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John Paulson: “Some of the most profitable trades we have done have been on the short side” |
John Paulson is regarded by many in the market as the king of merger arbitrage. He started his fund, Paulson & Company, in 1994, after a career with Bear Stearns in M&A and then as a partner at Gruss & Partners. His fund management firm now has more than $6 billion in assets. Merger arbitrage has been one of the top-performing strategies of 2006. As of the end of October, the HFRI merger arbitrage index had returned 11.76% year to date, and such high returns could well be expected to continue into 2007 as M&A activity continues to be strong.
“This year there has been a significant amount of merger activity in Europe, fuelled by the desire of companies to get bigger than their home market allows,” says Paulson. “In particular there has been consolidation in the banking, pharmaceutical and utilities sectors in Europe, and it is this sensible amount of consolidation that has created opportunities for us. Plus, the economic environment is favourable for merger activity in Europe. The economies are doing well; stock markets are up so companies are willing to use their stock as currency to make acquisitions; and there is readily available financing from banks and bond markets that are willing to finance deals at low interest rates.” The US has also seen a large amount of merger activity, says Paulson – particularly in the energy, mining and telecommunications sectors.
Tight spreads
In terms of profitability, however, Paulson says that merger arbitrage is suffering from the similar tightening of spreads experienced in the credit markets. Numerous bidding wars, however, have enabled profits to be generated. “The spread business has not been particularly attractive. However, a lot of money was made this year in competitive bidding situations in announced deals in Europe.” The most profitable deal he names was Endesa. “It initially received a bid from Gas Natural for €21, then E.On made a topping bid of around €27 per share, then Acciona bought stock at €32 a share, causing E.On to raise its bid to €35. That last bid is over 60% more than Gas Natural’s initial bid. In Europe there were also significant bidding wars in Arcelor (steel), Shering (pharmaceuticals), British Airport Authority and Associated British Ports (both infrastructure). And in Canada, mining firms Falconbridge and Inco were both targets in aggressive bidding wars.”
Shareholder activism
Paulson says it is obviously difficult to predict what deal flow will be like in 2007 but so far this year there has been no let-up in activity. Many involved in the market agree. Attila Bodi, an M&A partner at law firm McDermott Will & Emery in New York, says: “I think we’ll see further consolidation next year in several sectors, resulting in increased or sustained deal flow, especially in biotech, energy and financial services. And I would keep an eye on the luxury goods, commercial real estate and technology sectors as well.” Aside from favourable financing and a strong economy, consolidation is being driven by the increase in shareholder activism. “The growth in shareholder activism is increasing M&A activity and uncertainty in M&A, which in turn provides greater opportunities for merger arbitrage hedge funds,” says Geert Raaijmakers, partner in the corporate practice group at Dutch law firm NautaDutilh.
Shorting opportunities
But if deal flow does slow, it will not be the end of the world, says Paulson. “There are many ways to make money in merger arbitrage, and the spread business is just one of them,” he says. “There are opportunities within deals with complex structures and deals can be shorted where you can profit if a deal breaks.” Two deals broke in the US this year as a result of bipartisan regulatory disagreements. This shorting strategy is the most difficult, he points out. “Some of the most profitable trades we have done have been on the short side but it is tricky because the majority of deals close – it can be like finding a needle in a haystack, but over time we have seem patterns emerge.”
Although Paulson says he has not seen an emergence of new merger arbitrage funds being founded on the back of the current wave in M&A, he says that he has witnessed multi-strategy funds involved in merger situations. “I’m not concerned about competition,” says Paulson. Ninety percent of his fund’s analysts have an M&A background from top-tier investment banks, and the firm has a proprietary database of all deals and a global network of legal, business and regulatory relationships that give it a competitive advantage. “Over time we have invested in well over a thousand M&A transactions,” Paulson says. “We currently analyse every significant announced transaction globally. Our infrastructure, experience and skill set give us an edge in managing a global merger arbitrage portfolio.”
