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Hedge Funds Stumble Over M&A in 2014

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12/30/2014 | 09:32pm CEST
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.

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