Friday, December 31, 2004
Deal.com on Gloom in Risk Arb Land
Bring in the bomb squad!
by Scott Stuart Posted 03:48 EST, 8, Dec 2004
Leon Frank arrived at his desk Monday morning to find a lawsuit alleging that one target had committed fraud against the U.S. government, that a financial backer had gotten cold feet about another, that the Venezuelan government might shut down some operations in that country and that an explosion at a chemical plant in Alabama could scuttle a sale.
Just another day in arb land. And this might count as a good day, or at least a necessary one.
If there is a Leon Frank out there in the hedge fund world, we apologize. We made the name up. The point is that after chalking up phenomenal returns in the late 1990s, the business of risk arbitrage has been limping, and calamities such as those of the apocryphal Leon, as risky as they may seem, are the only source of relief for arbs. They at least provide the kind of uncertainty that yields decent spreads.
By many measures, 2004 was simply an awful year for arbs. Merger activity was still sluggish, and worse, over the summer a string of major transactions blew up or were repriced, many for reasons that were unforeseeable if not downright freakish: Titan Corp.-Lockheed Martin Corp. (Foreign Corrupt Practices Act); Monolithic System Technology Inc.-Synopsys Inc. (patent litigation); WellPoint Health Networks Inc.-Anthem Inc. (insurance regulator's objections); Advanced Fibre Communications Inc.-Tellabs Inc. (financial performance); InVision Technologies Inc.-General Electric Co. (FCPA); PanAmSat Corp.-Kohlberg Kravis Roberts & Co. (satellite malfunction).
Meanwhile, with financial buyers driving so much M&A activity, other deals fell victim to sponsors' tendency to demand price cuts at the signs of the slightest glitch.
In June, Oak Hill Capital Partners LP cut its $17 per share offer for Duane Reade Inc. to $16.50, citing an adverse ruling in a labor case against the drugstore chain. In August Leonard Green & Partners LP sliced its take-private offer for Hollywood Entertainment Corp. by 27%. And Silver Acquisition Corp., an entity backed by Cypress Group and DLJ Merchant Banking Partners, used a fraud claim against Gold Banc Corp. to slash its offer by about 10%, prompting Gold Banc to walk away.
Many of these deals were not trading as high-risk transactions before their spreads blew out: Titan, Advanced Fibre, InVision, WellPoint and PanAmSat all traded for annualized returns of between 4% and 6% — a more or less standard return for a "safe arb situation" in the current market.
This all would have been bad enough. But compounding matters, there were few opportunities to make up the losses on those deals. The headline deal of the fall, Kmart Holding Corp.'s $10.7 billion takeover of Sears, Roebuck and Co., was difficult to play because it was hard to short Kmart.
In the end, though, the problems of these particular deals may, largely, have been one-off. There are bigger difficulties than a few deals that tank, and these are systemic.
The truth of the matter is that as the arbitrage business has grown and matured, it has become increasingly commoditized. That is why some arbs feel the market has underestimated and underpriced the risks on deals this year.
Veterans of the game are asking whether there will be enough dealflow to feed on in the future or if there is now so much capital in the field that traditional, bread-and-butter spread playing has become a low-returns game.
It wasn't always like that. Historically, the business was built around cautious approaches to terrible risk-reward scenarios. In the 1990s it provided fine returns with very limited risk.
But spreads in simple deals have narrowed markedly as buyers with almost quantitative approaches have flooded the market. The days of setting up plain-vanilla spreads and racking up 15% to 20% annualized returns are gone for the next 20 years, one arb boldly predicts.
Many arbs will tell you that the qualitative aspect of risk arbitrage will in the end save them from this commoditization. When big deals blow up, they say, it will shake capital out of the market and "leave the strategy to the real arbs."
But the blowups of this past summer do not seem to have had any such effect. Spreads widened almost across the board for a time, but the fallout was short-lived.
Increasingly, it seems that the way to make money in risk arbitrage is to invest in deals that any self-respecting arb wouldn't touch: Problem-plagued situations such as the ones our Leon was tracking. That forces arbs into playing the equity market's equivalent of a bomb squad, however, rushing to the scene of impending disasters where spreads are more respectable.
