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From classic to Chinese or even Texan, hedge funds are deploying a variety of trading strategies this year to make the most of sizeable deals, including Glencore and Roche, after a freeze in deal-making dented their returns during the second half of 2011.
Known as arbitrageurs, hedge funds that make profits by betting on the outcome of mergers and acquisition activity finished 2011 with an average loss of around 2 percent, according to data from Hedge Fund Research - a far cry from the average 9.1 percent return they had enjoyed since 1990.
Economic uncertainty slowed M&A activity to its lowest since 2004 in the three last months of last year, with deal-making down 31 percent to $398 billion US.
However, deals have picked up since the start of 2012, and Glencore's 25 billion pound ($41 billion US) all-share takeover of miner Xstrata and Roche's $5.7-billion bid for U.S. gene sequencing firm Illumina provide arbitrage funds with a wide range of possible strategies to make money.
Merger arbitrage funds typically buy shares in the target company, hoping they can profit if the shares rise towards the offer price, or even from a sweetened bid, while hedging their position by short-selling the acquirer - borrowing shares you do not own and then selling them in the market, with the aim of buying them back later at a cheaper price.
Roche's all-cash hostile bid for Illumnia offers a classic arbitrage opportunity: the Swiss pharmaceutical company's strong M&A track record and its financial firepower make the deal relatively safe for hedge funds.
When bad results sent Illumina's shares into a tailspin in October, Roche came with an opportunistic $44.50-a-share offer. Illumnia had traded as high as $75 during the summer.
Since then, the stock has traded above the offer price, providing arbitrageurs with an investment opportunity called "spread" and signalling Roche would likely have to increase its offer.
Most hedge funds bought a small amount of shares on the day of the original announcement and would only build up their position when an increased offer looks imminent.
CATCHING THE BUMP
Arbitrageurs foresee lengthy trench warfare between Roche and Illumina. The difficulty is predicting when Roche will top up its bid and buying more shares just before this happens.
"I anticipate a long battle similar to Sanofi/Genzyme (in 2011), with Roche playing shareholder exhaustion and bumping its offer at the 11th hour. I hardly see them closing a deal before summer 2012," said Lionel Melka, fund manager at Paris-based Bernheim, Dreyfus & Co. and co-author of a book on arbitrage.
France's pharmaceutical group Sanofi sealed a deal with U.S. biotech firm Genzyme on February 2011 after a protracted saga initiated in the summer 2010.
"Roche are very patient. They will wait you out, look for an opportunistic moment, an ugly market or bad data, and then they pounce," said a U.S.-based fund manager.
Illumina could also use the rival bidder threat to put pressure on Roche although sector bankers say no other player would have the same synergies.
"At some point closer to the May meeting (Illumina's annual shareholder meeting), I'd bet on Illumina putting out more good news and ... showing its real value," said a second U.S.-based arbitrageur.
Hedge funds would then buy more shares in Illumina, increasing their holding from about 30 percent currently to above 50 percent and strengthening their bargaining power.
Arbitrageurs hope to fetch about $60 per share on this deal.
CHINESE OR TEXAN?
Hedge funds typically favour complex, all-share deals where in-depth research and patient combing through legal documents can give them an advantage over other investors.
In Glencore/Xstrata, most arbitrageurs do not see the risk/reward ratio as compelling enough to step in as they do not expect shares in the two companies to move much whether the deal goes through or breaks down.
Glencore made its long-awaited bid for miner Xstrata earlier this month, offering 2.8 of its shares for every 1 Xstrata share in issue to acquire the 66 percent of Xstrata Glencore does not already own.
Some are taking a different view, however, betting on the notion that the acquiree is overvalued and that the deal faces a number of hurdles and may not even get done. This is what arbitrageurs call a Chinese deal, or a reverse trade, as it applies the reverse of a classic merger arbitrage strategy.
By buying the bidder (Glencore) and short-selling the target (Xstrata), the arbitrageurs bet that the market overvalues Xstrata and is too confident a deal will get done. They expect Xstrata shares will eventually go down.
"I don't know for sure if the deal will eventually go through but I am pretty sure that volatility will arise at some point due to the lengthy regulatory process and the commodities' prices," said Melka.
The spread between the offer price and Xstrata's trading would then widen, offering arbitrageurs a window of opportunity. This will be the moment when they would switch from the Chinese to a straight trade by selling Glencore and buying Xstrata.
Most arbitrageurs see the current offer as not very generous for Xstrata minority shareholders and do not expect Glencore to increase the conversion ratio above 2.95 or 3.
But the expected synergies and the lack of alternative for Xstrata encouraged some hedge funds to play a Texan - buying shares in both companies while shorting the benchmark trading index to hedge the deal.
"You play a Texan when you believe that both companies would outperform the market or that their combination would create a greater value", said a London-based arbitrageur, citing Colfax's acquisition of engineering firm Charter last year.
"People expected Colfax to outperform the market. They also thought it was a very good deal for them and for Charter."
Colfax shares are currently trading at $36, about 44-percent higher than when it acquired Charter in last September.
Arbitrageurs are likely to keep a close eye on "Glenstrata" even after the merger as some believe the combined entity could well make a move on sector rival Anglo-American - offering more scope for strategic trades.