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."