June 12, 2013 / 1:24 PM / 5 years ago

Severn Trent deal blow hits 'merger arb' funds

LONDON (Reuters) - Hedge funds that bet Severn Trent (SVT.L) would agree to a Canadian-led takeover are reeling from losses after the water company refused to talk, casting further doubt on their money-making abilities in an anemic M&A environment.

A Severn Trent sign hangs on a gate at Cropston Reservoir in Cropston, central England, May 15, 2013. REUTERS/Darren Staples

The LongRiver consortium walked away after the British utility let the bid deadline expire on Tuesday, ignoring an effective invitation to negotiate on price.

That sent Severn Trent shares down 8.3 percent on Wednesday, adding to falls on Monday and leaving it below its pre-bid price, piling up the losses for hedge funds that bought stock in the past three weeks expecting a deal to be sealed.

“It’s pretty disappointing. It looks like the bid/ask spread wasn’t that wide, so it’s perplexing,” said one hedge fund investor who spoke on condition of anonymity. “The bigger problem here is the current deals environment.”

It is impossible to calculate exactly how many shares were held in the hands of hedge funds because UK regulations stipulate that investors must only publicly disclose stakes larger than 1 percent in a company under a takeover offer.

Two U.S. hedge fund giants, Elliott Capital Advisors and Davidson Kempner European Partners, did tip the scale with stakes in Severn on June 7 equivalent to 1.27 percent and 1.05 percent respectively, but others will have smaller holdings.

People familiar with the market say the deal attracted a number of hedge funds, though the short period between initial bid and collapse, and the lack of trading in Severn shares, ensured most funds’ bets were small - Davidson had to spend around 40 million pounds for the majority of its stake to earn itself a regulatory filing.

Two of those sources estimated hedge funds owned around 5 percent of Severn’s stock - by comparison, managers owned almost a third of TNT Express TNTE.AS when it was under offer from rival United Parcel Service (UPS.N) in January.

But losses on the Severn deal come on top of a series of struggles this year for merger arbitrage funds who wager on the outcomes of bid attempts.

Most are grappling with a slowdown in new M&A deals this year - particularly in Europe and the cross-border big ticket deals they thrive on - while the few takeovers that have emerged have left many funds wrongfooted.

The average merger arbitrage fund is up just 1.9 percent this year against a near 5 percent rise in the average hedge fund, data from Hedge Fund Research shows. Over the past three years merger arbitrage managers have made 3.4 percent, while across all strategies the average fund has gained 5 percent.

“Investors are chasing the same few high-profile M&A opportunities and end up hit by the same adverse events,” said Thierry Lucas, founder of London-based hedge fund Portland Hill.

“I’ve been staying away from merger arb. This may change if the environment improves and we see a big wave of M&A.”

Lionel Belka, partner at Paris-based hedge fund Bernheim, Dreyfus & Co said the collapse of Severn Trent dealtalks was not a depressing sign for future M&A activity because it was a very particular situation of a regulated company that attracts infrastructure investors for its inflation-protected cash flows.

“Given the low offer and the asset scarcity, we did not get involved. The nature of the bidder also played its part; it is always more difficult to bring a consortium in a bidding process with a board than an individual buyer,” he said.

“Finally, the fact that this deal did not go through is not similar to a definitive agreement not getting done.”

UPS’s decision to abandon its 5.2 billion euro bid for TNT in January left funds nursing potential losses of more than $700 million, sources said at the time. Funds owned an estimated 30 percent of TNT shares before news European antitrust regulators would veto the deal, the sources said.

Other losing positions this year include small wagers on Meda MEDAa.ST, currently in talks about a deal with India’s Sun Pharmaceutical Industries (SUN.NS), after shares in the Swedish drugmaker fell as prospects for a takeover faded.

The big hope for managers now is that a deal like Vodafone’s (VOD.L) approach to buy Germany’s biggest cable company Kabel Deutschland KD8Gn.DE - announced on Wednesday - becomes a prolonged bid battle from which they can wring a profit.

(Additional reporting by Laurence Fletcher; Editing by Will Waterman)

This story was refiled to remove surplus words from foot of paragraph 13

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