Use hedge funds to profit from M&A

Getting into hedge funds isn’t as hard as it used to be. And they’re not as scary as you’d think. While some funds certainly are for aggressive investors, there’s plenty to offer conservative investors who want hedged growth.

One strategy that can be tweaked to suit both types of investor is merger arbitrage (most call it merger arb). The manager tries to profit from equity price movements triggered by mergers and acquisitions (M&A). Ari Shiff, president of Inflection Management in Vancouver, notes this typically means two things:

Buying shares of the acquisition target: For a company that’ll be acquired, the stock price is lower after a deal’s announced than it is on deal closing. That spread between those two prices is part of how managers make money.

Shorting shares of the acquirer: Even though acquisitions are designed to bolster the acquiring company, its stock usually drops because it’s spending money.

Acquisitions usually make the market and shareholders wary. “So even if you believe the companies together will be much stronger than they were apart, it’s almost inevitable there’ll be a period of upheaval where the acquiring company underperforms.”

The biggest risk is if a deal doesn’t go through. When that happens, both stocks typically do the opposite of what managers bet. Shiff notes deals can break due to the following:

Shareholder disapproval: Resistance to the deal from shareholders of one or both companies.

Regulatory hurdles: Governments may have to approve the merger, generally focusing on whether the deal violates anti-monopoly rules. Sometimes deals need multiple approvals. For instance, a merger involving firms in France and Spain means approval from in-country and EU authorities. This adds risk.

Bull markets: If the market goes up substantially between the time a deal’s announced and when it’s set to close, the target may conclude the offer’s become too cheap. The target then tells the acquirer to sweeten the deal, or it’s off.

Squeamish bankers: Market volatility can make bankers wary of financing deals.

Fine tuning

The hedge fund’s management team scours every publicly available document. Shiff notes lawyers play a critical role, as documents often contain gems only lawyers can spot — and finding them can produce outsized returns.

Shiff notes managers’ positions aren’t static. “It’s not as if they’re going to sit back and wait six months for the deal to get done. They’re trading like crazy.” For instance, they may get the profit they want and sell; then, if prices fall they’ll go in again, buying on the dip. Or, they may get it wrong and have to stop-loss to meet their risk parameters.

A matter of style

There are three main ways to play the merger arb game:

Definitive: The deal’s been publicly announced and there’s a timeline for completion. “You may think in this situation you couldn’t make a lot of money, but there are some managers who are incredibly good at it,” notes Shiff. “They’re only going to make pennies on the dollar, but by consistently doing this for, say, 200 deals a year, they make 6% to 10%, including hedging.” (see “Returns by a thousand cuts,” this page).

Rumours: No deal’s been announced, but there’s a rumour companies will merge. This isn’t insider trading: rumours are based on analytically informed speculation. “Then you start to investigate and you find hints in the press or in the companies’ announcements,” says Shiff. A manager will bet on the merger if he or she concludes a deal would make sense and is likely. This is more risky than definitive merger arb, but returns are higher if the manager gets it right.

Activism: The manager’s involved in making the merger happen. Bill Ackman’s the archetype (think CP Rail). Shiff notes there’s a more subtle variant other big players use.

“[They’ll] work behind the scenes. [They’ll] go to a company and say, ‘What you’re doing is great, but have you ever thought of acquiring this company over here?’ Of course, [they] already have [their] stake in the company [they’re] promoting, and there’s no secret about that. But it also makes sense for the [acquiring] company to do it. It’s win-win.”

Another strategy is to derail announced deals by convincing the acquirer it’s better off buying a different company, and then helping to pull off the purchase.

Fees

Shiff notes a 2% management fee and 20% performance fee is standard. Some charge 1.5%-and-15%; others as much as 2.5%-and-25%, but “they would have to have an unbelievably good track record to be worth that.” There are two ways you can invest: funds, and funds of funds. Funds typically emphasize a particular strategy, such as definitive merger arb. Funds of funds offer diversification across multiple strategies and degrees of aggressiveness. They’re also nimble enough to move between strategies as market conditions change.

Shiff, who manages a fund of funds, says managers should have the majority of their liquid net worth in their own funds. “It shows commitment, and if they get it wrong they’ll suffer. So they’re not going to take crazy risks.”

Management and performance fees are proportionate in the 1.5%-and-15%, 2%-and-20% and 2.5%-and-25% models. But Shiff notes some funds deviate from this balance and should be avoided:

Lower-than-normal management fee with higher-than-normal performance fee: This creates incentive to take on too much risk. If the fund tanks, managers will likely cut and run.

Higher-than-normal management fee with lower-than-normal performance fee: Creates an incentive to hold your money, not grow it.

You used to need millions to access hedge funds; now as little as $100,000 gets you in the door.