Merger activity starts to reheat
A thawing credit market is starting to unfreeze some big M&A deals. Now the question is how cold will the economy grow.
NEW YORK (Fortune) -- Here's a sign that the credit markets are thawing: Some blue-chip merger targets are looking like less like blue-light specials.
Like so many strategies pursued by hedge funds, so-called merger arbitrage - the practice of buying the shares of an announced buyout target and often shorting the shares of the acquirer - has hit a rough patch. The HFRI merger arbitrage index compiled by the Hedge Fund Research data shop in Chicago was down almost 4% in the first three quarters of this year, with much of that decline coming in September.
While that decline compares favorably with many other hedge fund strategies - a broader HFRI index was down 10.5% through September - it comes after four years of gains in the merger arb index ranging from 4% to 14%. The HFRI number also doesn't count last month's deleveraging-driven stock-market bloodbath, in which firms and individuals sold everything that wasn't nailed down to raise cash.
The result was that blue-chip merger targets such as Anheuser-Busch (BUD, Fortune 500) and chemical company Rohm & Haas (ROH, Fortune 500) traded well below the sums shareholders are slated to get when their deals are completed in just a month or two. Wide spreads can mean big profits for investors who place the right bets.
"We haven't seen spreads like this since the late 1970s," says Nancy Havens, whose Havens Advisors investment firm specializes in merger arbitrage.
In the middle of last month, Havens notes, investors confident enough to buy into deals such as InBev's $52 billion all-cash purchase of Anheuser, Dow Chemical's (DOW, Fortune 500) $15 billion buy of Rohm & Haas or Invitrogen's (IVGN) $6.5 billion merger with Applera (ABI) could have realized annualized expected returns of 60% to 90%, assming the deal goes through The annualized return reflects the arb spread and the expected time to closing.
In a field in which many players have made a living by scooping up nickels and dimes just before deals close, those sorts of indicated returns are "ridiculous," says Thomas Kirchner, manager of the Pennsylvania Avenue Event-Driven Investment (PAEDX) fund.
Since then, though, the spreads have narrowed, while still reflecting an uncertain outlook for the economy and the availablity of financing. Anheuser, which is due to be taken out by year-end in a $70-a-share deal, closed Tuesday at $64.60, an 8% discount to the offer price. That compares with a 19% discount two weeks ago. The spread on the Dow-Rohm & Haas deal, due to close early in 2009, has narrowed to 8% from 14% in late October.
"Over the past six weeks, there wasn't much lending or borrowing going on in the markets," HFR President Ken Heinz says. "So prices in many strategies ended up being dislocated."
Kirchner adds that March's collapse of Bear Stearns, a big player in merger arbitrage, may have added to selling pressure in many merger targets by "removing a big pot of capital" used by hedge funds plying that trade. One more driver of the collapse of share prices was the liquidiation of various event-driven hedge funds.
Of course, those aren't the only factors affecting these deals. The economy is slowing sharply, with U.S. car sales off by a third in October from a year ago, and the credit crunch that took stocks down 20% in a week last month is only gradually easing. While the prospect of big payoffs is enticing, Havens says, "This is when deals break."
Just last month, United Technologies (UTX, Fortune 500) dropped its $2.6 billion unsolicited bid for ATM company Diebold (DBD), and Waste Management (WMI, Fortune 500) walked away from an offer for Republic Services (RSG).
A slowing global economy and weak domestic demand are only two of the factors conspiring to reduce the value of many companies, and to make acquirers pickier. The collapse of bank financing adds another hurdle, as does the wariness of investors to put down big sums amid general uncertainty.
Take Dow's $78-a-share purchase of Rohm & Haas. While the government's commitment to backstop big banks may limit the financing risk - the deal is being backed by Citi, Morgan Stanley and Merrill Lynch, firms that only a few months ago might have been less apt to finance the merger of the chemical companies - the risk that an adverse antitrust ruling could scupper the deal may have risen.
"The question there is whether they can find buyers for any overlapping businesses" should the government order divestitures, says Kirchner. That probably wouldn't have been a deal-killing issue in the credit boom of 2006 and 2007, when private equity buyers were easier to find, but it could create problems now.
Even deals that seem likely to close don't necessarily compensate investors for the risk of an acquirer walking away. One deal that Havens isn't betting on is Berkshire Hathaway's (BRKA, Fortune 500) $4.7 billion takeover of cash-strapped energy merchant Constellation Energy (CEG, Fortune 500). Berkshire agreed in September to pay $26.50 a share for the Baltimore-based company, which was having trouble financing its capital-intensive trading businesses as investors fled from risky positions in the wake of the collapse of Lehman Brothers. Constellation is trading at a 9% discount to that offer.
"I can't get too excited about that one," says Havens, noting that Berkshire chief Warren Buffett pried extremely favorable terms out of a Constellation management team desperate to keep the company out of bankruptcy. "The target was in such bad shape."
Even so, the rush of troubled leveraged companies to find stable suitors may yet pay off. Heinz sees the merger of Bank of America (BAC, Fortune 500) and Merrill Lynch (MER, Fortune 500), for instance, as creating a dynamic that may create opportunities for investors. The spread on that deal, hurriedly negotiated as Lehman imploded, narrowed to 5% on Tuesday after spending most of the past six weeks in the low double digits. "There's things getting done under duress," Heinz says. "You can call it a dynamic environment."