Some longtime arbs have thrown in the towel and looked to new strategies rather than join the bomb squad. Some funds have put more emphasis on distressed debt. Some arbs say they are forced to "be creative" and pay more attention to spinoffs, auctions and situations that have complex valuation issues.
Some of the malaise is no doubt cyclical. If there were a deeper pool of pending transactions, life would be easier. And in a bearish equity market, deal quality erodes. Cash deals, especially leveraged buyouts, carry added financing risks and the risks of an inherently jittery set of buyers.
(One buyout that stumbled didn't play out so badly for arbs who hung around. When Leonard Green pulled back from Hollywood Entertainment, two strategic bidders, Blockbuster Inc. and Movie Gallery Inc., stepped up with bids.)
And arbs aren't suffering alone. Returns in the stock market, private equity and venture capital have also slumped.
There have been a few encouraging up-ticks in merger dealflow over the past year, particularly late in the third quarter. There is a lot of pent-up cash in corporate America, which has some arbs hopeful that merger activity will rise. Some arbitrage operations have ramped up their marketing efforts because they think the time is ripe now to roll out hedge fund products and court new investors.
But so far the up-ticks have been short-lived, and arbs do not expect a stampede of new deals to create new opportunities in the New Year. The U.K. and Australia have experienced renewed activity, but the global universe of deals is relatively stagnant. And there is currently no deal that replaces Cingular Wireless LLC's $41 billion extended takeover of AT&T Wireless Services Inc., which was the major play for arbs in 2004.
The critical driver of M&A is CEO confidence, and some arbs do not think that has momentum. Consumer confidence, which is a correlate of CEO confidence, was at an eight-month low heading into December, which does not bode well for a near-term pickup in M&A volume.
Higher interest rates should bring wider deal spreads and slightly better risk-reward scenarios. But interest rate relief itself is not the saving grace for risk arbitrage.
As long as dealflow remains slow, particularly in the U.S., arbs are driven by limited opportunities to explore the lower-quality deals where risks tend often to be underpriced. And until M&A activity picks up, it will be hard to recovering from losses on scuttled deals.
Until then, Leon is likely to keep watching for bombs, and ducking.
by Scott Stuart Posted 03:48 EST, 8, Dec 2004
Leon Frank arrived at his desk Monday morning to find a lawsuit alleging that one target had committed fraud against the U.S. government, that a financial backer had gotten cold feet about another, that the Venezuelan government might shut down some operations in that country and that an explosion at a chemical plant in Alabama could scuttle a sale.
Just another day in arb land. And this might count as a good day, or at least a necessary one.
If there is a Leon Frank out there in the hedge fund world, we apologize. We made the name up. The point is that after chalking up phenomenal returns in the late 1990s, the business of risk arbitrage has been limping, and calamities such as those of the apocryphal Leon, as risky as they may seem, are the only source of relief for arbs. They at least provide the kind of uncertainty that yields decent spreads.
By many measures, 2004 was simply an awful year for arbs. Merger activity was still sluggish, and worse, over the summer a string of major transactions blew up or were repriced, many for reasons that were unforeseeable if not downright freakish: Titan Corp.-Lockheed Martin Corp. (Foreign Corrupt Practices Act); Monolithic System Technology Inc.-Synopsys Inc. (patent litigation); WellPoint Health Networks Inc.-Anthem Inc. (insurance regulator's objections); Advanced Fibre Communications Inc.-Tellabs Inc. (financial performance); InVision Technologies Inc.-General Electric Co. (FCPA); PanAmSat Corp.-Kohlberg Kravis Roberts & Co. (satellite malfunction).
Meanwhile, with financial buyers driving so much M&A activity, other deals fell victim to sponsors' tendency to demand price cuts at the signs of the slightest glitch.
In June, Oak Hill Capital Partners LP cut its $17 per share offer for Duane Reade Inc. to $16.50, citing an adverse ruling in a labor case against the drugstore chain. In August Leonard Green & Partners LP sliced its take-private offer for Hollywood Entertainment Corp. by 27%. And Silver Acquisition Corp., an entity backed by Cypress Group and DLJ Merchant Banking Partners, used a fraud claim against Gold Banc Corp. to slash its offer by about 10%, prompting Gold Banc to walk away.
