Fred: I started Westchester Capital Management in 1980. I had been on Wall Street for seven years at Kidder Peabody and Goldman Sachs. At Goldman, I was a senior portfolio strategist and member of the Investment Policy Committee. I left Goldman in 1980 to start Westchester Capital Management. I hadn’t been doing merger arbitrage at Goldman, but I’d been involved in some arbitrage situations and really fell in love with the strategy. I decided that I wanted to do my own thing and focus on merger arbitrage, and that’s what we’ve done ever since. Now, 26 years later, we’ve invested in more than 2,000 mergers and takeovers. That’s been our sole focus since the firm’s inception. We’re still a small shop. We have nine professionals here at Westchester, and Bonnie joined me in the mid-80s, so it will be 20 years in March for her.

Bonnie: It didn’t take me long to learn the business after I started here. I didn’t know much about arbitrage, but Fred was an excellent teacher. I also fell in love with the business. It was a lucky break for me, to have this as my first job when I was studying for my MBA. I was fortunate to end up in the right place.

Fred: We started out managing individual accounts for high net worth investors, and over the years we changed our focus and now basically just manage pools of capital. In 1989 we took over an existing mutual fund, turned it into The Merger Fund, and have been managing it for 17 years. Bonnie and I have been the co-portfolio managers every since. We took over the fund when it was at about $10 million in assets, and it has $1.3 billion now. We manage a little less that $200 million in hedge fund assets, so we’re around a billion and a half total, all in merger arbitrage. We run the hedge funds a little more aggressively than we run the Merger Fund. We take larger positions, use a little more leverage, and there’s not always a perfect overlap between the portfolios. Generally speaking, though, we're in the same arbitrage positions in both our hedge funds and in the big mutual fund.

Westchester Capital Management, the company I started in 1980, has always been registered as an investment advisor since in order to run a mutual fund you must be registered. Our affiliated "sister" company, Green & Smith Investment Management, which runs the hedge funds, had not been registered with the SEC until recently. We jumped the gun on the hedge-fund registration requirement and became registered around the middle of 2005. It was official in June or July. There are some hedge funds that are attempting to circumvent the registration requirements by imposing long lock-up periods or not taking new investors. If you have a two-year lock-up or you’re not taking new money, I believe you do not have to register with the SEC no matter how much money you’re managing, which is a huge loophole in the law, but that is another discussion entirely. We are perfectly happy registering Green & Smith Investment Management because we have been living in a "goldfish bowl" since 1989, when we started running The Merger Fund and have been subject to periodic exams by the SEC. We have gone through five examinations since we started running the Fund, and I have to say they have been rather thorough. The SEC comes in and camps out in the office and has the right to go through every file, every piece of paper, every trading record that you have. I think that this level of regulatory scrutiny gives the investors in our hedge funds some comfort. We have two portfolio managers, Bonnie and I, who are responsible for the investment decisions. We have a full-time trader, two arbitrage analysts, and we are trying to hire two more. We are thinking about hiring an analyst to help us out on European deals. We also have four people in the back office that handle trade processing and related functions. We have a whistle-clean regulatory record, and I think we are highly regarded by our peers.

Bonnie: We’ve had as much as 20% exposure abroad. Otherwise, the bulk of our investments are in companies located in the U.S. and Canada. It is sometimes difficult to get good information about foreign deals, but some countries are better than others. For example, we think we have a good understanding of the regulatory process in the U.K., and we also have access to a number of U.K.-based research analysts. When it comes to other countries in Europe, it is sometimes a little bit of an "old boy" network and information isn’t always disseminated fairly. The locals may receive new information before a hedge fund calling from New York is going to hear it. We will avoid deals when we have no competitive edge. If we aren’t going to be first in line to get information, we aren’t interested. I don’t anticipate our investments ever being largely European or non-U.S. I think U.S. deals will always be the focus of our investment strategy, but if there is some value that can be added abroad, we would be happy to take advantage of it.

