the two firms can’t
agree on a price, the acquirer will sometimes make their offer public in an
effort to get shareholders to change the target’s board’s
mind. In the meantime, the acquirer often increases its price.
How does your strategy work?
MS: If it’s a cash deal, we simply buy the
stock of the target. If it’s trading at $12 per share and the
acquirer announces a $20 per share bid, the target’s stock will
usually shoot up to about $19 as soon as the deal is announced. That’s
when we buy. It won’t go up to $20 because of the various risks
involved — approval depends on shareholders,
regulators, federal and state agencies. Once the deal closes, usually in 90 to
120 days, the share price will hit $20. That’s when we sell.
A dollar gain? That’s a pretty narrow spread you’re
working with.
RB: It’s small but meaningful. Depending on
how long it takes for a deal to close, that dollar gain can mean a 40 percent
annualized return.
What if there’s stock involved?
MS: If the buyer is offering stock for all or part of the
deal, we’ll buy the shares of the target and short the shares of the
acquirer.
When do you get in? After the deal is announced?
RB: We don’t bet on rumors. All of our
initial investments are after the companies have made an announcement.
What do you think of the Disney/Marvel merger?
RB: Marvel (
href="http://finance.bnet.com/bnet/?Page=QUOTE&Ticker=MVL">MVL) is an exceptionally good strategic fit for
Disney (DIS). It gives them content to produce their products.
MS: Disney also had a hole in its customer base. It
didn’t have much for boys in their late teens and early 20s.
What about Dell/Perot
Systems?
RB: That is what we call a high-probability
transaction. Dell (
href="http://finance.bnet.com/bnet/?Page=QUOTE&Ticker=DELL">DELL) offered cash [for Perot (
href="http://finance.bnet.com/bnet/?Page=QUOTE&Ticker=PER">PER)], and cash deals tend to close within 20 business
days. It’s a great fit.
And Kraft/Cadbury? That unsolicited bid seems a bit more troubled.
MS: Kraft (
href="http://finance.bnet.com/bnet?Page=QUOTE&Ticker=KFT">KFT) approached Cadbury (
href="http://finance.bnet.com/bnet/?Page=QUOTE&Ticker=CBY">CBY) with an offer of 717
pence (about $11.44). Cadbury didn’t like the price and Kraft went
public, but hasn’t increased its offer. The U.K. takeover
panel, a regulatory body, told Kraft to put up or shut up. Our
best guess is that Kraft will raise the bid to 850 pence
when they make a formal offer.
M&A activity is picking up, but it’s been near dead for
more than a year. How much activity do you need to run the fund?
MS: We typically track about 120 transactions around
the world — that’s enough to build a diversified
portfolio. We hold about 40 to 60 positions at any given time. In the past
six to nine months, it’s been slow but picking up, and
the deals that went through offered
very compelling spreads.
How do you choose the deals you invest in?
RB: We assess the likelihood of the deal’s
completion. First and foremost we look at the strategic rationale for the deal.
We look at the commitment of the two companies — is
the buyer buying out of desperation? Does the buyer need to raise a lot of
money to complete the transaction? Is there a product overlap, or do the
product lines complement one another?
Are you worried that the momentum in the M&A world will falter?
MS: It’s somewhat helpful to think of our
business as insurance. We take on the risk of the deals’ closing.
When there are a lot of broken deals, the spreads widen and we have more
opportunity.
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