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As an investment strategy, risk arbitrage -- playing the spread between target companies and their values in a pending takeover, with the attendant risks and complexities -- has its ups and downs. Merger activity ebbs and flows and, like other strategies, low interest rates test returns. While it has not always been easy to make money in risk arb, historically the strategy has had a high market-neutral element -- one of its attractions. Some might say that the market-neutral quality relative to fluctuations in the S&P 500 index has led to some commoditization of what is otherwise an information- and research-intensive investment strategy.

Since the financial crisis of 2008, some arbs have been working as hard to get work or raise capital for new funds as they have been policing merger portfolios. The smaller operators have been the most challenged at fundraising, which could mean there are opportunities to put money into seasoned talent that institutional investors are passing over.

Funds in the event space continue to see inflows as investors see M&A volumes rising, even though 2010 did not provide the level of activity widely expected at the start of the year, one investment bank source says. Despite that uptick, it's difficult to be a startup hedge fund, he says. Capital is flowing into pedigree names, and big funds are getting bigger while small ones are shrinking, he says. A primary issue: having the ability to deal with institutional investors that are increasingly focusing on a smaller range of names in allocating capital. Following the Bernie Madoff scandal, increased attention is being paid to compliance standards by institutions, and the collapse of Lehman Brothers Holdings Inc. showed them that even well-run hedge funds can get caught by events beyond their control, he says. The marketing and management required to attract investment is much harder for smaller funds to muster.

Any arb who got burned in 2008 when multiple private equity deals imploded -- particularly those not part of large funds that could ride out the crisis -- faces an uphill battle even if M&A volumes improve, one arb says. To make matters worse, while risk arb has been marketed as market neutral, the credit crisis and buyout collapse proved that's not always the case, he says. On the other hand, most strategies suffered in the crisis, some much more than risk arb.

Overall, the climate for raising capital for risk arb has been improving as merger activity has risen, says the marketing director of a substantial fund. The number of deals this fund has invested in has grown from about 60 to 110 over the past 18 months. Institutional investors that were tepid on the strategy a year ago are now calling around and placing capital, he says. In part, credit investments that were a draw in recent years have lost some luster, and with the M&A cycle reviving, pension funds are redeploying into risk arb. Regardless of the pain of 2008, the characteristic of M&A investing in definitive agreements as a market hedge remains a draw, but the primary driver is still dealflow, the source says. Globally, there are some 7,200 potential public merger targets in the market, roughly 25% of which are in the U.S., the source says.

Employment among risk arbs is on the rise, a sell-side source says. "We have seen guys unemployed for two years, but we've seen jobs added in arb funds starting in March," he says. Firms such as BNP Paribas SA are returning to the business on the sell side. The market is gearing up, but low interest rates are keeping spreads tight, he says.

The Volcker Rule provisions of Dodd-Frank, which limit proprietary trading by banks and their investments in hedge funds, could affect the business and perhaps spreads, another arb says. But any longer-term impact of the bill, which does not go into effect until 2012, remains uncertain, he says. The real effect of the Volcker Rule should be clearer in October following a comment period.