Getting clients into hedge funds isn’t as hard as it used to be. And they’re not as scary as many would think. While some funds certainly are for aggressive investors, there’s plenty to offer conservative clients who want hedged growth.
One strategy that can be tweaked to suit both types of client is merger arbitrage (most call it merger arb). The manager tries to profit from equity price movements triggered by M&A. Ari Shiff, president of Inflection Management in Vancouver, notes this typically means two things:
Long on 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.
Short on acquirer: Even though acquisitions are designed to bolster the acquiring company, its stock usually drops because it’s spending money, notes Shiff.
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 breaks. 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 on a tear 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.
The 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.
Say two Canadian large-caps are planning to merge. Both have multiple classes of stocks, bonds and derivatives. These securities have their own terms and may have different revenue streams.
“Most people buying and selling these stocks are brokers, who don’t have the time or [skills to] read those documents and understand why, for example, Class C [shares] will move differently from Class A [as a result of the merger],” explains Shiff. But a fund manager’s lawyers will discover Class C shareholders have the right of first refusal of the merger. “They can kibosh the deal unless they’re basically bought off.” Knowing this, the manager will immediately begin buying as many Class C shares as come on the market.
Shiff notes managers’ long and short 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 (see “An odd year,” below).
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.
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 clients 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 clients’ money, not grow it.
Clients used to need millions to access hedge funds; now as little as $100,000 gets them in the door.
Craig Machel, a portfolio manager at Richardson GMP in Toronto, has put several accredited investors in hedge funds that emphasize definitive merger arb.
They’re appropriate for conservative clients who want capital protection and low volatility, he says.
Clients get bond-like stability with higher returns—about 8% to 10%. And because the fund’s equity-based, returns are more tax-efficient than fixed income.
Machel says income-oriented or very low-risk clients can allocate about 5% of an overall portfolio to a definitive merger arb fund.
Aggressive investors may not find the moderate returns appealing, but their portfolios also need stability and these funds can fit the bill.
“I say, ‘This is for you if you want something that can potentially make you meaningful money if there’s a systemic crash and the rest of your holdings are in the doldrums,’ ” Machel explains. “Some of these guys made money in 2008.”
Returns by a thousand cuts
David Heden, president of HGC Investment Management in Toronto, runs a hedge fund that’s about 90% focused on definitive merger arb.
He illustrates his approach with a deal he’s currently working on: Slate Properties’ acquisition of Huntington Capital. Slate’s buying Huntington for $13.25 per share, but the stock’s trading at $13.16. That’s a $0.09 spread, which is 68 bps. The deal’s supposed to close October 21. If you annualize that return—68 bps in 52 days (stock purchase date to deal close)—it’s 6%.
Heden always has about 25 to 30 deals going. Doing a high-volume of small-return deals has returned 38% since his fund’s inception (14 months), and 23% year-to-date. Clients are earning roughly 2% a month.
“Our job is to analyze the conditions of the deal, the probability of closing, and the upside in comparison to the downside,” he says. “We’re talking to proxy solicitors, lawyers, investment bankers, company management teams and analysts.”
Typically, a merger takes between 50 and 90 days, but the average duration of Heden’s portfolio is only 20 to 30 days, which helps him better manage risk.
Relationships he’s built with trading desks over the last 15 years help keep costs down, which is crucial for his pennies-on-the-dollar strategy.
“In the Huntington deal, we may buy the stock today at $13.16 and sell at $13.20. It might sound crazy to trade something for only four cents, but we’re trading it back and forth so many times on so many shares, and that’s what makes our return.”
Heden’s done about 500 deals with HGC, and only two have gone bad. “We focus on deals that have a 99%-plus chance of happening.” He tracks mergers with a proprietary database built from numerous sources, including Bloomberg.
Geographically, he has about 70% invested in Canada and 20% in the U.S., with the other 10% sprinkled across Australia, Israel and Western Europe. Heden says losses from a failed deal shouldn’t exceed 2.5% of fund assets. Keeping his fund liquid is key to achieving this: more than 90% of it can be liquidated within one day, the rest within five. “You have to be able to change your mind and sell quickly. One of the reasons we could have two blow-ups and not even have a dent in our portfolio is because we saw them coming and acted quickly.”
An odd year
This year’s been atypical for merger arb: the classic approach of buying target and selling acquirer has flopped more than usual because both companies’ stocks are going up.
“The perfect example is Burger King and Tim Hortons,” notes Ari Shiff, president of Inflection Management in Vancouver. “Both rose about 19% on the announcement.”
No manager will get every deal right, says Craig Machel, a portfolio manager at Richardson GMP in Toronto.
“You have to give them a bit of rope in terms of the occasional deal going wrong. Where you start questioning the manager’s ability is with the size of the deal: if you see deals taking up 4% to 5%—meaning that’s the hit to the portfolio if the deal breaks—there’s something wrong with the process. It’s not well-researched, or has too big a weight for the risk they’re taking.
“If it’s only one or two bad deals with relatively small weights, you chalk it up to the fact that no one’s going to get it right every time.”
On the bright side, 2014 has, for the most part, been a good year as far as deals closing. “There’s been very little breakage,” notes Shiff.