A favorite going into the games of 2010

winner2Two thousand and eight was all about the big drop in hedge fund returns, while 2009 was all about the big rebound.

So with the markets seemingly having righted themselves, the focus among investors this year is coming back to strategy – convertible arbitrage, distressed, global macro, technology and others that fall under various categories depending upon what their managers do and on what markets they are focused.

One strategy commanding particular attention is merger arbitrage, which still managed to produce so-so returns last year (see chart below).

Source: Barclay Hedge

Source: Barclay Hedge

Merger arb managers are licking their chops this year for a variety of reasons: the global economy apparently on the path to recovery, hoards of cash sitting on companies’ balance sheets, the U.S. dollar seemingly back on the rise – and talk of the day is that funds that invest simultaneously long and short in companies involved in a merger or acquisition are going to bring it home this year.

Many have questioned the very rationale for the strategy in recent years – wondering if the opportunities have all been arbitraged away.  Since we ran a post about that possibility back in March, it appears the extinction of merger arb was greatly exaggerated.  The strategy has since posted a string of nine consecutive up-months.   At the very least, merger arb seems poised to continue its recent propensity to track the S&P 500 (see related post).  But will merger arb produce alpha in 2010?

GLG, one of the world’s biggest hedge funds with more than $20 billion under management, told the Telegraph earlier this week that Kraft’s recent successful bid for Cadbury was a sign of a new cycle of M&A activity. GLG believes conditions are similar to the late 1980s and early 1990s when conglomerates and large companies spun off operations that were not reflected in their valuation.

Indeed, analysts are predicting an M&A revival in 2010, with companies leading the way as private equity firms continue to be dogged by tough credit market conditions. According to KPMG, the M&A market is set for growth after revisions of over-optimistic earnings expectations in 2009, which it blames for skewing market activity last year.

David Simpson, global M&A head for KPMG, said in the firm’s annual Global M&A Predictor released last week that analysts had overestimated corporate earnings in 2009 by some 20%, which had skewed a clear view of the market.

So are merger arbitrage funds poised to pounce on this new era of M&A activity? Do they have their short lists of acquirers and targets ready to go, stop losses and all? After mediocre performance over the past two years, one would expect the M&A guys are more than ready to see some deals by the dozens emerge, and to profit from them.

The question, as with any hedge fund strategy these days, is whether investors are willing to put their chips on the table on their behalf. Not many are, based on the flow of assets going back into the space, which can be seen from the chart below from Barclayhedge.

Source: Barclay Hedge

Source: Barclay Hedge

Then again, if President Obama’s recently declared intention to limit banks’ involvement with hedge funds holds true, a flurry of M&A activity could quickly unfold, leading to some lucrative profits for merger arb managers – at least those betting on the right divestitures, the right acquirers and the right timing – and maybe some flows back into merger arb managers’ coffers.

Let the M&A games begin.  But will merger arb managers come home with any medals?

President Obama‘s declared intention of curtailing banks’ involvement with hedge funds, among other risky activities, has left asset managers anticipating a flurry of M&A activity as banks dispose of their stakes in hedge fund managers. At least six banks globally have significant holdings in the sector.

Obama announced yesterday: “Banks will no longer be allowed to own, sponsor or invest in hedge funds, private equity funds or proprietary trading activities.”

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