Fred: This is not a new area for us. I just want to make that clear. We have been investing overseas for a long, long time. I remember one of our juiciest arbitrage situations was Mannesmann, when it was being bought by Vodafone. That was an amazing transaction and we made a lot of money in it. That was at least five years ago or longer. We had one of the largest positions in Mannesmann that we ever had in an individual arbitrage situation. We are perfectly comfortable investing overseas, and I think with someone else onboard we would be able to look at a larger number of potential arbitrage opportunities in Europe. Bonnie mentioned that we have excellent access to analysts working for the major brokerage firms overseas. One of the nice things about a firm of our scale is that we get a great research call from firms such as Goldman, Merrill and J.P. Morgan. Many of these same firms have teams of analysts in London, some of which are specialists who focus exclusively in arbitrage opportunities, and we are able to compare notes with them on a continuous basis and take advantage of their expertise when needed. Europe has always been a place where we’ve invested over the years. We just want to get a little better at it and look at a larger number of potential situations.

Fred: First of all, we think that the level of M&A activity both here and in Europe will continue to be solid. We saw 2005 as a good year in terms of deal activity, and we look for more of the same this year. If you read our recent letters and our annual report, you know that at the top of the list of explanations for that is renewed confidence in the boardroom. M&A activity is not solely about confidence, but it is a huge factor. A few years ago, after 9/11, there were a number of constraints on deal-making. To start with the geo-political outlook, we had never been through something like 9/11 before, and it was unclear what was coming next. I think that put everyone in a pretty cautious mood. It also wasn’t that long ago that the accounting scandals were new news. The WorldCom fraud was a 2002 event, and we also had Adelphia, Enron and Tyco. Concern about the numbers was the second constraint on deal-making. A lot of boards decided that the number one priority was to make sure that their own accounting was accurate and could be relied upon, and it was not an environment in which you wanted to rush out and make an acquisition, as you might be worried about whether the target’s numbers could be trusted. Then you had economic uncertainty. It wasn’t clear if the U.S. economy was going to roll over, and a lot of companies were facing very difficult operating environments. There was this turning inward. Boards wanted to make sure the accounting was right, and management teams wanted to address the issues that they faced in a very difficult, competitive environment. We had these geo-political concerns hanging over the economy and the market like the Sword of Damocles. All of these uncertainties tended to turn inward to work against M&A activity.

What’s happened since is that we haven’t had a repeat of 9/11, the U.S. economy has shown amazing resiliency in the face of record oil prices, a record trade deficit, a record budget deficit and natural disasters, but the battleship America just keeps plowing through the waves. Most companies can feel comfortable that their accounting is appropriate since they have had to live with Sarbanes-Oxley for a while. Confidence in the numbers is up and companies are now not just looking inward. They’re thinking strategically, and when you think strategically, when you think about what you need to do to take your company to the next level, one of the things you have to think about is the possibility of some type of corporate reorganization, such as a merger or takeover, designed to enhance shareholder value over the long-term. So we’ve seen a significant recovery in deal-making. We are still not close to the levels we saw in 1998,1999 or 2000, but we are way above the lows we saw in 2002. I don’t think things are going to change dramatically in 2006, either here or in Europe, absent some shock to the system.

One thing I forgot to mention that is really important is the amount of money that private equity has raised. We've seen a huge increase in private-equity activity, and the percentage of deals that are initiated by private-equity firms is higher than it's ever been since we have been keeping the statistics. Billions and billions of dollars are out there to be invested, and that’s contributed to M&A activity as well. I think it’s fair to say that we see more of the same in 2006.

Bonnie: I think mergers breed mergers, and when there’s consolidation in an industry, other companies who are competitors feel as though they had better get on the bandwagon. They may see the need to bulk up or expand geographically or do something else to remain competitive. Often when we see a merger in a given industry, others seem to follow shortly thereafter. With respect to private-equity deals, it is also worth noting that many of the players are working together on individual transactions. Sometimes you see five, six, even seven private-equity firms pooling their resources to do huge deals. It used to be that they were only buying small- to mid-cap firms, but now they are able to do some of the largest deals as well.

