The ongoing merger boom keeps feeding the risk arbitrageurs' bottom line.

    An environment of historically low interest rates, soaring corporate profits and cash-rich companies is likely to keep driving merger activity in 2006. Merger and acquisition activity in Europe already has hit its highest level in 20 years. Moreover, private equity funds continue to invest heavily in deals, since many have raised huge funds and have to put their money to work in order to generate returns and collect the fees that make their business so lucrative.
    Published reports indicate that there was more than $2 trillion in merger and acquisition deals in the single month of November 2005. In the fourth quarter of 2005 big names like MBNA Corp., Reebok International Ltd. and AT&T Corp. were targets of acquisitions.
    Mario Gabelli, president of the Gabelli Funds, says that in addition to low-cost financing, new accounting rules are fueling mergers. Earnings get a lift because companies no longer must amortize good will.
    Other factors include the lower 15% capital gains tax that may or may not expire at the end of 2008, an attractive incentive for corporations to put their companies up for sale. In addition, many smaller companies want to get out from under the costly Sarbanes-Oxley corporate governance rules.
Merger activity is giving a strong boost to a number of stocks, both here and abroad. Bon-Ton Stores Inc. of York, Pa., rose 24% after it announced it was buying 142 department stores from Saks Inc. And when Pernod Ricard SA of France announced a $13 billion takeover of Allied Domecq PLC, a United Kingdom liquor company, its stock rose 20%.
    Financial advisors have a number of options if they want to invest clients' cash in mutual funds that could benefit from merger deals.
    On the plus side, these funds sport low correlations to the S&P 500, low beta values and high risk-adjusted rates of return, particularly when takeover activity heats up.  
    Some drawbacks:
    Merger and acquisition activity is dependent on favorable economic conditions. Funds that only invest in mergers may be forced to park money in cash when deal flow slows down.
    A danger always exists that deals could fall apart. In 2004 and early 2005, there were a large number of broken mergers, according to a report by Morningstar Inc. As a result, based on risk and return, merger arbitrage funds underperformed. Today, some current deals risk not being finalized due to regulatory issues. Problematic deals often occur in the utility and wireless communication industries. In addition, leveraged buy-out deals involving outside financing can fizzle.
    Funds that invest in mergers may close their doors to new investors when too much money flows in. The Merger Fund of Westchester Capital Management Inc., Valhalla, N.Y., the oldest mergers and acquisition fund, is closed to new investors. The Arbitrage Fund, of Water Island Capital LLC in New York, opened its doors to new investors this year.
    Portfolio turnover can be high when stocks are arbitraged. Investors end up paying large short-term capital gains distributions.  
    Funds such as the Gabelli ABC Fund, The Arbitrage Fund and the Merger Fund are low-beta stock funds that engage in arbitrage to profit from announced deals. This past year, the funds made some tidy low-risk profits on deals involving Pulitzer, Western Wireless, Liberty Corp. and Neiman-Marcus. The funds have delivered consistent returns above the risk-free rate of return over the longer term, says Morningstar. As a result, they may fit nicely in a diversified portfolio, depending upon how a financial advisor optimizes it.
    These funds, however, are not all alike. Even though they are low-risk, based on beta values and standard deviations, some funds are riskier than others.
    For example, the Gabelli ABC Fund only takes long positions in announced deals. The fund sells the stock when the deal is consummated. This tactic cuts the risk if a deal falls apart. By contrast, the other merger arbitrage funds frequently short the acquiring company and go long on the target company. The ABC fund sports a beta value of just 0.06. By contrast, similar funds have beta values above 0.20.
    In the ABC fund, Gabelli owns 50 to 60 target companies that already have received a formal acquisition offer. When a company agrees to be acquired by another, typically its stock appreciates to very near the stated acquisition price. The fund profits when the deal is consummated. Gabelli will make a small percentage on a transaction once a deal is announced and he closes out the transaction.
    The ABC fund currently has positions in Georgia-Pacific, Scientific Atlantic, Dreyer's Grand Ice Cream Holdings, Kaneb Services LLC, Gillette and Unocal Corp. Gabelli says his goal is to make 6% annually through arbitrage deals. Over the past ten years, he has achieved his objective. However, over the past three years, he hasn't hit the mark. Recently, he slashed the fund's expense ratio to just 50 basis points. His goal: Deliver absolute returns independent of the equity market. Low expenses boost the return on his cash position, which made up about half of the fund's assets at this writing.
