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Playing the game is tricky enough for the experts, let alone small investors, writes John Collett.

Small shareholders in takeover targets risk being short-changed by traders, especially hedge funds, if they do not understand how the takeover game is being played.

Most hedge funds scour the globe looking for opportunities that will reward their investors.

Over the past three years Australia has emerged as a favoured destination for hedge funds running event-driven strategies such as merger arbitrage. This is where the funds buy shares in takeover targets in the hope that a higher bid will be made for the shares before the deal is completed.

Overseas-based hedge funds, particularly those from Hong Kong, are the most active traders in the big mergers on the Australian market, says Brian Eley, co-founder of fund manager Eley Griffiths Group, which runs a traditional long-only small companies fund.

You cannot prove it is hedge funds [buying], but you see a rapid increase in volume, usually at a premium to the bid, Eley says.

Hedge funds started becoming active in takeover plays on the ASX following the 1997-1998 Asian financial crisis and the tech wreck of 2000. Australia was regarded as a boring market but, with problems in Asia and the US, there were few alternatives to play the merger arbitrage strategy.

Also, the robust corporate governance of Australian companies meant that hedge funds, whether in Hong Kong or New York, could have a degree of comfort that Australian mergers were a relatively low-risk game.

Offshore hedge funds have access to big lines of capital and take positions in target companies that are leveraged several times. That is creating a power shift away from traditional funds to hedge funds.

Traditional funds like to hug the index and shy away from taking bets too far from the market. They tend to sell shares that are under takeover offer early, rather than take the risk the merger will fail.

Hedge funds playing the merger arbitrage game, on the other hand, have globally diversified portfolios of takeover stocks and aim to deliver positive returns rather than adding a bit more than market returns.

Offshore hedge funds need to be able to buy and sell shares in a takeover target quickly, restricting them to larger and more liquid Australian companies.

A byproduct of their power is that they are helping to maximise the takeover premium enjoyed by small shareholders, says Colin Cruickshank, a private client adviser with Baillieu Polkinghorne.

Xstrata’s bid for WMC Resources last October was sure to make it a popular play for hedge funds. WMC is a plum asset and hedge funds took the view that the initial bid from the Switzerland-based Xstrata was unlikely to be the last. In February, to win over hedge funds and other institutional investors, Xstrata increased its initial $6.35 offer to $7.20 a WMC share.

The hedge funds formed the view that there was likely to be another bidder and they bought more WMC stock at up to $7.40 a share — taking their presence on WMC’s share register to an estimated 25 per cent. Then, early last month, BHP Billiton showed its hand with a counter-bid of $7.85 a share.

Cruickshank says for small shareholders looking to maximise capital gains from selling the shares they hold in the target company, the primary rule in all takeovers is not to accept the first bid on the first day.

The merger arbitrage specialists are always going to be more knowledgeable than small investors. They’ve done their homework and know that most announced takeover offers succeed.

They also know that the initial bid is often not the last.

And, if the merger arbitrage manager gets on to the target company’s share register early, subsequent bids can turn a good trade into an excellent one.

Usually, as each higher bid is announced, the hedge fund manager buys more of the target company’s shares, because each higher bid increases the chance that the deal will be completed.

At their best, hedge funds increase the efficiency of the market and help ensure fair value is achieved in takeovers.

Their presence enables small shareholders to sell out of the target company the day after the takeover is announced, generally at a premium to the bid.

For shareholders of the companies doing the acquiring, however, the influence of hedge funds can be unwelcome.

They [hedge funds] are making life very difficult for the acquirer, says Anton Tagliaferro, founder of fund manager Investors Mutual.

When hedge funds have a blocking stake in the target company, they can force the would-be acquirer’s hand.

It is a punt to force a higher offer price — and, in many cases, they have succeeded, Tagliaferro says.

That has partly been because of the almost 28 per cent return on Australian shares over 2004. A buoyant ASX and record corporate profits contributed to a record $77 billion worth of takeovers and mergers last year, 10 times the value of the deals done in 2002 (when the ASX was down 8 per cent over the year).

Some market participants think it’s about as good as it gets.

However, even if the appetite for deals wanes this year, the underlying structural characteristics of the local bourse should help it maintain its position as a favoured market for merger arbitrage funds.

The law that regulates takeovers in Australia is very much geared to auctions, says Peter Scott, UBS head of investment banking in Melbourne.

First, an entity cannot generally own 20 per cent of a listed company without making a takeover bid. Where the shares in the target company are widely held, or a large shareholder is looking to exit, that makes it possible for another party to make a competing bid with a good chance of success.

Also, compared with most overseas markets, there is a long offer period that gives other potential bidders time to assess whether to have a tilt.

In Australia, unlike in Japan and Europe, hostile takeovers are commonplace, Scott says. What that means is that in a hostile takeover the initial bid is seldom the final bid, he says.

If hedge funds can get on to a target’s register quickly enough in a hostile takeover, they will always make a little bit of money — and sometimes a lot, Scott says.

However, with the market return for the first quarter of this year only about 1.5 per cent — the lowest quarterly performance for Australian shares in two years — takeovers may no longer be one-way bets for hedge funds, Investors Mutual’s Tagliaferro says.

AMP Capital Investors’s chief economist and head of investment strategy, Shane Oliver, says that on balance the role of hedge funds is positive for small investors — but if a deal falls through, small investors can be left behind.

They [hedge funds] move en masse, and if a negative view of the deal is taken, then it could work against what is in the best interest of the company and in the best interests of small investors, he says.

Kenny Arnott, founder of Arnott Capital, a hedge fund manager that invests in Asian markets, says the effect of merger arbitrage funds on the target’s share price can be very negative if the merger falls through.

When a deal collapses, it can be like a wombat trying to fit through a mouse hole, Arnott says.

In the middle of last year, France’s Axa tried to mop up the almost half of the ASX-listed Axa Asia Pacific it did not own. Its offer (its second) of $4.05 was rejected by Axa AP and the deal fell through.

Hedge funds are thought to have owned as much as 10 per cent of Axa AP and had driven the share price up to $4.10; but when the deal fell through they sold up, and Axa AP’s share price fell to $3.80.

The effect on Axa AP’s more than 250,000 small shareholders, many of whom picked up shares when the insurer was demutualised (as National Mutual in 1996), was hardly devastating; the stock was trading around $3.20 for months before the attempted merger. But it shows how leveraged short-term traders can help shift the share prices of target companies.

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