Key Hedge Fund Betting on Microsoft-Yahoo Merger

Paulson & Co., the hedge fund that raked in billions of dollars over the last year in betting on the subprime credit meltdown, has built up a stake of about 50 million shares in Yahoo in recent months, sources familiar with the matter told Reuters.

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Paulson, a $30 billion "merger arbitrage" hedge fund led by veteran investor John Paulson, began increasing its stake around the time that Microsoft made its unsolicited offer to buy the company, the sources said.

While the Microsoft-Yahoo talks ended this month, the share build-up suggests that Paulson is betting a merger will eventually happen, according to analysts, particularly since billionaire investor Carl Icahn launched a proxy battle to replace the entire Yahoo board.

Yahoo rebuffed Icahn's proposal late Thursday (see below).

"We were disappointed that Yahoo failed to reach an agreement with Microsoft," a Paulson representative told CNBC. "We continue to believe that a combination between Yahoo and Microsoft would form a dynamic company and a stronger competitor to Google. We intend to support the Icahn slate, but sincerely hope that Yahoo will negotiate an agreement with Microsoft thereby making a proxy fight unnecessary."

Icahn disclosed Thursday he holds a stake of 59 million shares, or 4.3 percent, in Yahoo, including 9.9 million shares and 49 million call options.

Paulson's stake would be roughly 3.4 percent of Yahoo, based on 1.375 billion shares outstanding.

So far, Icahn hasn't formally allied with other hedge funds in his proxy battle for Yahoo.

But Paulson's move could add to Icahn's support among Yahoo shareholders, since hedge funds tend to pursue returns more aggressively than other institutional shareholders, and are more likely to vocally press for strategic moves that could boost stock values.

Paulson was among a handful of hedge funds that bet the credit markets would melt down, as they have over the last year.

The bets paid off. Paulson earned an estimated $3.7 billion in 2007, making him by far the highest paid hedge fund manager that year, according to industry publication Alpha Magazine.

Yahoo shares

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[YHOO  Loading...      ()   ] were up about 1.5 percent on the New York Stock Exchange Thursday. Shares of Microsoft

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[MSFT  Loading...      ()   ] were up similarly.

Icahn told Yahoo in a letter to Yahoo Chairman Roy Bostock Thursday that he launched a proxy battle to force it to reopen buyout talks with Microsoft.

Icahn has formed a 10-member rival slate for Yahoo's board to push the company to accept a $33-per-share, or $47.5 billion, offer from Microsoft.

Yahoo: Icahn Has 'Significant Misunderstanding'

Yahoo, meanwhile, late Thursday rebuffed Icahn's plans to nominate a new board, saying his letter "reflects a significant misunderstanding of the facts about the Microsoft proposal and the diligence with which our board evaluated and responded to that proposal."

Microsoft abruptly abandoned its bid after balking at Yahoo's $37-per-share asking price.

Yahoo added, however, that it remains open to a deal with Microsoft or anyone else it thinks fairly values the company.

Icahn also disclosed in his letter that he has acquired 59 million shares and has sought antitrust clearance from the U.S. Federal Trade Commission to acquire up to about $2.5 billion worth of Yahoo stock.

"It is clear to me that the board of directors of Yahoo has acted irrationally and lost the faith of shareholders and Microsoft," Icahn wrote.

Icahn's slate of nominees includes himself, Frank Biondi, a former Viacom chief, and Keith Meister, vice chairman of Icahn Enterprises.

Mark Cuban, Dallas Mavericks basketball team owner and co-founder of cable network HDNet is also on Icahn's slate.

Cuban is also familiar with Yahoo's negotiating style after he sold Broadcast.com to Yahoo in 1999 for about $5 billion.

- Reuters contributed to this report.