Looming mergers open door for investors

Big fish often gobble up smaller ones in the roiled sea that is the business world. And the appetite for such acquisitions is building. This month, PeopleSoft made a bid for J.D. Edwards. Days later, Oracle made a $5 billion hostile bid for PeopleSoft.

So how does that matter to you?

Once the exclusive province of wealthy individuals and large institutions, merger arbitrage funds are now benefiting mainstream investors. These funds, experts say, provide some stability in today's volatile stock market.

"Merger or risk-arbitrage tends to be relatively profitable in both up and down markets, and to the extent that the returns of funds mirror that performance, that's not a bad kind of vehicle to be in," says Ben Branch, a professor of finance at the University of Massachusetts, Amherst.

Stability has been the hallmark of merger arbitrage investing. Lipper, the mutual-fund research company, gives merger arbitrage funds its highest ranking for capital preservation.

The nature of these funds contributes to the stable results. Basically, managers of merger arbitrage funds buy stock in companies that are the target of a takeover or merger at a discount to the price paid when the deal is completed.

"The risk is that the deal [might] not close," notes John Orrico of the Arbitrage Fund in New York. "We analyze every deal in the portfolio in terms of what will be the impact to our fund's net asset value if the deal breaks or is terminated. Based on what we think could be a worst-case scenario, we will limit our position size in our portfolio such that a break in that particular deal will cost the portfolio no more than a 1 percent loss."

To further reduce risk, Mr. Orrico tends to follow at least 120 mergers or reorganizations and to diversify his portfolio by owning an interest in roughly 60 of them at any point in time.

That strategy has led to consistent returns for the Arbitrage Fund, which carries $129 million in assets. Over the past three years, it has been the leader among merger arbitrage funds, with returns of 9 percent and 9.3 percent in 2001 and 2002 respectively, and 5.2 percent so far this year. The fund beat the S&P 500 index by 20.8 percent in 2001 and by 31.4 percent in 2002. It lags the index by 10.5 percent so far this year. Orrico expects to lag the S&P 500 in a bull market or during large rallies.

The largest of the public merger arbitrage funds is the Merger Fund. With $846 million in assets, it lost money (5.7 percent) for the first time in its 23-year history in 2002. In communications with shareholders, the Merger Fund attributed the losses to the purchase of distressed securities, a strategy outside pure merger arbitrage. "In a bad market, you don't have a lot of merger and acquisition activity, and so there isn't a lot of deal flow," Professor Branch notes.

Lack of enough deals and enough large deals can hamper an arbitrage fund's ability to efficiently invest its capital in specific strategies. "Larger entities [such as large mutual funds] can't play smaller deals because they can't buy enough shares of the target to make an impact on their portfolio," says Orrico. "In this particular strategy, you have to limit your size in certain markets, if you want to be efficient and return decent numbers to your shareholders."

Returns on merger arbitrage funds will improve when more deals are made, says Bonnie Smith, comanager of the Merger Fund. "All the reasons for doing deals still pertain," Ms. Smith says. "Companies are going to have to look outside their own boundaries to obtain new growth - and synergistic mergers are a wonderful way to achieve that growth. Whether it's to fill a hole in your product line, expand your geographical presence, leverage up a sales force, all the reasons that make sense for deals are still there."

A recent article at Marketwatch.com reported that the consolidation of the high-tech industry, something predicted by Oracle CEO Larry Ellison a while back, is under way. One estimate from an investment banker who would benefit from lots of mergers is that the 8,000 tech companies will merge themselves into 2,000 tech companies within the next five years, the article said. That could give merger arbitrage a lift.

"In order for us to return to our trend-line growth of 10 to 12 percent, we're going to need a pickup in deal activity," Smith says.

Another fund linked to arbitrage investing is the FundX fund of mutual funds. Essentially, this fund buys into other mutual funds to create its portfolio. "We use [arbitrage funds] in our flexible fixed-income fund, particularly if we think interest rates are going up. We use them in our growth funds when we think that we are in a high-risk stock market," says Janet Brown, manager of FundX in San Francisco.

Morningstar, the mutual-fund research company in Chicago, notes that low correlation with the broader market can make merger-arbitrage funds an excellent tool for portfolio diversification.

Orrico agrees on the importance of portfolios having investments that do not move in lock-step with the broad market. "I don't think there's a portfolio out there that can't benefit from having some portion invested in market-neutral type strategies," he says.

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