Merger arbitrage to become crowded as style drifters return

2003 saw strong performances from event-driven strategies, but fortunes of sub-strategies differ wildly

Distressed hedge funds performed well last year but still have some way to go, according to hedge fund managers. Furthermore, they believe, merger arbitrage funds may also begin to perform as deals increase in number.

Distressed debt is now expensive and returns have been made but the next three to six months should still see the tail end of a strong period for the strategy, according to Tony Morrongiello, chief executive officer of 3A Alternative Asset Advisers, which manages the Altin fund of hedge funds.

The US and emerging markets were good for distressed in 2003, with some opportunities in Europe, including Parmalat, which has filed for bankruptcy. Emerging markets should continue to perform well over the next few months, but should be watched for any signs that the situation may change, he says.

Opportunities are returning for merger arbitrage managers, but with so many hedge funds in the market, and distressed managers around who switched from merger arbitrage originally, the strategy could soon become crowded, according to Morrongiello.

There have been strong inflows, particularly into highly leveraged merger arbitrage funds. Distressed is a directional strategy with risk of markets turning, while merger arbitrage risks deals falling through, but is generally more stable, according to Morrongiello.

"There is always a risk when dealing in paper – dependent on the way credit spreads relate to Treasuries – that when events like 11 September happen, the first thing to blow out is credit spreads," he says. "If you are long junk credit, credit spreads blow and liquidity is sucked out, and the strategy suffers in flight to quality."

Despite some risks, the next six months look good for event-driven strategies, says Morrongiello, but the second half-year is more concerning.

Marcus Vaughan, product manager of event-driven strategies at RMF Investment Strategies, also thinks it unlikely that distressed will have as good a year as 2003, although there are opportunities in the US and more still in Asia and Europe.

"Supply of distressed paper in the US is much lower now and will continue to fall as default rates are now at very low levels," he says. "However, there is enough restructuring work happening in the US for distressed players to earn a decent return."

Special situations are also now profitable and may remain so, he adds.

Most returns in event-driven should still come from distressed, he says.

"In the US there are still plenty of restructuring opportunities to work on, although managers will not benefit from the credit tightening that occurred in 2003," he says.

"The Asian distressed outlook is very positive with a large supply of distressed debt and few players. Positive economics and large inflows into the region can only help. European distressed is also interesting as European banks, especially German banks, continue to offload the non-performing loans from their balance sheets."

Special situations should continue to perform well, as should long/short credit players. "Credit skills will become much more important this year now that the easy ride of the credit market has almost finished," he says.

Merger arbitrage will struggle, he believes. "Deal activity certainly looks positive and the pipeline for deals in the investment banks looks very strong, but it is unlikely that spreads will widen significantly. There is still too much money chasing deals," he says.

Funds that trade on specific events performed well in 2003 and should continue to do so as companies reorganise, says to Rick Tarvin, director of research at Global Fund Analysis.

Merger arbitrage, despite more deals, is not likely to see a pick up in performance in the near-term because there is too much money chasing them.

Distressed funds have performed well and are likely to continue to do so. The main factor differentiating good funds from bad in this area is good credit analysts, says Tarvin. "They need to project forward and that is a talent," he says.

The most obvious danger to distressed managers is a rise in interest rates, which would increase the cost of debt for companies exacerbating their distressed state, he adds.

Key Points

Distressed funds are likely to see falling performance compared to last year

Deals are increasing for merger arbitrage, but there is still a lot of money chasing them

Asian and European distressed debt offers opportunities