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A recent string of corporate mergers, notably the $57 billion deal between marketing mammoths
(GGet Report), has the Street buzzing over potential profits from corporate pairings.
For John Orrico, portfolio manager of the $269 million (ARBFX) Arbitrage Fund, the chatter has grown so loud that he decided to reopen his fund this week after being closed to new investors for the past year.
The Arbitrage Fund employs a strategy called merger arbitrage that calls for buying the stock of an acquisition target and selling short the would-be acquirer. The idea is to exploit the so-called spread between trading prices and the agreed-upon merger price. This spread arises due to uncertainty about whether a deal will close and typically narrows as closing approaches.
spoke with Orrico about the markets vibrant mood surrounding mergers, as well as where investors might look for the next possible mega-marriage.
We are reopening because deal flow has been elevated since the end of 2004 and we have the capacity to take advantage of it. And deal flow has increased not just in the mega-caps like P&G and Gillette, but across a wide array of market caps and industries. too.
We always remained fully invested, but the opportunities have definitely improved. Weve seen spreads widen because of the increased deal volume. Due to the level of deal flow, we are at a point where the number of dollars invested in this strategy is becoming easily absorbed by the number of deals out there, and that has not always been the case.
We think the deal makes sense strategically for both companies. Its a well thought-out deal with strong rationale related to distribution, technology and strategic positioning, which are all competitive strengths for P&G. And we think they are in a position to take Gillettes business to a whole new level in terms of growth on the top and bottom line.
What we expected to happen — and actually we are seeing it now — is that competitors are being forced to react to what they see going on within their industry. So while it is hard to predict what
(CL) will do in response to P&Gs move, we do know that competitors tend to react to what their peers are doing. There is a natural competitive response that takes place when there is consolidation in an industry.
A big component of our review is figuring out what the regulators will think about the deal. We want to find out how the regulators will react in terms of the combined companys concentration within the industry. For example, in a telecommunications deal we want to know how the Justice Department or the
Federal Communications Commission will view it with regard to pricing and how customers will react to the deal. If our analysis says there are too many hurdles to a deal, then we will avoid the deal.
There is not so much money chasing too few deals like there was in 2000 and 2001. But what people need to realize is that this is now happening across the spectrum and internationally as well.
We think the P&G deal will take six to seven months to close, and right now the market is offering a spread at about a 3% rate or return. Annualized this is about a 5% rate of return, which is quite low — not abnormally low, but its low within the spectrum of deal flow. We normally target annualized returns of 6% to 8%. Our annualized return for the last four years, or since inception, has been over 8%.
Because of the way we invest, we tend not to be correlated with the equity and fixed-income markets, which is definitely a plus for investors looking to diversify.
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