Fred: We made the point in our annual report that there are now very few companies listed on the New York Stock Exchange that are too big to be taken private. To Bonnie’s point about deals begetting more deals, a perfect example of that would be the proposed acquisition of Inamed by Medicis. Inamed specializes in products for cosmetic procedures and they’re one of the largest manufacturers of breast implants. Medicis does much of the same thing. They are not in breast implants but they do have dermal fillers which are used to reduce facial wrinkles. These two companies decided to merge, but there was a problem because at the time Medicis thought that Inamed would be on the same track as Mentor, its competitor, to get FDA approval for silicone breast implants, which have been off the market in the States for a while. During the pendency of the transaction, however, Mentor got tentative approval but Inamed did not, and the arbitrage spread widened dramatically. At that point, Medicis sort of sat on the deal, waiting to see whether Inamed could get back on track with the FDA. In fact, they did. Right after that, Allergan came in to buy Inamed and Mentor came in out of the blue to buy Medicis. There’s no question that the Inamed-Medicis transaction spurred the others, but who would have imagined that the target and the acquirer would six months later be involved in deals, but not with each other. It's absolutely true that often when a transaction is announced, there is a competitive reaction and the other players in that industry have to reassess their position and think about doing their own deals. Once again, we expect that M&A activity will continue to run at healthy levels through 2006, absent some external shock to the system.

Another important component of our returns in arbitrage is the spread, and there too the news is reasonably good. We have noticed in the last six months that arbitrage spreads have widened a little bit, not dramatically, but widened a little bit across the board, not just for riskier deals, but for "plain vanilla" transactions as well. I don’t know if that’s because money has been shifted out of arbitrage, which I think is true, or if something else is going on in the market. Interest rates are a factor. Arbitrage spreads ought to widen as interest rates go up, and they have. Let me give an example of a transaction that is one our largest positions now. We really like the deal, but I don’t want to say it’s a "slam dunk" because we’re on record saying that there’s no such thing as a risk-free deal. It’s Burlington Resources, being acquired by Conoco Phillips. Burlington is a natural gas play. They have large natural gas reserves, and I think virtually all of them are in the U.S. You don’t have any third-world-country risks associated with this transaction, so the reserves are high quality and they are in politically safe places. There’s no financing contingency here. Conoco has plenty of money. Also, we don’t see a serious antitrust risk. Just because of the politics of big oil, it’s possible the FTC might take a closer look, but our antitrust counsel says there’s zero deal risk from an anti-trust stand point. It’s not in health care, unlike Guidant, where if one of their products malfunctions, someone could die. These are natural resources, oil and gas, so you don’t have quite the headline risk. For a variety of reasons, we think this a very high-probability transaction, and the only real question for us is when will it close. The companies talked about closing the deal by the middle of the year. We think that’s unduly conservative and that it could close as soon as the end of April. If it does, the annualized return before rebate would be 8%. Since the deal is part cash and part stock, we get a rebate on our short stock position. The rebate is calculated at the Fed Funds Rate less 25 basis points (currently 4%). But since it is only part stock, not all stock, we add about two percentage points, 200 basis points, to the return for the short rebate, which takes it to about 10% on an annualized basis if it closes by April. I would say that six months ago, a deal of this quality might have been one or two percentage points lower than that in terms of the annualized rate of return. My point being that spreads are wider across the board, not just with riskier transactions, and that some of the "plain vanilla" deals that are our bread and butter and make up the core of our portfolio are offering more attractive spreads than they might have a year ago. Burlington Resources is also a huge deal, and at some point the arbitrage community gets full, and that allows the spread to widen out even more. Just to share with you how merger activity has picked up, there were several years when we had a cash position, and right now we are not only fully invested, but we are as leveraged as we can be. We’re about 125% invested, which is just about the maximum. We have about sixty deals in the portfolio, which is also as many as we’ve ever had. There’s both quantity and quality for us right now, which is really nice.

Fred: Let me just walk you through the mechanics of it. Our prime broker is Bear Stearns, and let’s take Burlington Resources-Conoco Phillips. As I said a minute ago, the deal is part cash and part stock. The stock part is a fixed exchange ratio, .7214 shares of Conoco Phillips, and the cash component is $46.50. We like to hedge away every risk that we can, leaving us with pure deal risk, which is what Bonnie and I are supposed to be good at. We are supposed to be able to analyze the risk of the transaction, but we are not in the business of making bets on the market, interest rates or the U.S. dollar versus other currencies. Whenever we can, we hedge away those risks. So let’s go back to Burlington Resources-Conoco Phillips. Although we do not, we could take a flyer here and say, "We think Conoco Phillips will keep going up because natural gas prices and energy prices generally are going to continue to rise," and we’ll just go long Burlington Resources and not hedge our market exposure in Conoco Phillips. But that’s not what we do and that’s why The Merger Fund has a beta of only .25 and why our standard deviation is so much lower than any conventional mutual fund. We are not subject to those roller-coaster swings in stock prices, because in stock-for-stock deals with a fixed exchange ratio, like Burlington Resources-Conoco Phillips, we are short the acquiring company’s shares through the pendency of the transaction at the appropriate hedge ratio. So for every 10,000 shares of Burlington Resources that we’re long, we are short 7,200 shares of Conoco Phillips. We’ve locked in the arbitrage spread, and we don’t care whether Conoco Phillips goes up or down. If it went up, we could have said, "Gee, it would have been nice not to have that short because we would have experienced the windfall." But more important to us is the fact that if Conoco Phillips goes down, falls by ten points over the next few months while we’re waiting for the deal to close, we have no market exposure there because we’re short .72 shares of Conoco for every share of Burlington that we’re long. That’s how we hedge out a stock-for-stock deal with a fixed exchange ratio.

