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Arbitrage Lures Gabelli After 920 Hedge Funds Fail

Date: Monday, February 2, 2009
Author: Cristina Alesci and Michael Tsang, Bloomberg.com

Mario Gabelli is buying Wyeth to book a 13 percent profit from its takeover by Pfizer Inc. Managers at Cohen & Steers Inc. are scooping up closed-end funds trading at a 16 percent discount to the value of their holdings. Huntington Asset Advisors Inc. is betting the widest gap between silver and gold prices in 14 years will narrow.

A year ago, these so-called arbitrage strategies would have been favorites of hedge funds whose debt-fueled trading squeezed out other investors. Since then, the credit-market seizure wiped out about 920 of the 10,096 funds in business at the start of 2008, according to Hedge Fund Research Inc. The survivors have reduced borrowing to close to nothing, according to Rasini & C., a London-based investment adviser.

“The opportunities are there, and they’re much wider than they used to be,” said Peter Sorrentino, 49, who manages $16 billion including mutual-fund assets at Huntington in Cincinnati. “The fact that hedge funds are gone is exacerbating it. Back in the day, the big guys would have had them. Now, that stuff is left standing and you’re able to go out and exploit it.”

The hedge fund retreat left fewer arbitragers to push costlier assets down and cheaper ones up, allowing bigger profits just as credit markets show signs of thawing. The Libor- OIS spread, a measure of how reluctant banks are to lend, fell to 89 basis points last month to the lowest since Lehman Brothers Holdings Inc. filed for bankruptcy in September, according to data compiled by Bloomberg. One basis point equals 0.01 percentage point.

Forced Sales

Forced sales and investment losses reduced hedge fund assets by a record $600 billion in 2008, according to New York- based Morgan Stanley. Managers who specialized in trades that count on similar assets rising and falling together had the biggest losses, according to data compiled by Chicago-based Morningstar Inc. So-called corporate actions funds lost 29 percent, prompting investors to remove $3 billion, data from Morningstar showed.

Gabelli, who oversees $20 billion as chief executive officer of Gamco Investors Inc. in Rye, New York, is betting on New York-based Pfizer’s $64 billion, or $47.36-a-share takeover of rival Wyeth in Madison, New Jersey.

The 66-year-old money manager is buying the target company and betting on a decline in Pfizer, anticipating the 10 percent gap between the offer and Wyeth’s $42.97 stock price will narrow. The trade would yield 13 percent, including dividends, if the deal is completed by year-end as planned, Bloomberg data show.

‘Big Bell’

Merger arbitrage would return a median profit of 31 percent should the 21 pending U.S. takeovers with announced closing dates be completed on time, annualized data compiled by Bloomberg show. The average in the bull market between 2002 and 2007 was 12 percent annualized, London-based Barclays Plc says.

“A big bell just sounded,” Gabelli said. “If you’re making 1 percent on your cash balances and you can buy a high- quality, fully financed, cash deal and earn 12 percent annualized returns, at some point you’re going to start taking risk.”

Whitney Tilson at T2 Partners LLC is putting his money in Rohm & Haas Co., which agreed in July to be acquired by Dow Chemical Co. Tilson is keeping his bet even after Dow said it wouldn’t close the $15.4 billion takeover on time.

Dow, which offered $78 a share to buy the Philadelphia- based specialty chemical maker, said last week it was delaying the purchase because of “uncertainties” about funding.

‘Airtight Deal’

Rohm & Haas says Midland, Michigan-based Dow’s $17 billion in financing is enough to pay for the deal. The difference between Dow’s offer and Rohm & Haas stock widened to $22.81, implying a profit of 41 percent.

“They have an airtight deal, and the spread is way too wide,” Tilson, 42, said from New York. “There may be some concessions made by Rohm & Haas and the price may be reduced somewhat, but we think we’ll still do well given the price.”

Unlike hedge funds, largely unregulated investment vehicles that can trade any asset, aim to make money regardless of whether markets rise or fall and participate substantially in profits from money invested, most mutual funds aren’t allowed to juice their trading with borrowed funds.

That left them less vulnerable when credit markets froze in August 2007 after declining real-estate prices shuttered the market for securities backed by subprime mortgages and triggered the 18-month credit crisis.

The crunch has reduced the ability to speculate on mergers because takeover bids for publicly traded U.S. companies tumbled 37 percent from a year ago, data compiled by Bloomberg show.

Fool’s Errand

Steve Gross at Penso Capital Markets says the rewards of merger arbitrage aren’t worth the risks as credit constraints jeopardize deals and the biggest economic contraction in 26 years undermines profits.