    The fund is the lowest-risk fund in its class. Yet, it has grown at nearly 7% annually over the ten years ending in November 2005.  
    The Merger Fund uses a traditional merger arbitrage strategy. It shorts the acquiring company and goes long on the target company when deals are announced. The fund profits on the spread between the investments when the deal is finalized. The fund sports a beta value of just 0.23, and has grown at 7.2% annually over the past ten years. Largest holdings include Unocal, Nextel Communications, Guidant, Gillette and Accredo Health. Unfortunately, the fund is closed to new investors.
    The Arbitrage Fund takes a slightly more aggressive stance when investing in merger arbitrage and sports a beta value of .30-higher than its peers. The fund stays fully invested, primarily in smaller deals.
    John Orrico, fund manager, uses a number of tactics to profit from announced deals. The fund will engage in short sales, long sales and hedges. Orrico also uses options if it looks like a merger will run into problems. For example, in 2005, when the Johnson & Johnson acquisition of Guidant hit a snag, he bought puts against the Guidant shares to hedge the downside.  
    The average market capitalization of The Arbitrage Fund's deals is less than $600 million. But Orrico's investments span the gamut from Procter & Gamble's multibillion-dollar acquisition of Gillette to $100 million deals involving small U.S. community banks and a New Zealand commodity firm. He also has invested in small deals in China and India.
    Orrico only invests in announced deals of undervalued companies. He favors smaller deals because the spreads between an acquirer's stock price and target stock price are around 12%. By contrast, large-cap deals have spreads of about 5%. The fund is up over 6% annually over the past five years.
Orrico's goal is to earn two to three times the risk-free rate of return on Treasury bills. So far, he has been successful. Over the past three years, the fund has grown at an 8.5% annual rate.  "Rising interest rates are leading to wider spreads and enhanced profit potential on deals," he said. "Model studies have shown that our fund can lower the duration of a bond portfolio or improve the risk-adjusted rates of return on an equity portfolio." The fund's top five holdings are Macromedia, August Technology, Guidant, Acetex and May Department Stores.
    Meanwhile the AXA Enterprise Mergers and Acquisitions Fund, run by Gabelli, also arbitrages announced deals. However, one-third of the portfolio is invested in potential takeovers. As a result, the fund is riskier than funds that solely engage in merger arbitrage. On the plus side, its return is much higher.
    Potential takeover candidates held by the fund sell substantially below their private market value, creating the potential for higher returns than Gabelli's own ABC fund. For example, the Enterprise Fund has a stake in Sequa Corp., an aircraft component manufacturer with nearly $2 billion in revenue in 2005. Earnings for 2005 were expected to hit $3.25 to $3.50 per share.
    Due to the company's profitable airplane parts refurbishing division, its airbag division and specialty chemical and industrial machinery business, earnings could grow $5 per share in two years. Norman E. Alexander, controlling owner and chairman of the company, is 90 years old, and that's a big reason why Gabelli believes the company will be sold.  
    Many value mutual funds also should benefit from the merger and acquisition boom. Brian Rogers, manager of the T. Rowe Price Equity Income Fund, expects to see some gains in his portfolio due to takeovers, although he isn't hunting for these kinds of stocks. Key factors in his stock selection include low price-to-earnings, price-to-book value and price-to-cash flow numbers.
    But he also monitors for the possible sale of a company or the replacement of a chief executive officer. "We try to buy in anticipation of that because quite often, by the time the catalyst emerges, the stock price has already moved up," he says.   
Meanwhile, Gabelli says large numbers of stocks are selling below private market value, or the value a buyer would pay for a company, in the Gabelli Value, Gabelli Asset and Gabelli Small Cap funds. 
    Over the past year, the Gabelli Value Fund has grown at nearly 12% annually, partially due to holdings such as Cablevision Systems, ITT Industries, Liberty Corp and Neiman-Marcus, which all were involved in mergers.
    The Gabelli Asset Fund and the Gabelli Small Cap Growth Fund, up 14.5% and 19.2% annually respectively over the past three years, have sizable stakes in potential takeover stocks. Among those: U.S. Cellular, Aztar, Kaman Corp. and Sequa Corp. 
    "There is plenty of ammunition left to hunt for corporate bargains," Gabelli said. "Corporations are flush with cash and have plenty of borrowing power to fund cash deals. Leverage buyout groups are back in the action. We are confident increased deal activity will continue to have a favorable impact on our portfolios."