As for the rebate, when we sell those shares of Conoco Phillips, we create a short-sale balance at the brokerage firm where the trade settles. And remember, Bear Stearns is our prime broker. We could sell our shares of Conoco through any broker on the Street, but let’s keep it simple and say that we sell them through Bear Stearns. Those shares are sold on the floor of the New York Exchange just like any other shares, and there are proceeds from that sale. Those proceeds sit at Bear Stearns, and Bear Stearns is earning interest. Because we are an institutional client of Bear Stearns, they rebate to us a portion of the interest that they earn on that short sale, and the formula is tied to the Federal Funds Rate. The Fed Funds Rate is currently 4.25%. Bear Stearns rebates to us Fed Funds less 25 basis points, or 4%. Going back to the arithmetic on Burlington Resources-Conoco, the annualized rate of return, before rebate, is about 8%, assuming an April close. Since the deal is about half stock, half cash, I’m simply taking that 4%, dividing by two, and tacking on roughly 200 basis points to the 8%, which adds up to a 10% annualized rate of return. We consider that a compelling rate of return for a deal of this quality.

Bonnie: Well, it’s funny you should ask. We’ve been thinking about it a lot lately. In the past, the times that we’ve re-opened, were times when we felt that there were wonderful opportunities for us. Usually, that was after some negative events in the world, such as after Long-Term Capital’s demise in 1998, and in 2001 after 9/11. When there are catastrophic events that cause a dislocation in the markets, arbitrage spreads start to widen. People get nervous that deals won’t happen anymore and pending deals will be called off. Fred and I have been in this business a long time. We’ve lived through the crash in 1987. That was the first catastrophe in the market that we experienced. Yet every deal in our portfolio got done. Every strategic deal was completed because generally the reason behind a merger is some long-term, strategic business plan. Whether Russian debt is collapsing or not, the deal still makes sense for the acquiring company. We’ve found that strategic deals get done despite what’s going on in the world. What causes deals to fall apart is something going wrong at the target company, usually something very specific. The times when there have been market dislocations have been some of the best times to be out there buying. This past October was an extremely difficult month for pretty much all hedge funds. It was difficult for arbs also. The turmoil created opportunities, and we were putting on deals at really attractive spreads. Interest rates have continued to go up and that also helps spreads. We are at a point now where we see really attractive opportunities, more so than we’ve seen in many years, and we are seriously considering re-opening the fund. Again, we don’t know if it’s going to be a permanent re-opening. I think if we start to see that too much money is coming in and it’s going to be a drain on our performance, we’d close the fund again. The most important thing for us is to keep the performance up, although you might not be able to tell that based on the last couple of years. We have a board meeting later this month and it will be discussed.

Fred: We’ve mentioned money flowing out of merger arbitrage. We have not been immune to that. We’ve lost assets in The Merger Fund and we feel we have excess capacity. I think Bonnie and I have a lot of credibility when it comes to managing the Fund in the best interests of our existing shareholders. We’ve shown no reluctance over the years to close the Fund when we thought that was the right thing to do. We’ve also shown no reluctance to re-open it when we thought that was the thing to do.

Bonnie: Just a reminder that both Fred and I, and actually everybody at Westchester Capital, have 100% of our pension money in the Fund, along with our investors. Our future is right there with our shareholders, and we’re not going to do anything that would hurt performance.

