Tuesday, November 11, 2008 0 comments ++[ CLICK TO COMMENT ]++

Another example of risk arbitrage blowing up...for an unusual reason

I have talked about merger arbitrage blowing up in the past and here is another example. In the recent case, a Canadian hedge fund has posted massive losses this year due to some unusual problems with their merger arbitrage positions.

The fund posted superb returns over the last few years, only to collapse this year:

The president of Lawrence Asset Management Inc. made a name for himself running the firm's flagship hedge fund with stellar returns such as his 75-per-cent gain in 2007.

But the stock market crash has dealt a blow to Lawrence Partners Fund, which suspended redemptions this week after plunging 65 per cent for the first 10 months of this year.

Do keep in mind that returns are geometric so a 50% decline would wipe out a 100% gain in the past. The problem with hedge funds is that you cannot tell if they are making money due to skill or via leverage. A 75% return in one year is great but how much of that is due to leverage? There are many hedge fund managers who have records far better than the young Buffett (1960's & 1970's) but are nowhere near as good in my opinion. They do well due to leverage. Even someone like William Ackman, who some people think is a top investor, boosts his returns using derivatives such as CDS and options so I'm not quite sure how good he really is.

Anyway, going back to the story, the relevant part about the risk arbitrage is the following:

Sources close to Lawrence Partners say the fund's prime brokers at BMO Nesbitt Burns and CIBC World Markets cut back on their loans, and that forced the fund to sell holdings in takeover targets Fording Canadian Coal Trust and BCE Inc. at a loss.

The fund was also “negatively impacted” by the delay in closing and lowered pricing in the acquisition of PBS Coals – a major holding – by OAO Severstal, Mr. Sood wrote.

Days before the fund was expected to receive proceeds from the deal, PBS Coals went into a renegotiation process that led to the hedge fund receiving less than 70 per cent of the expected proceeds, and several weeks later than expected, Mr. Sood said.

This is an unfortunate way to lose money. There are two different causes here.

One is the lowered takeover price for PBS Coals. If you take risk arbitrage positions, it is important for you to realize that there is always a possibility of the takeover price being lowered. This is why I tend to look at wide spreads. Admittedly wide spreads imply much higher risk but at least it would mitigate a lowered price.

The unfortunate part for the hedge fund in question has to do with the Fording and BCE deals. Fording closed successfully and BCE likely will (I think so.) Yet you have this fund posting massive losses on those deals. The reason, of course, as the story says, is that the prime brokers pulled their loans. Now, how many people would have expected big losses on deals that closed (or will likely close) successfully simply because loans were called?

If you are into risk arbitrage, you can learn some lessons from these blow ups.

The blow up from the January situation I described was typical of failed deals. Nearly all M&A funds use leverage to boost returns. They are almost forced to do this because takeover spreads during normal times are less than 5% over, say, 10 months. When a deal collapses, the funds can end up with huge losses if they don't unload quickly and if they can't hedge the risk.

So the lesson is that leverage is dangerous, especially for risk arbitrage where a deal failure can result in a stock losing 30% of its value within a few minutes. On top of leverage amplifying losses, you can get situations where the bank calls in the loan during inopportune times--like when all your assets are down.

However, do keep in mind that using leverage for arbitrage is fine according to Warren Buffett (As far as I can tell, Warren Buffett has recommended to never use leverage for any other investment activities, including the typical long-only investing.) It might seem like I'm contradicting myself here but not really. My point is not that you should never leverage with risk arbitrage but, rather, you should be very conscious of the risk. If you are borrowing money make sure you can pay them from assets that are liquid and unlikely to suffer big declines in most circumstances (say, short-term government bonds.) Collateralizing your borrowing with stocks--what most investors do--is akin to skating on thin ice.


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