From the November 2004 issue of Investment Advisor • Subscribe!

Merger Arb Returns Mirror Rate Hikes

Federal Reserve policy makers raised the federal funds rate to 1.75% with three hikes in the period from June through September and indicated a continuation of the quarter-point increases, as economic growth appears to be strong. Rates can be expected to stay on an upward course through this year and possibly beyond. What does that mean for hedge funds?

Merger arbitrage returns will become more attractive as interest rates go up, said Jonathan Bean, managing director of Mellon HBV Alternative Strategies LLC, a manager of several event-driven strategies based in New York.

Other event-driven managers agree. "We are a beneficiary of a gradually rising interest rate environment," said James Sheehan, director at Brencourt Advisors LLC, New York.

Bean acknowledges that lower bond prices are an obvious positive factor, but argues that several other mechanisms are also at work. A potentially large one is the interest rate earned by the proceeds of short sales of securities.

High rates on short sale proceeds can contribute as much as 20% to 30% or more of the returns in merger and convertible arbitrage funds, he estimated.

Moreover, a wider spread blunts the force of unexpected market moves. Merger arb managers might earn two and a half to three times the risk-free rate. A transaction is less likely to have a major effect on the portfolio if the fund is earning 12% instead of only 3%. "At higher interest rates, it is easier to withstand mistakes that might occur," Bean said.

To the extent that higher interest rates drag down stock prices, the effect on M&A can be negative. But it depends on timing. If both equity markets and interest rates rise for a few years, that would make for a friendly merger arb environment.

As alternative investment strategies continue their meteoric ascent in the financial industry, experts expect the number of mergers and acquisitions will increase commensurately. Executives at New York-based Freeman & Co. view the current uptick in M&A activity as another step in the evolution of the hedge fund industry into the investment mainstream.

Moving beyond the boutique funds of funds swallowed up in acquisitions during the past two years, acquirers now are considering traditional long/short equity or fixed-income arbitrage funds.

As more interested buyers enter the hedge fund space, many are becoming more comfortable with the asset class that has gained so much ground among institutional investors. According to Freeman, hedge funds with adequate scale, an institutionalized investment process, and an established "edge" will succeed in such an environment.

The firm estimates that seven fund-of- funds deals and three traditional hedge fund transactions took place in the first half of 2004. Deals included: Mellon Financial Corp. and Evaluation Associates Capital Markets; Numeric Investors LP (an employee buyout); Deerfield & Co. and Triarc Companies; and Javelin and BNP Paribas.

Moving forward, Freeman executives expect that deals will remain in the middle- to smaller-size range and that companies with as much as $1 billion in assets will be put on the block. Most traditional firms, especially those relying on growth or value stocks, know that alternatives are now a core asset class that they need to build internally or through acquisition, a Freeman executive said.--Jeff Joseph and Chidem Kurdas

Jeff Joseph is managing director of Rydex Capital Partners and serves on the advisory board of HedgeWorld (www.hedgeworld.com),?a?global provider of hedge fund information and investment products. Chidem Kurdas is the New York bureau chief for HedgeWorld.

Have a hedge fund question? Contact Jeff Joseph at jjoseph@rydexfunds.com.

For further inquiries about HedgeWorld, e-mail inquiry@hedgeworld.com.

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