Bonnie: No, everything in our portfolio is a corporate reorganization. There are some positions that aren’t exactly "Company A taking over Company B." It could be a spin-off or some other kind of reorganization. The overwhelming majority of the portfolio is comprised of "plain vanilla" deals. There are a few that are a little more complicated, but they’re still a corporate re-organization of some kind. They are publicly announced. Nothing is speculation.

Fred: We have three bond positions. One is in Adelphia Communications, which we’ve owned for a while. That qualifies in our judgment as a straightforward arbitrage situation. The company put itself on the auction block last year, and it’s to be acquired by a joint venture between Time Warner and Comcast. The wrinkle in this is that Adelphia is operating under Chapter 11, so it’s a company in bankruptcy. Therefore, there’s an overlap with some distressed investment funds out there. But, as Bonnie suggested, everything that we invest in is related, one way or another, to a corporate reorganization.

Fred: No, we will not. We have a very small clone of The Merger Fund called The Merger Fund VL that we started in 2004. It’s designed for variable life accounts and it’s a very small fund, $5 million in assets. It’s sold through Travelers and Hartford. We think it’s a nifty product because of the tax-advantaged nature of doing merger arbitrage in a variable life context. However, we’re not going to start any more mutual funds. I just want to speak for a moment on the issue of personal trading. Not only do we have our entire profit-sharing plan and retirement plan invested in The Merger Fund, but Bonnie and I do no personal trading whatsoever. All of our investable assets are either invested in The Merger Fund or one of the other pooled vehicles that we manage for others. For 17 years, neither of us has ever bought an individual stock or bond for our own account.

Bonnie: We’re also pretty strict about trade allocations among our various investment vehicles, and we have a firm policy about how we allocate trades at the end of the day so that no one fund is advantaged or disadvantaged. The SEC always looks at that when they come in the door, and they have always given us their seal of approval.

Bonnie: We do allow our employees to do some trading. They have to get approval from us first, and there’s a 30-day window during which they can’t buy or sell stocks that we’re trading for the firm. But in reality nobody has ever traded in any of the deals in which we’ve invested.

Fred: I don’t think in the last two years that I’ve seen more than one request for trading authorization, and all of these would have to cross my desk.

Bonnie: We’re reactive, not pro-active when it comes to choosing sectors. We’re generally indifferent to the sector weightings. However, we are more cautious in certain sectors, like healthcare or technology, where deals might be a little more accident-prone. We might want to shy away from one-product companies as well. There’s just too much risk when earnings are dependent on one product, and suddenly a competitor launches a new one with better bells and whistles. Otherwise, we go where the deals are. Last year there were a lot of energy deals. As a result, we had a heavier weighting in that sector. This year we have been involved in more transactions in the consumer-services sector However, it really doesn’t matter to us.

Fred: We wouldn’t want to be 50% in LBOs, for example. Let me just amplify on what Bonnie said about what we call systemic risk. We don’t like systemic risk. We try to minimize it. We want to minimize factors that could influence more than one of our investment positions at a time or that could broadly impact a large sub-group of the portfolio. A conventional money manager faces systemic risk all the time because conventional investing leaves you completely exposed to the vagaries of the stock market. No matter how good you are, it’s going to be tough to make money in a bear market. That’s why, when we’re faced with market risk in a stock-for-stock acquisition, we hedge that risk away by selling short the shares of the acquiring company. Regarding industry or sector risk, the problem with financially driven transactions, with leveraged buyouts, is that they’re very sensitive to conditions in the financial markets, particularly the high-yield financing market, which consists of the leveraged loan market and the high-yield bond market. If you have some kind of shock to the system, a radical change in Fed policy or something along those lines, a whole bunch of deals could be put at risk at the same time. We are particularly sensitive about putting a lot of our assets in LBOs. Therefore, we try to manage that number pretty carefully. That’s a good example of our risk-management strategies and our attempt to minimize what we call systemic risk.