Many of these deals were not trading as high-risk transactions before their spreads blew out: Titan, Advanced Fibre, InVision, WellPoint and PanAmSat all traded for annualized returns of between 4% and 6% — a more or less standard return for a "safe arb situation" in the current market.
This all would have been bad enough. But compounding matters, there were few opportunities to make up the losses on those deals. The headline deal of the fall, Kmart Holding Corp.'s $10.7 billion takeover of Sears, Roebuck and Co., was difficult to play because it was hard to short Kmart.
In the end, though, the problems of these particular deals may, largely, have been one-off. There are bigger difficulties than a few deals that tank, and these are systemic.
The truth of the matter is that as the arbitrage business has grown and matured, it has become increasingly commoditized. That is why some arbs feel the market has underestimated and underpriced the risks on deals this year.
Veterans of the game are asking whether there will be enough dealflow to feed on in the future or if there is now so much capital in the field that traditional, bread-and-butter spread playing has become a low-returns game.
It wasn't always like that. Historically, the business was built around cautious approaches to terrible risk-reward scenarios. In the 1990s it provided fine returns with very limited risk.
But spreads in simple deals have narrowed markedly as buyers with almost quantitative approaches have flooded the market. The days of setting up plain-vanilla spreads and racking up 15% to 20% annualized returns are gone for the next 20 years, one arb boldly predicts.
Many arbs will tell you that the qualitative aspect of risk arbitrage will in the end save them from this commoditization. When big deals blow up, they say, it will shake capital out of the market and "leave the strategy to the real arbs."
But the blowups of this past summer do not seem to have had any such effect. Spreads widened almost across the board for a time, but the fallout was short-lived.
Increasingly, it seems that the way to make money in risk arbitrage is to invest in deals that any self-respecting arb wouldn't touch: Problem-plagued situations such as the ones our Leon was tracking. That forces arbs into playing the equity market's equivalent of a bomb squad, however, rushing to the scene of impending disasters where spreads are more respectable.
Some longtime arbs have thrown in the towel and looked to new strategies rather than join the bomb squad. Some funds have put more emphasis on distressed debt. Some arbs say they are forced to "be creative" and pay more attention to spinoffs, auctions and situations that have complex valuation issues.
Some of the malaise is no doubt cyclical. If there were a deeper pool of pending transactions, life would be easier. And in a bearish equity market, deal quality erodes. Cash deals, especially leveraged buyouts, carry added financing risks and the risks of an inherently jittery set of buyers.
(One buyout that stumbled didn't play out so badly for arbs who hung around. When Leonard Green pulled back from Hollywood Entertainment, two strategic bidders, Blockbuster Inc. and Movie Gallery Inc., stepped up with bids.)
And arbs aren't suffering alone. Returns in the stock market, private equity and venture capital have also slumped.
There have been a few encouraging up-ticks in merger dealflow over the past year, particularly late in the third quarter. There is a lot of pent-up cash in corporate America, which has some arbs hopeful that merger activity will rise. Some arbitrage operations have ramped up their marketing efforts because they think the time is ripe now to roll out hedge fund products and court new investors.
But so far the up-ticks have been short-lived, and arbs do not expect a stampede of new deals to create new opportunities in the New Year. The U.K. and Australia have experienced renewed activity, but the global universe of deals is relatively stagnant. And there is currently no deal that replaces Cingular Wireless LLC's $41 billion extended takeover of AT&T Wireless Services Inc., which was the major play for arbs in 2004.
The critical driver of M&A is CEO confidence, and some arbs do not think that has momentum. Consumer confidence, which is a correlate of CEO confidence, was at an eight-month low heading into December, which does not bode well for a near-term pickup in M&A volume.
Higher interest rates should bring wider deal spreads and slightly better risk-reward scenarios. But interest rate relief itself is not the saving grace for risk arbitrage.
As long as dealflow remains slow, particularly in the U.S., arbs are driven by limited opportunities to explore the lower-quality deals where risks tend often to be underpriced. And until M&A activity picks up, it will be hard to recovering from losses on scuttled deals.
Until then, Leon is likely to keep watching for bombs, and ducking.
# posted by Tom @ 11:05 AM 
