Franklin-Templeton's Mutual Recovery fund is a hedge fund alternative.

    Activist investors are back rattling the cages of corporate America.  Since the stock market rallied in 2003 from its post-bubble depression and the build-up to the invasion of Iraq, most shares have appreciated at a snail's pace.  Strong corporate earnings have failed to ignite a new bull market, of the type that investors came to know in the 1980s and 1990s.
    Instead, investors have slowly grown accustomed to a sideways market with an upward bias, hardly a reason for excitement. If the investment world we are living in today looks very different from the one we used to know, the reappearance of one familiar investing niche should provide a measure of comfort.
    Fresh from engineering an impressive turnaround at JC Penney, Carl Icahn is demanding a restructuring at Time-Warner, while calling top corporate managers "morons." Private Capital Management's Bruce Sherman grew so frustrated with his laggard holdings of big newspaper companies he decided to put one of them, Knight-Ridder, in play, while reminding big shareholders in the Knight and Ridder families that they were suffering as much, if not more, than he was. Furthermore, several hedge fund managers like Eddie Lampert have jumped into the acquisition game, purchasing giant companies like Kmart and Sears Roebuck, while others like William Ackman have advocated major restructurings at companies like McDonalds.
    This resurgence in activist investing was clearly anticipated by executives at Franklin-Templeton when their Mutual Series arm launched its Mutual Recovery fund in 2003. It's a style of investing that the firm has practiced successfully for decades and, after fading from the front lines of financial news during the tech bubble in the late 1990s, officials at the San Mateo, Calif.-based fund complex and its Short Hills, N.J.-based value shop clearly thought the time was right.
    According to Mutual Recovery's manager, Mike Embler, the fund focuses on three investment strategies: risk arbitrage, distressed securities and special situations. Depending on opportunities at any given time, distressed securities could account for 70% or more of the portfolio, with the rest split between risk arbitrage and special situations, which usually are undervalued stocks with the potential to realize value through a restructuring, spin-off or some catalytic event.
    Once upon a time, these three strategies represented obscure, overlooked areas of the securities markets. Today, they are among the most popular strategies in the hedge fund world. They also are strategies in which Mutual Series has scoured for value for decades, and has gained experience in investing billions of dollars.
    For years, Mutual Series executives had considered starting a distressed securities fund but viewed such a charter as too narrow. "The issue I had with it was you didn't want to have a fund that was forced to invest in one particular strategy when that strategy didn't make sense," Embler says.
    Both risk arbitrage and distressed securities investing tend to be quite cyclical in terms of the opportunities they offer investors. Yet Embler notes the good news for Mutual Recovery is that they are inversely correlated.  "What you saw in 2000 [through] 2003 was that there was no risk arbitrage activity, or virtually none," he explains.

Yet those bear market years proved to be a golden age for distressed investing, as overleveraged telecommunications companies cratered and smart investors scooped up bargains. "Risk arbitrage and distressed investing are inversely correlated," Embler says. "If you think about it intuitively, that makes a lot of sense."

Merger and acquisitions activity tends to jump when the business climate is relatively robust and corporate executives are eager to boost their share prices, frequently by using their stock as currency to buy a rival whose shares are deemed more undervalued than their own. This was a very different environment from earlier in the decade, when most businesses were obsessed with repairing their balance sheets, cutting capital spending and building up cash to ensure their own securities didn't become distressed.

On the other hand, the distressed debt market, based on corporate bond default rates, typically explodes during economic slowdowns when troubled companies suddenly find that access to credit dries up. However, the past year provided an anomaly, when the bonds of the nation's leading automakers, General Motors and Ford, were downgraded to junk status.

But aside from the unusual situation arising from ongoing decline of America's auto industry, Embler doesn't expect a big jump in default rates for at least another 12 months. Why? Because 2004 was a record year for junk bond issuance, so most companies in the high-yield arena still possess relatively liquid balance sheets. Historically, he says, most junk bond defaults tend to occur three to four years after issuance, which would make 2007 and 2008 years to watch in the troubled credit business.

Sometimes distressed securities can produce spectacular returns. "Often we are taking a position in the expectation that in a reorganization or a restructuring the distressed bond will be converted into equity, and that we will end up owning an equity that we have acquired at an attractive price," Embler says, alluding to the potential for manifold appreciation. When it doesn't always work out this way returns can still be very respectable. "On the other hand, if you buy a bond at 30 cents on the dollar and they end up paying you near or at par, that's not a bad outcome," he adds.

The risk and return parameters of the risk arbitrage business are quite different. "You are not going to initially earn 30% or 40% [annualized] returns there," Embler says. Only if a bidding war erupts over a company can returns approach those levels. After mergers or acquisitions are announced and terms are agreed upon, investors typically seek to earn about 1% to 1.5% a month as they wait for the deal to close. "We try to understand not only the legal and regulatory risks, but also the underlying business rationale for the combination," Embler says.

Different deals have different risks, though, and so the returns that are acceptable have to be adjusted accordingly. For example, in the friendly Procter & Gamble-Gillette transaction, a small spread between the acquisition price and the target's price was understandable, since both boards of directors had approved the transaction before it was announced.

Ultimately, Mutual Recovery is a value investing fund like the rest of the Mutual Series funds and is trying to purchase assets at a discount to their intrinsic value. An area Embler likes right now is the paper business. One of its largest holdings is Temple-Inland.

"We have bought a lot of companies with significant paper holdings," he says. "We think that if you look at the private market values for timber assets and then look at integrated timber companies with paper operations, we think the private market valuations are more than double public market values. So there is a significant amount of value to be realized, which we think will happen over time."

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