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Merger arbitrage is one of the most common hedge fund strategies that can produce relatively small correlations with market returns. This doesn’t mean that the strategy is risk-free though. When a merger is announced the acquired company’s stock price increases close to the merger price but usually stays a little bit below the announced price. The spread between actual price and the announced price is what merger arbitrageurs aim to make for their investors. One of the best pieces on merger arbitrage is written by Joel Greenblatt in You Can Be A Stock Market Genius. Here is how he explains the risks in merger (or risk) arbitrage:

First, the deal may not go through for a variety of reasons. These may include regulatory problems, financing problems, extraordinary changes in a company’s business, discoveries during the due diligence process, personality problems, or any number of legally justifiable reasons people use when they change their mind. In the event of a broken deal, (acquired) Company B’s shares may fall back to the predeal price of $25 (from $38) or even lower, resulting for big losses for the arbitrageur. The second risk that the arbitrageur is underwriting is the timing risk. Depending upon the type of the deal and industry involved, merger deals can take from one to eighteen months to close. Part of the $2 spread made by the arbitrageur is payment for the time value of laying out $38 before the close of the deal (when the acquirer purchases all of company B’s shares at $40). One of the arbitrageur’s jobs is to assess the time required for the merger to be consummated.

As you can see this is not an easy strategy to implement for do-it-yourself individual investors. Hedge funds have access to experts, lawyers and other professionals who can judge more accurately which mergers will go through and which ones are more likely to fall apart. If you make a single mistake it can wipe out all your returns in a given year. Insider Monkey, your source for free insider trading data, thinks imitating prominent hedge funds’ merger arbitrage plays might be a better option for individual investors. Here are hedge funds’ most favorite merger arbitrage plays during the fourth quarter:

1. Qwest Communications (Q): Qwest is being acquired by Century Link (CTL). Qwest shareholders will receive 0.1664 CTL shares for each Q shares they own. Tom Steyer’s Farallon Capital had a $175 Million Q position at the end of December.

2. Dollar Thrifty Auto Group (DTG): Dollar Thrifty and Avis have been trying to clear regulatory hurdles for a potential acquisition of Dollar Thrifty by Avis Budget (CAR). Richard Perry’s Perry Capital had a $25 Million long DTG position. However, Bridger’s Roberto Mignone had put options on DTG and he was long CAR.

3. Alcon (ACL): This was one of the most favorite merger arbitrage plays among hedge funds. Alcon is acquired by Novartis (NVS). John Burbank’s Passport Capital, Tom Steyer’s Farallon, Jim Simons’ Renaissance, and Dan Loeb’s Third Point had Alcon in their portfolios at the end of December.

4. Universal American Corp (UAM): CVS Caremark (CVS) announced at the end of December that it is acquiring UAM. The deal is expected to close at the end of June. Richard Perry had a $139 Million UAM position at the end of December.

Source: Hedge Funds' Favorite Merger Arbitrage Plays