InvestmentsOct 13 2014

Mispriced shares generate big profits

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As equity and bond markets look increasingly highly valued, investors are seeking diversified sources of returns to protect their portfolios.

A survey by Deutsche Bank suggests that while long/short equity funds have been the principal beneficiary of this, event-driven strategies have also picked up inflows. Such strategies have benefited from increasing merger and acquisition (M&A) activity as corporate confidence builds, driving higher returns.

Event-driven hedge funds have been among the top-performing strategies for the year to date. The average fund is up 4.12 per cent, with specialist activist funds up 6 per cent. Only long/short equity, directional credit and distressed debt funds are up further. The sector is building on a strong performance in 2013, where the average fund delivered 14.61 per cent, with the activist funds up 19.15 per cent, according to eVestment.

Antoine Mallard, founder and chief investment officer at D’Alembert Capital Management, says: “The more activist funds have performed best, lifted by a booming equity market and often a light or no hedging in their strategies. Even the vanilla risk arbitrage players have seen their performance go up as the number of transactions have significantly increased and with a number of major transactions being announced.”

Event-driven funds aim to take advantage of the mispricing of a stock that comes as a result of mergers, acquisitions or restructuring. The event-driven manager will look at the underlying value of the company, whether the ‘event’ is likely to be beneficial for the share price in the long term and how they can best exploit any anomalies in the market’s view of the deal. For example, if the manager believed the deal would be beneficial, he would buy the stock while the market was unsure.

Activist investors go one step further and attempt to force change on company boards. Headline-grabbing groups such as Pershing Square build stakes in companies and then use their position as shareholders to try and expose poor practice at companies and bring about strategic change. Pershing Square’s most high-profile campaign has been against weight-loss group Herbalife. Bill Ackman, head of the hedge fund, accused the group of “incredible fraud” and of operating a pyramid scheme. At the same time, he took significant short positions in the shares.

The M&A environment is vitally important for event-driven funds. Thomson Reuters data showed year-to-date global deal volume to the end of June had surged to $1.75trn (£1trn), up 75 per cent from a year ago. This represents the highest level since 2007 and is in large part a reflection of increasing corporate confidence. As the economy recovers, corporate management is more inclined to buy, sell and do deals.

At the time, Thomson Reuters predicted that the dealmaking frenzy could endure for as long as buyers were keen to take advantage of high stock prices, ample cash reserves and cheap available financing. But can this environment continue in the face of higher interest rates and geopolitical uncertainty?

Mr Mallard says: “The environment is clearly extremely supportive for the strategy as a whole with a flurry of corporate activity, while volatility is increasing, which is a good thing for those who know how to use options.” He adds that while cash-heavy balance sheets and the return of CEO confidence will bolster corporate activity for a few years, it will be only in certain industries. “Some industries are almost consolidated with just four to five players and as such, there is only a small window of opportunity. We see that in such industries as beer, cigarettes, cable, French telecom services and specialty chemicals.”

He believes that private equity-type deals should continue to perform well: “This means identifying potential leveraged buy-out targets and obtaining the same required changes as their private equity counterparts.”

Some believe that higher interest rates may not stall M&A activity. Amit Shabi, a partner at event-driven hedge fund house Bernheim Dreyfus, says that while it may be easier to finance debt to undertake M&A activity in a climate of lower rates, often higher interest rates will generate more confidence because they reflect a more buoyant economy.

As a result, there is nothing to suggest that the current vogue for event-driven funds is likely to subside. Nevertheless, investors should exercise some caution if interest rates or geopolitical problems start to exert an influence on markets.

Cherry Reynard is a freelance journalist

Risk arbitrage: key figures

$1.8trn

Worldwide M&A deal value in the first half of 2014, up 73 per cent on a year earlier

39%

The amount (totalling $689.1bn) of overall M&A volume in the first half of 2014 that came from cross-border M&A

$337.8bn

Deals announced in Asia Pacific in the first six months of 2014 – the region’s strongest first half of dealmaking since 1980

Source: Fidelity Worldwide Investment