Amid the highest global merger and acquisition quarterly activity in five years, the Paulson Merger Funds low volatility arbitrage strategy returned near 2% in the first quarter of 2014.
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After a strong start to the year, gains near 3.7% returns and near 7.4% in the enhanced funds in February were nearly taken back in March. Spreads upon which the arbitrage strategy depend remained tight in the first quarter, the report noted, averaging 3% to 6% “with little perceived risk,” an investor letter reviewed by ValueWalk said.
The portfolio de-emphasized low yield simple spreads, focusing instead on complex deal structures, competitive bids, hostile takeovers, spin-offs, accretive acquires, liquidations, exchange offers and pre-announced deals. “This approach should enable us to obtain higher returns than those available from spreads alone,” the letter said. “Having this broad toolkit and knowing how to implement it has typically permitted us to deliver above average investment returns consistently through different market cycles, including the current low interest rate environment.”
Vodafone Group Plc (NASDAQ:VOD) (LON:VOD) is an example of a complex spread that returned above average returns when compared to a “plain vanilla spread deal.” Last September, Verizon Communications Inc. (NYSE:VZ) agreed to pay $130 billion to purchase Vodafone Group Plc (NASDAQ:VOD) (LON:VOD)’s 45% stake in Verizon Wireless, for example. Vodafone received $59 billion in cash and $60 billion in Verizon stock along with $11 billion an additional consideration. The transaction, with closed in February of 2014, returned cash to shareholders and generated a 29% return for the fund, the letter noted.
Identifying takeovers before announcement
The letter noted the fund’s positive track record at identifying takeover targets prior to public announcement of the deals. The hedge fund investment teams have sector specific experience in industry consolidation and apply this knowledge to make investments in companies that are likely takeover targets. “While the risks in these investments are higher than the risks in announced deals, we attempt to mitigate the downside by choosing targets that trade at discounted valuations and could rise even if no takeover occurs,” the letter said, pointing to a higher risk reward ratio than the funds other strategies. Included in the fund’s wheelhouse of activity are takeover targets Time Warner Cable Inc (NYSE:TWC) and Thermo Fisher Scientific Inc. (NYSE:TMO).