“This is not an environment for heroes,” said Gross, the Cedarhurst, New York-based principal at Penso, the hedge fund and advisory firm that oversees about $400 million. “We’ve entered into a world where it has become hard for people to assess the risks of financing. It’s better to miss an opportunity than to take too many risks right now.”

Closed-end funds are ripe for arbitrage after prices fell to record lows compared with the assets they owned last quarter, according to data compiled by Thomas J. Herzfeld Advisors Inc., a Miami-based investment firm.

The funds, which issue a fixed number of shares that trade on an exchange like stocks, became a target for hedge funds squeezing profits from gaps between asset values and share prices. As the financial crisis unfolded, hedge funds unwound the trades and the discounts widened.

Closed-End Discounts

The biggest arbitrage opportunities are in closed-end funds that invest in emerging-market debt, which trade at an average 17 percent discount to their holdings, according to Herzfeld Advisors. That’s more than four times the 4 percent average for all closed-end funds between 1989 and the third quarter of 2008.

Douglas Bond, who runs the $246 million Cohen & Steers Closed-End Opportunity Fund that invests in other funds, says the risk of default drove down prices of emerging-market debt funds too far.

“There is a tremendous amount of fear in the financial markets about the potential impact of a global economic recession on emerging-market economies,” Bond, 49, said from New York. His fund bought 60,800 shares in the Morgan Stanley Emerging Markets Domestic Debt Fund last quarter, according to the firm’s Web site and data compiled by Bloomberg, when it traded at an average of $9.06 per share on the New York Stock Exchange.

Buffett For Less

The Morgan Stanley fund, which held sovereign bonds from South Africa to Mexico and Thailand, trades at a 16.2 percent discount to its assets. Should the gap narrow to the historical average for similar funds, shares bought last quarter would generate a return of almost 40 percent, Bloomberg data show.

Bond also favors closed-end funds that own dividend-paying companies. He added 294,200 shares of Eaton Vance Tax-Managed Global Diversified Equity Income Fund last quarter.

The fund trades 13.1 percent below its underlying assets, which included Nestle SA, British American Tobacco Plc and Roche Holding AG. That’s more than double the average discount for the 10 biggest funds with similar strategies.

The Boulder Growth & Income Fund lets investors buy a slice of Warren Buffett’s Berkshire Hathaway Inc. at a 19.6 discount to its market value, according to Herzfeld. About 25 percent of the assets are invested in the Omaha, Nebraska-based holding company that Buffett transformed from a failing textile maker into a $139 billion investment firm.

Precious Metals

The fund’s discount is almost four times its average of 5.2 percent in the past two decades, data compiled by Bloomberg show. That means an investor can effectively own Berkshire, which closed at $89,502 last week, for $71,960 a share.

Commodities markets are providing more trading opportunities after the Reuters/Jefferies CRB Index of 19 raw materials slumped a record 36 percent. New York-based Ospraie Management LLC, once the world’s largest hedge fund dedicated to natural resources, told investors on Sept. 2 that it would close its largest pool after slumping 39 percent.

Huntington’s Sorrentino is looking at metals, where the gap between gold and silver prices grew to the widest since 1994 last quarter.

Gold rose 5.5 percent last year on the New York Mercantile Exchange’s Comex division, the eighth straight annual gain, because traders hoarded bullion as the U.S., Europe and Japan contracted simultaneously for the first time since World War II. Silver tumbled 24 percent on concern industrial demand will wane in a recession.

LTCM’s Lesson

The price difference is more than 30 percent greater than the average in the previous 10 years, Bloomberg show data. Sorrentino stands to reap about $4.5 million in profits from a $10 million bet if the spread returns to its average.

Investors make the most money when others won’t take risks, said T2’s Tilson. Hedge funds returned an average 2.7 percent a year from 2000 to 2003 when the bursting of the dot-com bubble sent the Standard & Poor’s 500 Index down 49 percent.

Futures on the S&P 500 today lost 1.9 percent at 10:52 a.m. in London, indicating the benchmark for U.S. equities may extend its worst start to a year.

“There are probably all sorts of bargains out there for the last man standing with capital and courage,” he said.

Bets that similar assets would converge hastened the 1998 collapse of Long-Term Capital Management LP, the hedge fund run by former Salomon Brothers Inc. Vice Chairman John Meriwether. Unlike then, when rival funds exploited LTCM’s money-losing trades for their own profit, today’s opportunities arise because there are fewer competitors.

“There are more opportunities out there just because there are fewer hedge funds,” said Erik Herzfeld, 35, head of alternative strategies at Herzfeld Advisors. “If you ask John Meriwether, he’ll say arbitrage opportunities always exist. It’s a matter of to what extent.”

To contact the reporters on this story: Cristina Alesci in New York at calesci2@bloomberg.net; Michael Tsang in New York at mtsang1@bloomberg.net.