market folly

Alcon (ACL) has reached an agreement to sell the remaining 23% of the company to Swiss drug maker, Novartis (NVS). Novartis is offering 2.8 shares of NVS for each share of ACL, the equivalent of $168 for each ACL share. The deal is supposed to close in the first half of 2011, pending shareholder approval.

While Novartis' offer comes in at $168 per share, ACL is currently trading just above $164. The deal is contingent upon shareholder approval and if you examine the list of shareholders, it's littered with prominent hedge funds. Back in the second quarter issue of our Hedge Fund Wisdom newsletter, we flagged Alcon (ACL) as a 'consensus buy' due to numerous hedge funds starting and accumulating positions in the company. You can check out a full free sample issue here.

Then in our new third quarter issue, we singled out Alcon as a featured hedge fund merger arbitrage play three weeks ago. To understand the hedge fund investment thesis, here's some of our commentary from our newsletter:

"Alcon was purchased by Nestle in 1977. Nestle floated to the public a 25% stake in the company in 2002. In April 2008, Novartis (NVS) purchased from Nestle a 25% stake in Alcon for $143 per share. And in August of 2010, Novartis exercised its call option to acquire Nestle’s remaining stake at a price of $181 per share.

In January 2010, Novartis made an offer of 2.8 shares of Novartis stock for each share of Alcon for the stake owned by the public (which currently values Alcon at $156 per share). Still, Alcon is trading at $163 because the offer has been rebuffed so far and investors are looking for a more equitable offer to the Nestle stake takeout that was done at $181. Arbitrageurs are betting that Novartis will increase the effective exchange ratio, so they buy Alcon and short Novartis in order to hedge out the risk that Novartis shares may go down by the time the deal closes.

Novartis closed its acquisition of Nestlé’s stake in 3Q, which increased investors’ confidence that a buyout of the public shares will happen sooner rather than later. In addition, Alcon’s share price is tied to the value implied by the exchange ratio offered by Novartis. So, as Novartis’ shares dropped in late 2Q / early 3Q, so did Alcon shares. At $135, the spread to the Nestle takeout at $181 was seen as too wide and the value of Alcon’s franchise was under-appreciated by the market.

This combination motivated some new funds to add Alcon to their portfolio. Magnetar Capital started a new position in Alcon and made it its top portfolio holding with a 12% weight. Steven Cohen’s SAC Capital maintained Alcon as its #1 position and increased its exposure during the quarter by 20%. John Paulson’s hedge fund Paulson & Co increased its exposure by 30%. Highbridge Capital doubled its position while Jamie Dinan’s York Capital and Thomas Steyer’s Farallon Capital also added shares of ACL. And while some funds are obviously short Novartis as part of the arbitrage pair (though they don’t disclose it), other funds have elected to purchase puts on Novartis to round out the merger-arb trade."

Given the quantity and quality of hedge funds involved in this trade, it will be very interesting to see if they approve the current deal valued at $168 per each ACL share or if they push for the same $181 per share that Novartis paid Nestle. With shares still trading slightly below the deal price, it will be interesting to follow.

The above is the type of research and analysis we cover in our Hedge Fund Wisdom newsletter. Be sure to click here for a free sample issue as we examine the investment theses behind hedge fund trades.