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These Hedge Funds Are Losing Big Thanks to Pfizer and Halliburton

Merger arbitrage hedge funds are about to be tested.

So far this year, the dollar volume of withdrawn deals has increased four times from last year, according to Dealogic. Wednesday was a particularly woeful day in the land of merger arbitrage. The U.S. sued Halliburton (HAL) to try to block its takeover of Baker Hughes(BHI), and Pfizer (PFE) said it was walking away from its deal to buy Allergan (AGN) after the Treasury Department issued new rules on Monday meant to prevent so-called tax inversion deals.

Merger arbitrage funds take big bets on the varying likelihoods that a deal will close. Deals that have been withdrawn aren’t necessarily a bad thing. Some funds could have been betting that a particular deal wouldn’t get done. But in general most merger arbitrage funds place their money on deals going through, typical playing the spread between the stock price of the company being bought and the company doing the acquisition.

Over time that’s been a pretty good bet. Most deals have a high likelihood of quick consummation so hedge funds can cash in and move onto the next bet. As a result, merger arbitrage has become a pretty big sector of the hedge fund industry.

But the arb business has become more competitive over the last few decades. In 1990, merger arbitrage funds had only $100 million in assets, according to Hedge Fund Research. Now they have more than $20 billion. So pricing this risk has become more efficient, and the better deals often have a much smaller spread. The average spread for a merger deal was nearly 8% in 1990, according to a study published by the CFA Institute. By 2007, that spread had fallen closer to 2%.

Nonetheless, the huge volume of M&A deals in the past few years continued to make these funds some of the top performers among hedge funds, which in general have had lackluster performance. The average merger arbitrage hedge fund rose 3.4% last year, compared to a near 1% drop for all hedge funds, according to HFR. For the first three months of this year, arb funds returns have been a decent 1.6%, according to the HFRX ED: Merger Arbitrage Index.

Recently, though, deal volume has been slowing. On top of that, more and more deals that the funds bet on last year are getting broken up. According to Dealogic, so far this year deals worth over $375 billion have been withdrawn, versus about $90 billion for the same period last year. It’s the largest number of deals withdrawn by volume since 2007. That’s in part due to some big deals, including Pfizer’s deal today and Honeywell’s defunct deal to buy United Technologies.

And withdrawn deals can be particularly painful for these funds. For example, Allergan’s stock fell 15% yesterday when U.S. Treasury announced its new ruling—a far more dramatic swing than the typical spread. Again, that doesn’t mean merger arbitrage funds are doomed to poor returns. The nimble funds may be able to start profiting from the drop in stock prices as more deals don’t go through. But it seems for now some prominent hedge funds have been caught flatfooted. According to reports, hedge fund masters, like John Paulson, who got his start in merger arbitrage before making big bucks in the financial crisis, have lost $3 billion on the drop in Allergan’s stock. There’s always two sides to every trade.