Fred: That’s hard to say. We pass on lots of deals. We look at virtually everything with a market cap of $200 to $300 million and up. I want to make an important point on deal size. There is not a cornucopia of opportunities out there in small mergers and takeovers. There are plenty of people looking at those transactions and, if anything, on a risk-adjusted basis, it could be a less attractive place to be focused. One of the advantages you have in investing in a transaction with, say, IBM on the buy side or any large transaction with a buyer of that quality, is that the decision to do the acquisition in the first place has to be an institutional decision. It’s not the whim of one strong-willed executive who might have founded the company and treats it like his personal fiefdom. We’ve seen deals called off on little more than what appears from the outside to be just a change of heart on the part of one key person or small group of advisors. In multi-billion dollar transactions, it tends to be more of an institutional decision-making process. I’m not suggesting they’re without risk. Obviously, there are examples of billion-dollar deals that didn’t happen. The risks are different, however. In answer to your question, we look at just about everything with a market cap of $200 to $300 million or higher. I’m not sure what percentage of transactions we invest in, but we tend to be pretty selective. There are whole groups of deals that we tend not to invest in. Bank deals used to be an area where we had lots of investments. Now we have fewer bank deals in the portfolio because the rates of return tend to be pretty uninteresting at 3% or 4% for some of these transactions. You can do as well in a money-market instrument, and it makes absolutely no sense to me to be invested in a deal that offers those kinds of rates of return relative to what you can get in a money-market investment. So, we haven’t invested in many bank deals, and I think we’re involved in just one right now. But there are some wrinkles there, and the expected return in that transaction is in the mid-teens.

Bonnie: First of all, we look at every deal every day. We have real-time spreadsheets that update every time a stock trades, so we’re always looking at deals whether they’ve been extended or not. If the spread narrows too much and we think that we’re not being compensated for the risk, we’ll reduce or eliminate the position. Maybe it will then widen out tomorrow and we’ll reinvest in it. We’re very fluid here. We’re always looking at the spread. Deals may be extended for a variety of reasons, sometimes for a reason that increases the risk, sometimes not. Again, we’re going to want to be compensated for any increased risk. Or if we think that it’s too risky, we might choose to get out of it completely. For all of our positions, nothing is in there for life. Positions are added and stay in the portfolio as long as we think that the risk-reward profile is attractive. If we feel at any point that the deal is getting too risky relative to the potential reward, we’ll sell the position.

Fred: We have no mechanical decision-making rules here. Arbitrage spreads have gotten more volatile. I think part of that is because there is a lot of money allocated to the business, maybe a little less now than six months or a year ago, but nonetheless a lot of money. Not all of the players in our space have been around the block that many times. Many of the people setting up arb shops are former traders, and this may be true for hedge funds in general. They bring a trader’s mentality to the business, and I think that some of the aphorisms floating around Wall Street capture the trader’s mentality. For example, "Never fight the tape.," or "The tape never lies." Well Bonnie and I, in 26 years of investing in over 2,000 arbitrage situations, have seen the tape lie a lot. If you bring a trader’s mentality to the business, and you see a spread blowing out and you don’t know why, there’s a real temptation to sell first and ask questions later. I think that kind of mentality leads to volatility and, on occasion, to compelling opportunities for those of us who don’t get shaken out because of the way the stocks are acting on the tape. This is particularly true in a period just after some major blow-up in the business. After Guidant ran into some problems last fall, we saw spread volatility increase in other names as rumors spread through the marketplace that those deals might be in trouble as well. The problem is that if you say, "Well, I’m going to pick a point beyond which I’m not going to stick it out any longer," or "I’m going to dump our position or part of it if the spread goes against us by 10% or 15%," you’re asking to be whipsawed. You’re setting yourself up to be whipsawed. Just as your trigger point is hit and you’re selling, that could be a great opportunity to be buying. As a result, we don’t employ mechanical stop-loss trading rules at Westchester. I think they might lend themselves to other kinds of investing, but I don’t think they work very well in the arbitrage business.

