This is the fourth article in an ongoing series that examines what’s ahead in 2004, from the viewpoints of industry experts.

NEW YORK (HedgeWorld.com)–Several factors suggest that good times might return to merger arbitrage strategies in 2004. After peaking in 2000, returns in this field declined in tandem with slumping merger and acquisition numbers. Capital moved away, attracted in particular by spectacular profits in distressed securities.

But in 2003, deal flow picked up, especially in the last quarter, as equity prices rose. Companies now are more willing to do deals with their stock, said John Paulson of Paulson & Co. Depressed share prices in recent years had discouraged activity. Now, however, the same deal can be done with fewer shares, he said.

Corporations such as General Electric, which have been quiet in this area, are proceeding with all-stock acquisitions. A strong economy and robust corporate earnings also are driving M&A. And large multinationals are looking to buy businesses across the world as part of their global expansion plans.

Mr. Paulson pointed out that there are several ways to make money in merger arbitrage. One source of profit is the difference in the price at the time the deal is announced versus when it closes. This spread is still tight because of record low interest rates, he said.

But the spread is not uniform across industries and deals. For example, in some cases the market has overcompensated for the risk of regulators blocking the transaction on antitrust grounds. These, as well as changes in the price after initial bids, present ways of earning profits, Mr. Paulson said.

“Overall, 2003 was better than 2002, and 2004 will be better still,” he said. New York-based Paulson & Co. manages US$1.7 billion in distressed strategies.

Event-Driven Perspective

The CSFB/Tremont index for merger arbitrage shows a 7.9% return as of November. Mr. Paulson did better than many of his peers–various funds he managed returned between 19% and 42% in 2003.

Event-driven strategies as a whole, covering both merger arbitrage and distressed securities, were up more than 18%. Historically, merger arbitrage and distressed securities returns have been in a seesaw pattern, one rising as the other falls.

Distressed just had a banner year–up almost 23%, according to the CSFB/Tremont index as of November, second only to emerging markets managers in performance. Many industry observers see 2003 as a peak for distressed.

Some sources of alpha in this sector may have shrunk, but managers believe substantial opportunities remain. There’s around US$1 trillion in high-yield issues in the public market alone, said Phil Falcone, portfolio manager for Birmingham, Ala.-based Harbert Management Corp.’s distressed investment fund.

Some sectors, such as automotive, paper and textiles, face a growing pressure in pricing primarily because of globalization, he said. These provide openings for distressed investing.

Mr. Falcone expects returns in the strategy will continue to be strong in 2004, but opportunities will be in new places–in mid-cap companies that are less likely to show up in top business news, rather than large-cap names such as Enron, Adelphi or K-Mart that have dominated the field in the past three years.

We will have to wait a year to learn whether the two event-driven strategies will seesaw again as they have in the past, with returns in merger arbitrage rising to double digits and those in distressed falling. Right now, the latter’s eye-catching performance continues to attract investors.

CKurdas@HedgeWorld.com