Sunday, 11 April 2010

Returns from Special Situations to Become Special Again?

A few months ago I was a guest on the hedge fund radio show "The Naked Short Club" on Resonance FM. A question for the panel was "which hedge fund strategies did we each prefer this year?" My choice then and now are the event-driven strategies. I chose those strategies partly because the evidence of surveys of investors have not mentioned event-driven as a favourite (except for distressed), and on the basis of the market environment I see unfolding this year. Distressed securities funds posted the biggest inflow as a percentage of AUM in February this year (at 4.2% of assets) according to TrimTabs Investment Research and BarclayHedge - so they are hardly being ignored.

It still remains the case that investors compiling survey responses cite what has done well for the last six months, but what has changed over a shorter time-frame is the outlook for the special situations component of the event driven set of strategies. At the turn of the year it was somewhat fanciful to suggest that the market environment would be suitable for special sits investors - up to that point corporate activity was very limited in publicly traded markets. From a UK perspective we had a clear landmark takeover in the acquisition of Cadbury's by Kraft Inc, but other forms of M&A activity have taken place and there is activity in sectors beyond those that are consumer-related. The stock markets have reached recovery highs, retracing all of the fall from the second week of January into mid February. This has revived the animal spirits that drive markets, and primary and secondary issuance has picked up and will increase from here. 

IPOs  Spin-outs and Buy-ins as well as Takeovers

The issuance will be for a range of purposes- IPOs, spin-outs, and buy-ins as well as takeovers. IPOs that were scheduled to take place in February and were postponed will now be back under active consideration. The recovery in valuations in markets will encourage managements to listen to the sum-of-the-parts arguments and enhance shareholder value through spin-outs like that of Enquest from Petrofac. Just last week there was an example of a buy-in, as Agnico-Eagle Mines stepped up to the plate and elected to offer to acquire all the shares it does not already own in Comaplex Minerals.

M&A is back in the revived energy sector, and will come back in other resource-based sectors. The Chinese have stated their desire to acquire strategic resources on a global basis, and their activities will spark the attention of other acquirers on a game theory basis. In upstream energy in 2009 alone, China spent $16 billion gaining footprints in Canadian oil sands, the Gulf of Mexico, Nigeria, Gabon, Trinidad and Tobago, Ecuador, Syria, Iraq, Iran, Indonesia and Kazakhstan. There are expected to be more National Oil Company acquisitions this year in unconventional oil and gas production primarily sourced from gas shales, tight gas sands and oil sands according to industry consultants. Energy M&A will not be confined to NOCs and producing assets as shown by the acquisition of Smith International by Schlumberger.
In mining the secondary and tertiary stocks amongst the miners and mineral exploration stocks have started to out-perform the global major mining stocks as interest warms up. Before Easter there was corporate activity in gold (Newcrest's proposal to merge with Lihir Gold) and in the coal sector, and further deals in zinc. 

Not Just Resources

However, deal flow will not be confined to resources industries, as value is apparent elsewhere to corporate buyers. Hedge fund manager Leon Cooperman of Omega Advisors has been interviewed in Fortune magazine recently. Asked about increased takeover activity he said that it reflects the fact that the stock market is selling about in line with replacement costs. "With the credit markets improving and business getting a little better, corporations are showing a willingness to buy other businesses, and they are paying up for them," he noted*.

He continued, "We have seen a large number of deals where the average premium over the market price has been approximately 40%. When Air Products (APD, Fortune 500) bids $5 billion in cash for AirGas (ARG), which is 38% over market price, Air Products is telling us they feel sufficiently comfortable about their own business that they are willing to take on a lot of debt to do the deal. It's the same thing with Merck AG's $7 billion offer to buy Millipore (MIL) and Simon Property's (SPG) $10 billion bid to acquire General Growth Properties (GGP). When you buy a share in a business, you're buying a share of its brick, mortar, machinery, and earning power. What corporations are saying is that the equity market is not overvalued."

The corporate buyer has not been absent from the market, but should be more evident in the rest of this year. The pressures resulting from the "shareholder value" mantra is still there, and the continuing recovery of the banking sector will allow some debt financing this year, which was largely absent last year. For similar reasons it would not come as a surprise to see more activity by private equity in the second half of the year, both disposals and acquisitions. This combination of factors will present an increasingly rich environment for managers of special situations capital, both on a dedicated basis and as part of a multi-strategy offering. Better returns will result for special sits strategies.

  *The article won't link directly but can be found at, using search term "Leon Cooperman"

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