By Liz Hoffman
In a hot year for mergers and acquisitions, hedge funds that bet
on the deals were anything but.
So-called event-driven investing, which involves bets on mergers
and other corporate shake-ups, was the worst performer among major
hedge-fund strategies, according to research firm HFR. Their
struggles come amid a sharp rise in M&A activity, but an even
greater increase, by dollar volume, in aborted transactions--the
bane of such funds.
This year through November, the average event-driven fund gained
1.5%, according to HFR, versus a 3.5% gain for the average hedge
fund and a 14% return in the S&P 500 index including dividends.
The funds, also known as merger-arbitrage investors, wager on
whether announced takeovers will close. They also often invest in
companies that are the subject of publicly discussed takeover bids,
in hopes that a deal will ensue.
One of the most costly disappointments for merger-arbitrage
funds in 2014 was the October collapse of AbbVie Inc.'s agreement
to buy Shire PLC, which burned firms that had bet the $54 billion
deal would go through, including Paulson & Co., Pentwater
Capital Management LP and Magnetar Financial LLC. Other
transactions that were pursued but never inked also proved costly
for investors, like 21st Century Fox Inc.'s $80 billion bid for
Time Warner Inc. and Sprint Corp.'s dalliance with T-Mobile US
Inc.
"If you had told me that we'd see the amount of M&A that we
did this year, I would have expected a great year," said Charlie
Sweat, portfolio manager at Magnetar. "But when big,
high-conviction deals go south, that hurts everybody."
Paulson, whose main event-driven fund fell more than 16% in the
year through November, was stung by bets on Shire and T-Mobile,
according to filings and investor letters. The $9 billion Mason
Capital Management LLC, another big Shire holder, lost 7% in
October and was down 11% this year through the end of November,
according to investor correspondence.
Merger-arb funds "hit one pothole after another," said Keith
Moore, an analyst with research firm MKM Partners.
The funds didn't lack for deals to examine, a common complaint
in the lean years that followed the financial crisis. The M&A
market shifted into high gear in 2014, with some $3.4 trillion of
deals struck globally through Monday, up 29% from the prior year
and the most since 2007, according to Dealogic. Shareholders in
general were rewarded richly by the takeover surge, pocketing
premiums when companies they owned got sold and, in many cases,
enjoying increases in the value of acquirers' stocks, too.
But it was also an unusually treacherous M&A market:
Government scrutiny, recalcitrant targets and other factors drove
up the tally of rejected or withdrawn deal proposals to $571
billion, according to Dealogic. That is more than double the 2013
level and the second-highest on record. It left many investors on
the wrong side of arbitrage trades, which seek in part to pocket
the difference between a company's trading price and what it might
fetch in a sale.
"Getting a deal done always was a small miracle, which requires
buyer and seller to agree, and stakeholders to be supportive," said
Luigi Rizzo, head of European M&A at Bank of America Merrill
Lynch in London. "It is more so today."
Still, some investors in hedge funds remain confident: About
$3.2 billion flowed to event-driven managers in the fourth quarter
through Nov. 30, according to HFR. Many of the funds stand to
profit handsomely if pending deals such as Covidien PLC's $43
billion sale to Medtronic Inc. and Allergan Inc.'s $66 billion sale
to Actavis PLC go through as expected.
And not all funds had a bad year. Pentwater's main event-driven
fund, for example, remained up 7% over the first 11 months of the
year even after it lost 5% in October, according to investor
updates.
A primary force vexing arbs in 2014 was a government crackdown
on so-called inversion deals, which allow U.S. companies to buy
overseas firms and relocate in lower-tax countries. The structure
became popular in 2014, particularly in the pharmaceuticals sector,
until the U.S. Treasury in September issued rules to make it less
attractive.
Event-driven investors had already been reeling after, in one
day in early August, Time Warner's resistance prompted Fox to walk
away from its bid for the media company; Sprint dropped its pursuit
of T-Mobile amid opposition from regulators; and Walgreen Co.
decided against an inversion it had been contemplating.
Shares of the affected companies slid sharply on a day traders
dubbed "arbageddon."
Then, on Oct. 14, AbbVie said it was re-evaluating the Shire
takeover in light of the new inversion rules. Dublin-based Shire's
New York-listed shares tumbled 30% on the news, and the deal soon
fell apart.
Shire "just decimated the strategy," said Jeff Holland,
co-founder of the $7 billion Liongate Capital Management, which
invests in hedge funds.
The Shire deal's collapse sent funds into a protective crouch,
leading many to cut exposure to other pending takeovers, people at
some of the firms said. That hurt the funds further when markets
subsequently strengthened and the outlook for other pending deals
brightened. Shire shares have rebounded 24% from their October
low.
Investors were also hurt by another of the year's M&A
trends: deal-jumping. Suitors including Hillshire Brands Co. and
Chiquita Brands International Inc. ended up as prey instead of
predator after striking acquisition deals of their own.
Such flip-flops can be doubly painful for merger arbs, which
often make paired bets on the stocks of buyers and sellers.
Shayndi Raice and Rob Copeland contributed to this article.
Access Investor Kit for Covidien Plc
Visit
http://www.companyspotlight.com/partner?cp_code=P479&isin=IE00B68SQD29
Access Investor Kit for Allergan, Inc.
Visit
http://www.companyspotlight.com/partner?cp_code=P479&isin=US0184901025
Access Investor Kit for Chiquita Brands International, Inc.
Visit
http://www.companyspotlight.com/partner?cp_code=P479&isin=US1700328099
Access Investor Kit for Medtronic, Inc.
Visit
http://www.companyspotlight.com/partner?cp_code=P479&isin=US5850551061
Access Investor Kit for Time Warner, Inc.
Visit
http://www.companyspotlight.com/partner?cp_code=P479&isin=US8873173038
Access Investor Kit for 21st Century Fox, Inc.
Visit
http://www.companyspotlight.com/partner?cp_code=P479&isin=US90130A1016
Access Investor Kit for 21st Century Fox, Inc.
Visit
http://www.companyspotlight.com/partner?cp_code=P479&isin=US90130A2006
Access Investor Kit for Walgreen Co.
Visit
http://www.companyspotlight.com/partner?cp_code=P479&isin=US9314221097
Subscribe to WSJ: http://online.wsj.com?mod=djnwires