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Although risk arbitrageurs were slammed by a series of busted deals as 1999 ended, annual returns appear to be strong and the trading fraternity is upbeat about the new year as well.Arbs expect heavy deal flow in the first half of 2000, prompted in part by the scheduled demise of pooling accounting. In addition, says one arb from a major New York investment bank, capital inflows into risk arbitrage look strong.Despite that good news, arbs are growing cautious about tougher stances by antitrust regulators on some M&A deals.Annual returns for merger arbitrage are tough to come by because hedge funds and investment bank trading desks that specialize in merger speculation are, in the main, a secretive lot. However, most arbs have pegged average annual returns at about 20%, depending on the cost of money-although a few expect a more modest 15%.By contrast, in 1998, arbs estimated average returns of only 8.5%. The collapse of hedge fund Long-Term Capital Management, which had piled heavily into merger arbitrage as its macroglobal bets fizzled, reduced 1998 arb returns.In 1999, a handful of broken deals did shave arb returns at yearend, most particularly Abbotts Laboratories’ aborted merger with Alza Corp. Arbs in the $7 billion Alza deal, which was heavy played, lost between 10% and 15% of the year’s gains, one trader estimated. “Depending on how much leverage they used, that could be more,” he said.Merger arbitrage is the practice of trading in stocks in merging companies. In a stock swap, because shares of the target company are exchanged for shares of the acquirer when the deal is completed, the two securities can be viewed as essentially the same. Assuming that a merger offer includes a premium to the target stock price, arbs may take a position by buying shares in the target company and selling short shares of the acquirer in proportion to the deal ratio. In a short sale, an investor sells borrowed stock and deposits the proceeds as collateral until the short is covered, or the stock is repurchased and returned.A simple example: BP Amoco, trading at $59.13 per share, is buying Atlantic Richfield Co., which is trading at $85.38, for 1.64 shares of BP for each Arco share. Each short sale of 1.64 shares of BP gains $96.97, or $11.59 profit over the cost of one Arco share. That difference, the spread, is a 13.6% gain over the $85.38 cost of Arco. On completion of the deal, an Arco share would be exchanged for 1.64 shares of BP, which would be used to cover the short sale.The size of the deal spread is an indication of the level of risk and the time span arbs attach to its completion. As a consequence, deals with considerable antitrust or financing concerns can trade at spreads well over 10%, while deals without significant problems trade at 3% or 4% spreads. Naturally, as a transaction nears its close, the spread can narrow to less than 1%.As the year ends, spreads on some deals open simply because arbs are pulling back to protect year-end gains, noted one arb with $400 million under management. This December, an arb desk with $1 billion under management might have have $300 million to $400 million invested in long positions, a second arb noted. In January, arbs will be fully invested again, he said. Deals that will likely get the most attention early in 2000 include: Motorola Inc.’s merger with General Instrument, which is expected to close within weeks; Pfizer’s bid for Warner-Lambert; Vodafone’s hostile bid for Mannesmann. And the Media One-AT&T deal and the US West-Qwest Communications transaction, both of which should close during the first half of the year, will continue to be big arb plays.The recently announced merger of Monsanto Co. and Pharmacia & Upjohn may be another matter. “I don’t know anyone with a position in Monsanto yet,” he said. The reason: The deal has been received poorly by investors and may not get shareholder approval. Perhaps more important, many arbs lost money both on Monsanto’s failure to complete its merger with American Home Products Corp. in 1998 and on its recent termination of the deal for Delta & Pine Land Co. Arbs often steer clear of companies that have disappointed in the past.On the positive side, an arb liked American Online’s stock swap with Mapquest.com, which seemed to have no regulatory issues in a market that has been rocked by antitrust reviews of late. Clear Channel Communications’ deal with AMFM Inc., which is under Federal Trade Commission review, is the best spread currently, the arb noted. AMFM traded at about $6.19, or 7.9%, to its deal value. However, Clear Channel has worked through FTC antitrust reviews well, he said. The trickiest FTC reviews in coming months will be deals that represent vertical integrations, such as Abbott and Alza, rather than those that have a traditional market share problem, like AMFM, he said. Other arbs are less confident about the clarity of recent FTC deal busts. “There are no clear [antitrust] issues anymore,” one arb declared. When the Pathmark-Royal Ahold deal cratered over its review in late December, the companies insisted that the FTC had changed the antitrust rules. “How do you confirm that?” he said. “The government doesn’t talk, you’re out in no-man’s land.” “Both the FTC and the DOJ are coming out with a less standard way of looking at deals,” added another arb. “It’s not going to be as easy to psych-out, with the help of antitrust attorneys, what the problem would be and what the fix would be,” he said. “In addition, it’s not as clear that the fix will be independent of core technology, which has been typical in the past.”Potential changes in antitrust reviews makes planning for arbs difficult and could affect corporate M&A strategies, the arb said. This raises the question of whether arbs are mispricing antitrust risk. Deals with antitrust concerns should be trading at spreads of 18% to 20%, he suggested.

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