Understanding Hedge Fund Strategies: Event-Driven Strategies

moscow2-hedgethink Understanding Hedge Fund Strategies: Event-Driven Strategies

Some hedge funds choose to focus on event-driven strategies. This involves event-driven managers seeking to profit from security pricing inefficiencies that can occur when companies are involved in a range of corporate events, which includes takeovers, restructures, mergers, capital raising, share buy-backs, spin-offs, asset sales, liquidations, bankruptcy, capital returns and many others.

As you can see, this gives event-driven managers an array of investment opportunities and chances for profit.

How it works

The focus of funds that invest in this way is to analyse the likely effect on security prices due to such a corporate event, rather than examining and researching company earnings or dividend streams, which is the typical focus of more traditional equity investment funds.

The chance for profit arises when companies are involved in corporate ‘events’, as the prices of the securities of the companies involved can become artificially inflated or deflated as the market in general finds it harder to evaluate the true value securities hold during times of corporate activity.

An event-driven manager will specialize in forging strong knowledge-based or sophisticated models of corporate events, and will add to this deal- and company-specific research, in order to identify mispriced situations where they believe they can achieve superior risk-adjusted returns.

The aim of these investments is to produce consistent high risk-adjusted returns that are non-market correlated. Because of the types of investments made by event-driven funds and the general short to medium term holding period of each of these investments, the returns here are likely to be less sensitive to movements in the general equity market than conventional equity investments.

Types of Event-Driven Strategies

Just as there is an array of potential corporate events, so there are numerous investment strategies that funds will use to profit from them. It is up to each individual manager which to use, when to use it, and how to implement it. Let’s take a look at some of these strategies, beginning with the most common.

Merger or risk arbitrage – this is probably the most well known event-driven strategy. It involves purchasing securities that are subject to a takeover or merger at a discount to the takeover or merger price, or where a higher price is expected. If a takeover offer contains a security (or non-cash) element, the event-driven manager can short sell the securities offered as consideration or use derivatives to reduce the exposure to downward movements in the bidding company’s security price.

For example, say a firm is subject to a cash takeover at $50 a share. Prior to the announcement of the deal, the firm’s shares sat at $30 per share. The deal relies on a number of conditions, including shareholder approval, financing, as well as being cleared by regulators, so it is expected to take six months to complete. Once the deal’s been announced, the share price rises to $45 per share. As the deal involves some risk, the market has some doubts over whether the deal will go through successfully. Meanwhile, the original shareholder may not be wiling to wait this long for deal completion, as they’re already up 50% on their original investment (that’s (45-30)/30). If the deal were to fail, the original shareholder could lose all this and more.

The event-driven investment manager, however, takes a different view. They see that by purchasing shares at $45 their known upside is $5 (that’s 50-45). This works out to the same as an annualized return (ex-funding) of over 22%: (50-45)/45*12/6= 22.2%.

So, in this example, the returns look highly tempting. There’s also the chance that a second bidder may emerge at a higher price. However, the manager essentially faces the same risks as the original shareholder – that the deal will fail.

This is why the bulk of event-driven investing is undertaken by large investment institutions like hedge funds – great expertise, specialized knowledge and serious research and analysis is required to identify precisely where opportunities exist that will deliver enough reward to compensate for the risk taken. Deals can be far more complex than the above example too, with deal collars, share for share and share for cash exchanges and more presenting barriers to effective hedging.

Other Event-Driven Strategies

A fund manager may choose from a variety of further investment strategies, depending on the subtlety of the event in question. Some popular examples are:

Distressed debt – this strategy sees funds taking positions in the debt of distressed companies. Funds will seek out firms that are going through severe financial or operational difficulties, or they may even have filed for bankruptcy, or are in the process of restructuring. The key here is for the event-driven manager to seek out opportunities where they believe the market is undervaluing the potential returns to the stakeholders of a successful restructuring, a sale, or a liquidation of the company.

Holding companies vs. subsidiary companies – this kind of strategy works in countries where there are a number of holding companies that hold assets in quoted subsidiaries and it is possible to figure out a net asset value for the holding companies. From there it’s possible to calculate the discount or premium at which the holding company shares are trading. Here an event-driven manager can spot a corporate catalytic event that may have some affect on the discount or premium, and can take a position at the existing discount or premium to profit from the expected change.

Capital structure arbitrage – this strategy involves a fund taking long and short positions in the same issuer. A couple of examples would be long senior debt versus short junior debt when the fund expects a debt restructuring or bankruptcy which will favour the senior debt holders, or long debt versus short equity when the fund foresees some kind of rights issue.

Seeking Returns

The above are just some of the potential investment avenues open to event-driven investors. But across the board, the main source of returns for an event-driven manager tends to lie in successfully identifying situations where the market, in general, is mispricing the securities of companies that are involved in some form of corporate activity.

As with any investment that offers attractive returns, the risks increase. For this reason, many event-driven funds seek to make their strategies as market-neutral as possible. Successful event-driven strategies offer the chance for absolute returns that are not correlated to the market. As such, a savvy multi-event-driven fund can seek out profitable opportunities throughout the economic cycle, from mergers to bankruptcies.

Seeking opportunities

In order to locate these investment opportunities, funds use a variety of techniques to sift data. Some screen huge amounts of risk-arbitrage deals, relying mainly on market-driven probability models. Other funds perform incredibly detailed research and analysis of companies involved in catalytic events, examining areas such as competition, regulatory issues, legal issues, and the nature and terms of transactions before deciding whether or not to invest. Whatever method is used, success comes when investments are made in transactions that deliver superior risk-adjusted returns.

The Risks – and Managing The Risks

For individual transactions, the risks for investors can be notably high. Corporate events tend to be highly complex, involving many steps of approval to be completed, and transactions can fail at any of these hurdles for an array of reasons.

That’s why a good event-driven investment manager will always seek to mitigate some of these risks. This can be done by thorough analysis of events to improve understanding of them above that of the market in general, by being highly aware of the risks involved in a transaction failing, by ensuring that their event-driven portfolio is sufficiently diversified, and by monitoring event developments as closely as possible.