After having been closed twice since its inception in 1982, the Merger Fund (MERFX) is again open to new investors. The fund, co-managed by Westchester Capital Management’s Fred Green and Bonnie Smith, had been closed from June 1996 until October 1998, and again from September 1999 until reopening on October 5, 2001. “We’ve tried over the years to carefully manage our growth so as not to disadvantage our existing shareholders,” Green says. “It’s a function of how fast the money’s coming in and the number of attractive investment opportunities that we are presented with. If money is coming in fast and opportunities aren’t there, there’s no reason to have the fund open.”
Green and Smith’s disciplined approach has proven to be successful. According to Morningstar, the Merger Fund ranks third out of 833 domestic hybrid funds with a three-year annualized return of 14%.
The fund is also maintaining its streak of never posting a negative return for any single year since its inception: it has a year-to-date return of 3.03% as of October 31, while the average domestic hybrid fund is struggling along with a -7.50% return.
Green admits that the terrorist attacks of September 11 played a role in swinging economic conditions into a favorable position for his fund to reopen. “At certain critical points over the last few years we’ve had some redemptions and at the same time had really attractive opportunities,” he notes. “After September 11, arbitrage spreads widened across the board.” On September 10, the Merger Fund was about 30% in cash, largely because of the continuing slump in merger activity, which in dollar terms was down slig
Managers: Fred Green, Bonnie Smith
Managers’ tenure: 12 years
Fund started: July 20, 1982
Min. initial investment: $2,000
Load (front-end): 0.00%
12(b)-1 fee: 0.19%
Net assets: $967.8 million
P/E ratio: 41.37
P/B ratio: 10.87
Expense ratio: 1.34%
3-year alpha: 1.01
3-year beta: 0.10
3-year r-squared: 0.24
3-year standard deviation: 4.15%
12-month (annualized): 4.52%
3-year (annualized): 14.16%
5-year (annualized): 11.25%
Top Five Holdings
Ultramar D.S Corp.: 5.5%
C.R. Bard, Inc.: 4.5%
GM Class H: 4.1%
Inverness Med. Tech.: 4.0%
htly more than 50% from a year earlier. When the markets reopened after September 11, “some of the spreads widened dramatically and we put a lot of money to work,” according to Green. “We invested over $300 million in the last two weeks of September. So by the end of September the fund was fully invested again. While spreads were not quite as juicy at that point, they’d recovered somewhat; there were still opportunities so we decided to reopen.”
Goldman Sachs said recently that it would be closing its Spear, Leeds & Kellogg risk-arbitrage operation due to “a huge slump in merger activity and declining returns for the risk-arbitrage community.” Is this how you see things? Green: We’re optimistic that over the next six to 12 months merger activity will show a significant upturn. The economic outlook is going to stabilize at some point when factors such as the disconnect between buyers and sellers stabilizes, when buyers realize that pricing isn’t going to go much lower. Also, you have to realize that the consolidation of corporate America is not over. Companies want to deepen their product offerings. They want to offer one-stop shopping, and foreign companies want a stake in U.S. commerce. What you have to look at really is the flipside of why M&A activity has been in a slump. At the top of the list have been economic uncertainty and the recession. The economic outlook has never been murkier. It is very hard for corporate America to make intelligent decisions with respect to corporate mergers with the outlook being so uncertain. And then there is a whole class of companies that are trying to keep their companies afloat.
Smith: We do think there will be some opportunistic buyers who are going to look at these struggling companies and realize that there are some great opportunities. We wouldn’t be surprised to see more types of those deals with deep-pocketed corporate acquirers announcing cash deals for some of those struggling companies.
Green: A major factor that helps explain the slump in M&A activity, and when it is corrected will lead to an upturn, is what we call the disconnect between buyers and sellers. By that we mean the fact that sellers remember the price they could have gotten for their companies six months or a year ago and buyers are looking at today’s prices at depressed levels thinking those would represent pretty good transaction prices. Until that disconnect is resolved, you’re not going to have a transaction. What is required is for the market to stabilize and stay at this level for a while so the sellers see that their stock prices are not going to recover dramatically anytime soon and they may be better off doing a deal with a deeper-pocket company. We hear anecdotally that there are deals in the pipelines but it’s hard for companies to pull the trigger. This disconnect is clearly an important factor in that.
Do you strictly invest in companies involved in mergers and acquisitions? Smith: Yes, or companies that are involved in some type of corporate reorganization.
Do you follow any market cap restrictions in the companies you look at? Smith: We never look at any company with less than $200 million in market cap. We rarely look at companies with less than $500 million. The majority of deals we’re invested in are over $1 billion. If we were to take a position in a lower market-cap deal it wouldn’t be a large position because we are sensitive to liquidity. We don’t ever want to decide we don’t like a deal and then not be able to get out of it.
How many mergers may you be involved in during any given year? Smith: We typically like to have 40 to 50 deals in our portfolio at any given time. Right now we have 37 or 38. The average life of a deal is three to four months, so we probably have a 300% turnover rate.
