John Orrico expects to revive his mutual fund's performance by concentrating investments in companies being bought for less than $1 billion.

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John Orrico, whose Arbitrage Fund trailed U.S. stock-market benchmarks for the past two years, expects to revive his mutual fund’s performance by concentrating investments in companies being bought for less than $1 billion.

Orrico and co-manager Matthew Hemberger are devoting about half of the fund’s $268 million to these types of transactions. The fund buys shares of companies being acquired and holds them until the deals are completed.

The risk is the takeover agreements fall apart and the stocks drop.

“We want to play the smaller deals because you’re more likely to see multiple bidders for a company, and spreads are potentially better,” Orrico said. “The sweet spot for us are deals between $200 million and $600 million.”

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The Arbitrage Fund is encountering its worst period of performance since the fund opened 4 ½ years ago, falling 3.1 percent during the past 12 months. The fund lagged behind the 7.4 percent advance of the Standard & Poor’s 500 Index and the 1.3 percent gain of the competing Merger Fund.

Orrico is betting this year on deals such as Nanometrics’ $122 million agreement to merge with August Technologies to improve returns. Shares of Bloomington, Minn.-based August Technologies, which makes equipment to test microchips, have gained 51 percent since Jan. 21 when the bid was announced.

Takeover battle

A week later, Flanders, N.J.-based Rudolph Technologies offered $190 million for August Technologies, only to be topped by a $204.8 million cash bid from KLA-Tencor of San Jose, Calif., the world’s biggest maker of semiconductor-inspection equipment.

“The bidding has yet to run its course,” Orrico said. “That’s the kind of deal we love.”

More than 1,700 U.S. acquisitions valued at almost $241 billion have been announced so far this year and 98 percent of them have been for less than $1 billion, according to data compiled by Bloomberg.

The Arbitrage Fund was hurt last year by investments in canceled or renegotiated deals involving companies such as U.S. defense contractor Lockheed Martin and telephone-network-equipment maker Tellabs.

Lockheed Martin’s $1.7 billion proposed purchase of Titan collapsed amid a criminal investigation over whether Titan consultants bribed foreign officials. Tellabs in September cut the purchase price of fiber-optic-equipment maker Advanced Fibre Communications by 22 percent to about $1.5 billion after Advanced Fibre’s profit fell.

“We had the perfect storm last year and it showed in our results,” said Orrico, whose fund invests in as many as 60 transactions at a time.

Relative returns

The Arbitrage Fund climbed 9 percent in 2001 when the S&P 500 fell almost 12 percent and gained 9.3 percent in 2002 when the U.S. benchmark index dropped 22 percent. The fund started trailing in 2003 as equity markets rallied.

Last year, the fund rose 0.6 percent, compared with the S&P 500’s 11 percent increase and the average 7.4 percent gain of five mutual funds that focus on M&A, Bloomberg data show. The Pennsylvania Avenue Event-Driven Fund was the top performer, climbing 26 percent.

The largest arbitrage fund, the $1.6 billion Merger Fund, run by Frederick Green and Bonnie Smith, is closed to new investors. The others are the $317 million Gabelli ABC Fund, managed by Mario Gabelli; the $285 million Enterprise Mergers & Acquisitions Fund, overseen by Gabelli and Paolo Vicinelli; and the $425,000 Pennsylvania Avenue Fund, managed by Thomas Kirchner.

Hedge funds focusing on merger arbitrage have more than tripled since 1999, according to Chicago-based Hedge Fund Research. About $14.5 billion was invested in merger arbitrage funds at the end of last year, up from $4.3 billion in 1999.

“Approaches to risk”

“People take different approaches to risk,” Vicinelli said.

“One of the questions we put a lot of emphasis on is: ‘Who is the buyer?’ We would much rather see a big blue-chip company like Procter & Gamble or General Electric.”

The Enterprise Fund, which devotes a third of its assets to companies the managers single out as potential takeover targets, advanced 6.4 percent last year. The fund had 28 percent of its assets in cash at the end of December, compared with the Arbitrage Fund’s 3.5 percent.

Johnson & Johnson’s purchase of Guidant helped make 2004 the busiest year for M&A since 2000 when stock prices peaked. Orrico first bought shares of Guidant a week after the maker of heart devices agreed to be acquired by Johnson & Johnson for $25.4 billion.

At the same time, Orrico borrowed shares of J&J and sold them as a way to protect the fund from swings in the stock’s price.

He plans to sell his stake in both companies, the fund’s largest positions on Dec. 31, once the deal is completed. Until then, Orrico adjusts his holdings in both companies depending on fluctuations in the share prices, and as the companies overcome administrative and regulatory hurdles. The stocks accounted for 5.4 percent of the fund’s assets at the end of December.

“Our hedging is a day-to-day process,” Orrico said. “Sometimes it’s more art than science, more instinctual.”

Orrico tries to handicap the likelihood that a transaction will be completed before making an investment. He talks to Wall Street analysts and the management teams of companies involved as well as to rivals to gauge whether regulators and shareholders will approve a takeover. He limits his investments and sometimes buys options to ensure that if a deal unravels, the fund wouldn’t lose more than 1 percent of its net asset value.

“That’s the worst-case rule,” Orrico said. “We need to understand what’s driving these guys to combine and how receptive shareholders are going to be to this deal.”