Each firm finds its own comfort level with respect to risk-management strategies. Our rates of return in the last year or two have been nothing to write home about, but I don’t think anybody can look at our standard deviation or our beta and suggest that we haven’t at least served as a good diversification tool during that time, or that our risk management strategies aren’t working. For example, I think the way that we have played Guidant speaks volumes about our approach to risk management, and it has nothing to do with mechanical stop-loss orders or mechanical loss-control rules. Before the first story appeared in the New York Times about a death resulting from a defective Guidant defibrillator, Guidant was one of our largest positions. I think if you went around the Street and talked to other arbs, you would have found the same thing. Everybody liked the deal because it was a big, highly liquid, seemingly high quality situation that offered an above-average arbitrage spread. What was not to like? Plus, you had a very high-quality buyer. When the first story about defective products ran in The New York Times, they put it on the front page, and it seemed like every day they had a new story trashing Guidant. The arbitrage spread widened out a little bit, but it didn’t widen out that much. The first good thing that we did with Guidant is we said we think our peers are being a little too complacent about this. We didn’t think the spread had widened enough relative to the headlines and the headline-risk going forward, so we significantly reduced our Guidant position. As the problems became more severe and the recalls became larger, doubts about the deal grew. We shifted from a spread position where we were long Guidant and short Johnson & Johnson to a covered-write position, in which we were long Guidant and short Guidant call options. You’re almost always in a less risky situation when you’re doing covered-writes. There was a lot of juice in the options, and we just thought that was a better way to play the deal. Hence, we not only cut our position, but we were playing the deal in a less risky fashion, while many of our peers were maintaining their positions or even building them. Before Johnson & Johnson cut the price, we felt there was a good chance that they would do so. However, we thought it might be on the order of 10%, and we were not expecting 17%. We were one week away from having our entire Guidant position called away from us because our options were about to expire and they were in the money. We would have looked like complete heroes, but because we were short Guidant options and not long the spread, we lost less money than our peers. Then, after Johnson & Johnson cut the price, the spread was really large because many arbs were concerned that the new merger agreement might still give Johnson & Johnson an out, which we didn’t believe. We started rebuilding the position on spread, going long Guidant and short Johnson & Johnson. We timed that perfectly because a week or two later, Boston Scientific came out of the blue and decided that it would offer $72 a share for Guidant, topping J&J’s $63 offer. I’d say that right now, thanks to all those option premiums we earned and how we kept rolling our Guidant options, we are close to a break-even level in Guidant. I can’t imagine that there are many other arbs who could say that. That’s an example of risk management, and it was never done with any kind of mechanical decision-making approach. It was done based on judgment and on straightforward risk management. You don’t always have to be long the spread, that is, long the target and short the acquirer. You can play deals with options or take other approaches. I think even though we haven’t made any money yet on Guidant, it was one of our finest hours in terms of risk management. We will know in a week or so if we are going to actually make money on this position, because we’ll be hearing from Boston Scientific on whether they are going ahead at $72 per share.

Fred: Our expense ratio hasn’t increased at all. It’s the way they’re calculating the expense ratio. It has to do with whether dividends owed on short positions and interest on borrowing should be included in the expense ratio or not. The SEC is now saying that you have to show it both ways and there are certain times when you can only show the higher number. Our expense ratio has not changed, it’s always been about 135 basis points. If there are dividends owed on short positions or interest charges on borrowing, we really don’t think that has anything to do with an expense ratio.

You can go back and look at our prospectuses and Statements of Additional Information, and you will always see those two numbers. One is an expense ratio without dividends on short positions and interest expense, and another line in the prospectus has those added back. The only thing that has changed is that the SEC wants the headline number to be the all-in number, including dividends on short positions and interest expense.

Just to clarify the point about dividends on short positions, when you sell a stock short and you maintain that short position through an ex-dividend date, you owe that dividend to the person from whom you borrowed the shares. It is a cost of doing business and one that we include in our rate-of-return calculations. It’s embedded in the Fund’s daily NAV. What’s a little strange about the SEC’s approach to this particular calculation is that, as I explained before, when we sell a stock short, we generate a rebate. We earn a rebate on that short position, and that’s worth real money to the Fund, but the SEC does not allow you to take rebates on short positions and net them against the dividends you owe on those same short positions. That’s why we don’t think it’s a very helpful statistic. But, nonetheless, just to nail down the point, there has been no change in the Fund’s expense ratio in recent years.

Fred: We are actually going to make some money this year! October was one of those outliers. We’ve been in this business 26 years, and we’ve only had one or two months in our history like that. We were on our way to having a solid year in 2005 but then we had four broken deals in one month. That’s never happened to us before and I don’t think it’s likely to happen again anytime soon. I believe we will get back on our trendline and have a good year in 2006. We’re optimistic about the opportunities available to us. As we mentioned earlier, M&A activity is running at healthy levels. Arbitrage spreads are a little wider and we see enough opportunities that we’re seriously considering re-opening the Fund. So I think we’ll have a good year.

Bonnie and Fred: Thank you. We appreciate your support over the years