Good Times Are Back In Risk Arbitrage Business

For the first time in years, folks in the risk arbitrage business are happy as clams. Spreads in this specialty sector, also known as merger and acquisition arbitrage, have rarely been better. Why?Peter Schoenfeld, head of the eponymous asset management firm, points to several reasons. First, M&A activity is booming. Second, a lot of the business is being driven by private equity players.Third, short-term rates have been moving up, and deals are priced off short-term rates. And, finally, because concerns about the hedge funds’ exposure to the Ford and GM debt downgrades shook up the high-yield market, albeit briefly, spreads have widened.All this is wonderful news to the risk arbitrage community, an increasingly lonesome group in recent years. Risk arbitrage investors take advantage of the spreads that open up after one company agrees to buy another. Typically, the risk arbitrageur buys the stock of the target company and sells short the stock of the purchasing firm.As the deal nears completion, the spread between the market price and the offering price of the target company usually narrows, and the risk arbitrageur takes his gains. Many factors enter into whether or not a particular trade works out. First and foremost, however, this sector needs substantial deal volume to be fruitful.The most recent surveys of hedge fund performance hint at the turnaround. The CSFB/Tremont Hedge Fund Index for May showed overall hedge fund returns for the month up 0.15%, and, finally, slightly in the black for the year (up 0.03%).The risk arbitrage subset of that group logged gains of 0.32% for the month and 0.23% for the year, while their event-driven multi-strategy cousins were among the industry’s best performers with gains of 0.89% for the month and 1.91% for the year. Much of those in creases doubtless came from merger arbitrage trades.That may not bowl you over, but the sector is outperforming most other categories after several years of underperformance. Since 2000, when the sector was truly hot (the group gained 19% in that year, according to Van, versus the industry’s overall 8.4% rise and a drop of 9% in the S&P 500) the M&A category has trailed hedge funds every year.What’s changed? Mainly, the number of deals has ballooned. According to Thompson Financial, $466.7 billion worth of deals have been announced this year, up from $375.6 billion last year. Worldwide transactions exceed $1.08 trillion, considerably ahead of last year’s totals.Arbitrageurs have also benefited from an upswing in private equity transactions. Last year the sector accounted for $77 billion in American transactions, the biggest total since 1988. So far this year, private equity groups have undertaken $30 billion in deals. Judging from the massive amount of funds raised by some of the major firms, like the Carlyle Group and Bain Capital, deal activity may heat up in the second half.Private equity deals are especially rewarding for the arbitrage community since they often are perceived as entailing a greater degree of risk. As a result, the spreads on the deals tend to be wider.Risk assessment for these transactions stems from the fact that for private equity firms, acquisitions are entirely prompted by financial returns, as opposed to business strategy.When Verizon buys MCI for $8.5 billion, one assumes that there is a business purpose to the deal. When private equity star Tom Lee makes an acquisition, the numbers have to work out or the deal is off. Therefore, one can argue that the transactions are a bit more fragile, and likely to break if the financials get off base.Finally, there has been an exodus of proprietary traders from firms like Goldman Sachs to the hedge funds. According to some professionals, there is less competition coming from the big investment banks, which are focused elsewhere.

Good Times Are Back In Risk Arbitrage Business

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