Describing the pitfalls of being in the merger arbitrage business, a veteran arb once likened it to trying to move through a dark room full of furniture without bumping into anything, illuminated perhaps with occasional glimmers of light, like lightning.

Risk arb has been a tough business for more than a year. But while latter 2007 and early 2008 were very difficult, compared with the last half of 2008, they look like a stroll in the park.

Trouble began when the credit underlying the 2006 private equity boom dried up. Investing in leveraged buyouts produced losses and pink slips, and then got worse. Fund redemptions have taken a toll; some say up to 40% of capital left the hedge fund industry. Most hedge strategies, such as convertible arbitrage, suffered. Markets have taken plenty of players to school or to the woodshed.

As a consequence, risk arb looks different today. Volatility has translated into historically wide spreads. Perhaps an unprecedented portion of pending deals -- whether LBO or strategic -- have faltered. Some of this is simply cyclical, a reflection of the ebb and flow of the M&A market.

But some of this is secular. Despite all the chatter about arb operations scaling back or closing down, there's a giddiness over historic opportunities presented by current arb spreads, although some believe reaching for yield is the sort of attitude that leads to slaughter.

Others think the business is in a shakeout that will bring risk management back into vogue over portfolio concentration and leverage.

The M&A market will be slower for months to come. While debt and equity capital is hard to come by, there will clearly be fewer transactions. "Not every buyer is a Johnson & Johnson," an arb says. The merger market will be smaller, with private equity and large, leveraged strategic deals unlikely, he says. Arb funds will have to shrink -- under $2 billion -- be nimbler and more selective, he says.

There has also been a commoditization of risk arb over the past decade that made the business more competitive in good times; that may be abating, an arb says. The growth of sell-side arb research did not make the business better, he says.

As investment banks consolidate and scale back proprietary trading desks, opportunity increases. Once the hedge industry knows who will survive and how much capital is available, the situation will change for the better, the arb says. By some reports, based on the current risk-reward for M&A targets, 84% of deals must close to hit breakeven, the arb adds. So the days of looking for a rate of return in the mid-20s may be over. Risk has come back into the game, he says, and that means opportunity.

The M&A business relies on predictability, another arb says. The lack of predictability in, say, equity values, will be a drag on dealflow for a time. But predictability in pending deals -- the track following the proxy and deal conditions to the close -- is also out of whack and has not been functioning. That creates opportunity, he says.

This is a function of volatility. Any risk arb will say his ideal equity market would return an annual 8% with zero volatility because arbs are essentially short puts on deal stocks, he says. When the M&A market slowed back in 2002, the CBOE Volatility Index, or VIX -- a measure of near-term market volatility based on option prices for S&P 500 stocks -- ran between 25 and 30, and arb spreads were tight, he says. After spiking to 80 recently, the VIX has fallen to 60. Arb spreads will remain wide with this level of volatility, so arbs will need to be selective, and funds with a broad skill set to play restructurings, split-offs and turnarounds, in addition to straight arb situations, will be better positioned, he says.

All agree that arbs will employ less leverage in the future.

And, of course, raising capital is a challenge for arbs starting new funds. The correlation between the broader equity market and hedge funds is at a historic high, an arb says. This is partly due to the recent drive to liquidity. Hedge funds must recapture their distinction from the broader market, he says.

All assets are down, an arb says. Hedge funds will continue to provide value because the market always looks for talent, he says. Opportunistic market environments are not ideal times to raise capital by definition, he adds. But stability will return, and, in the meantime, sticking to your knitting, managing risk and selectivity will be the name of the game.