Monday, February 2, 2009 2 comments

John Paulson partner letter... talks about M&A

There is a reason I gave the investor of the year Turtle award to John Paulson. New York Times' DealBook has a run down of his performance and includes his partner letter (thanks to gurufocus for pointing out the article.) You might want to check out his letter to see where he stands.

He is still bearish on financials and seems to have a negative view towards the broad market and the economy (this is somewhat similar to my view, although I am not as bearish on financials as he is.) The interesting thing for me is his comment about M&A arbitrage. Amazingly, while most investors, including hedge funds that specialize in risk arbitrage (sometimes called 'event-driven' funds,) were negative last year, Paulson's finished positive. He has some thoughts on M&A and it is somewhat similar to my view:

(source: The Paulson Funds 2008 Year-end report, Paulson & Co)

Our merger funds produced positive returns for the year in the face of steep market declines and numerous deal failures. A properly managed Merger Arbitrage portfolio can protect capital in down markets while showing attractive long term returns.

As I have mentioned in the past, one of the most attractive aspects of risk arbitrage or special situation investing in general, is the ability to post positive returns in down markets and this is one of the reasons Warren Buffett had positive returns in some down markets in his younger life. Paulson points out how he has been running his risk arbitrage fund since 1994 with only a single down year. It's hard to do that by long-only investing in some asset. The downside to risk arbitrage is that returns will be lower than owning companies, and it will be difficult as the fund gets really large.

The weakening economy in 2008 required an adjustment of our merger arbitrage strategy to a more defensive position. Our strategy in 2008 was to sharply reduce allocations to the hostile offer area, continue to avoid and in some cases short LBO deals, reduce exposure to the merger/event area, fully hedge our market exposure and increase the allocation to the corporate strategic deal spread area. Generally, recessions cause merger volumes to decline, corporate earnings to fall, credit to contract, and stock prices to fall which, in turn, causes the more speculative areas of merger arbitrage to underperform. In 2008, many hostile offers were withdrawn (BHP/Rio, Vale/Xstrata, NRG/Calpine, OMV/MOL), leveraged buyouts failed (Apollo/Huntsman, Ontario Teachers/BCE, Fortress/Penn Gaming, Blackstone/Alliance Data), and long concentrated activists positions collapsed (Deuschte Bourse, CSX, and Cleveland Cliffs). By minimizing our allocation to these areas and hedging out the market risks we mitigated the impact from these areas on our overall results.

The silver lining from losses in these more speculative areas was a sharp rise in the spreads in corporate strategic deals. In fact, spreads in strategic deals widened to the highest rates of return over the past 20 years. The spread in Inbev’s $70 per share all cash acquisition of Anheuser Busch, for example, widened in October to over a 90% annualized rate. The market mispriced the risk of the transaction creating a strong buying opportunity. We aggressively added to our position in October 2008 with our funds becoming the largest shareholder of Anheuser Busch and Anheuser Busch becoming our largest position. When the merger closed in November at the agreed $70 price, the gain represented the largest profit we ever earned on a spread deal in our history.

We can see how he finished positive: he bet big on the Anheuser Busch deal, which closed successfully.

The important point he makes is that he is starting to favour strategic deals rather than financial buyers (example of financial buyers are private equity firms or investment funds.) He says he even shorted some of the LBO deals last year. I share a similar view right now, in favouring strategic buyouts, but risk is still present (e.g. consider the Rohm & Haas buyout by Dow, which seems to be on the verge of collapse.)

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2 Response to John Paulson partner letter... talks about M&A

February 2, 2009 at 11:16 PM

Hey Siv,

Any thoughts on the Pfizer deal?

February 3, 2009 at 11:14 AM

I haven't looked at that deal much but usually I wait for a while for the info to be digested. Typcially the upside is low initially and that's the case right now. The upside is too low for me. We are looking at around 10% upside for a deal that may close by October. It's not terrible but I would get interested if the upside were, say, 15% to 20%. If the price declines a few dollars, maybe due to some panic selling, it would be more attractive. The good thing about the Wyeth deal is that the downside is low--around 10% to 15%.

The only M&A deal that I've looked at is the Westaff (WSTF) buyout. This one will close in two months (if everything goes smoothly) and the upside is around 15% (right now 13% it seems). But it's a very risky deal and the downside could be as much as 80%! So I'm not sure whether I want to risk capital. Also, I have zero interest in owning this company if the deal fails (whereas I'm ok with owning BCE or Puget Sound.)

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