Green: We’ve been averaging over 100 deals per year the last several years.
Can you speak about your investment process? Smith: There are four of us here who are doing research. Besides Fred and myself, we have Mike Shannon who’s the head of the research team, and a fourth professional, Roy Behren, who is an attorney who helps with research, litigation analysis, and trading. Step one is always to talk to the companies involved. We also may follow up and talk to investor relations people at the company. We go back and look at all of its filings with the SEC to make sure there are no outstanding issues we are not aware of. We want to make sure the company is not involved in some major litigation or that there has suddenly been a huge downturn in revenues. The most important thing for us is to understand the company’s strategic rationale. If we cannot understand why one company is buying the other, we probably won’t invest in it.
We also look at any regulatory issues. Today, antitrust has become more of an issue than it was 10 years ago.
Our expertise in only looking at merger arbitrage for over 20 years leads us to think we really understand what it takes to get a deal done. That’s where we can add value to our investors. We start out slowly. We don’t acquire a full position on day one. We’ll build it over time. If we have an area we’re concerned about, such as regulatory approval, we may have to wait until they get that approval. Or maybe we’ll just watch a deal, and if it does not have a large enough arbitrage spread initially, maybe over time something will happen to cause the spread to widen. We look at deals through many different angles and we continue to monitor them throughout their life cycle.
Why is there so little correlation between your fund and the broader market? Smith: Once a deal is announced, the price of the target stock is going to move based on the price of the deal and not on the market. If a company offers $25 to buy company A in cash, if the market’s up 500 points tomorrow or down 5,000 points, they’re still going to get their $25. The price of that stock is going to move against that $25 target and as the deal gets closer to completion the price is going to get closer to $25. If the market is up big time we are still going to get $25, so we are not going to keep pace with a roaring bull market. But if the market craters tomorrow we are still going to get our $25 and we are not going to participate in the downside either.
If it is a deal that is being paid for in stock, again if company A says “We are going to give you two shares of our stock for every share of company B,” every time we buy one share of company B, the target, we are going to sell short two shares of company A, the acquirer. We are not going to have any market exposure on that deal. When that deal is completed we’ll take all of our shares in the target company and we’ll get back twice as many from company A and we’ll use those shares to cover our short position. It won’t matter if that stock is up or down 20 points from where we shorted it, we’re just going to cover it with the shares we received. So we have absolutely no market risk as long as the deal gets completed.
What strategies do you use to protect against failed mergers? Smith: Well, we lose money when a deal falls apart. That’s the risk in our portfolio. The best thing is to do your homework and know everything you can possibly know about a deal. That doesn’t mean you aren’t going to get blindsided sometimes at the last moment. It’s important to have a diversified portfolio and spread the risk over 40 or 50 deals and to not have any outsized positions. No matter how much you love a deal you can’t bet the ranch on it because that might be the one that surprises you at the end. I think it’s being disciplined in position size and the number of deals you’re involved in. For us it’s doing the research.
Green: We’re always hedging against market risk in stock-for-stock deals by shorting the acquiring company’s shares at the same time we buy the target company’s shares so that our fund has a very low beta (Standard & Poor’s lists the Merger Fund’s beta as 0.10% as of October 31, 2001).
Who is the ideal investor for this fund? Green: The fund is a great diversification tool. The Merger Fund has been ranked by Morningstar as having the lowest risk-adjusted performance as measured by the Sharpe Ratio and the most consistent return as measured by standard deviation out of 3,806 equity funds for the three-year period ended September 30, 2001. Those numbers are a function of our investment approach of merger arbitrage and the way we go about investing. As a result, our fund, even though it’s basically an equity fund, doesn’t behave like other equity funds, but instead has a unique risk-reward profile. During a bull market it is going to lag and underperform, but during a bear market it is going to shine.
Smith: It’s a fund for anybody who doesn’t want to lose principal.
Are you confident your performance numbers will stay in positive territory through year-end? Green: I think we’re in good shape to have an up year. Our objective is to do 10% to 15% a year by taking substantially less risk than the typical equity fund. In 1999 and 2000 we were well above our target numbers with over 17% each year. This year we’re below, but on average over the last three years the fund has been up 14.5%; over longer periods of time it’s up closer to 11% or 12%.
What sectors do you think will be involved in the most M&A activity over the next six months or year? Smith: It really doesn’t matter to us where the deals are. We’re reactive, not proactive. We don’t say we want to make a sector bet in energy. That just happens to be where the deals are that we like so that’s where we’ll be.
What percentage of your assets comes through advisors? Smith: I don’t know exactly, but I’d say it’s a high percentage. More and more of our assets are coming through the supermarkets like Schwab and Fidelity, and I think those are almost always financial advisors investing on behalf of their clients.
Our fund is a hard one to understand for the average individual. Most people have no clue what merger arbitrage is so it doesn’t necessarily lend itself to individual investors unless they are pretty sophisticated. Usually it’s something where an investment advisor says “I have a combination of funds for you to invest in and a certain percentage of your portfolio should go into the Merger Fund because it’s a great diversification tool.”