InvestmentsSep 23 2013

Strategies for the event-driven investor

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Vodafone’s sale of its stake in Verizone Wireless and Microsoft’s purchase of Nokia’s handset business are just the type of corporate deals that interest event-driven investors.

Joe Childs, manager at Hedge Fund Performance, explains: “Event-driven investing is an investing strategy that seeks to exploit pricing inefficiencies that may occur before or after a corporate event, such as a bankruptcy, merger, acquisition or spin-off.”

Once primarily used by hedge funds, event-driven investment strategies are increasingly being used by managers of Ucits funds that are available to the retail investor. It could even be argued that the majority of active equity fund managers, to some degree, use an event-driven strategy as part of their process.

According to Towers Watson, the key investment driver behind this strategy is “identifying the mis-pricing of assets due to events such as M&A or corporate restructurings”, and the outcome of these events are not always linked to economic factors which means decent returns can be made in spite of ongoing macroeconomic turbulence.

Co-head of the RWC European Focus fund Maarten Wildschut, explains: “The short-term orientation of financial markets can often lead to mis-pricing of the shares of companies that are undergoing change. With an in-depth understanding of companies and their transformational opportunities, active owners are in a good position to generate strong returns.”

Event-driven investing comes in many forms. Those adopting the strategy may focus on merger and acquisition activity, corporate restructuring, distressed debt securities or active ownership.

Chris Jones, head of alternatives at bfinance, advisers to institutional investors and corporations, explains: “Returns, for example, are driven by the deal premium, the deal flow in mergers, by the default rate, the discount to fair value in distressed debt. There is also a return coming from liquidity premium or, to be more precise, illiquidity premium.

“A lot of distressed debt is semi liquid and can quickly become illiquid in the sense that the hedge fund manager doesn’t want to sell at a completely decorrelated price.”

Active ownership is slightly different and sees investors take a significant stake in a company that they feel is currently being mis-managed and engage with that management team in order to improve future share price performance.

Mr Wildschut’s co-head on the RWC European Focus fund, Petteri Soininen, explains: “Active ownership seeks to generate sustainable shareholder value by improving economic value creation within portfolio companies, reduce discounts through improving interaction with capital markets and improving corporate governance.”

It is argued that the event-driven strategy is largely uncorrelated to the wider macroeconomic events that affect stockmarket.

Towers Watson’s global head of hedge fund research Damien Loveday, explains: “Event-driven strategies can be a source of idiosyncratic returns. For example, the split of assets in a liquidation situation is determined purely in court and the outcome of M&A transactions is often determined by regulators.

“Additionally, for managers with the flexibility to move in and out of event-driven, and between the various strategies, there are different opportunities available throughout a market cycle.

“In recessionary environments, distressed investments in corporates going through liquidations or restructurings can provide attractive investment opportunities, while in economic upswings strong balance sheets and confident management can initiate mergers or distributions of cash to shareholders and even equity opportunities become an attractive strategy.

Mr Jones, however, doesn’t agree.

“If getting a direct yield from complexity and market inefficiency can look like, in good times, quite a diversifying strategy, in bad times it can become quite correlated with equity and credit exposures.

“This issue is never going to fade,” he says. “A market crash or a big sell-off in equity or a big winding of credit spreads will affect the event-driven book and there is very little that can be done to isolate that book from market crashes, or illiquidity problems.”

Mr Jones adds: “As a result, although there’s a good measurable level of inherent return in event-driven strategies, they don’t qualify as effective diversifiers due to the inefficiencies and hidden risks that drive performances.

“This doesn’t mean that it is a bad strategy, but for an investor presumably targeting diversification, this is not the first port of call.”

Jenny Lowe is features editor at Investment Adviser

THE EVENT-DRIVEN STYLE

SUB-STRATEGIES

According to Man Group, which employs the event-driven style in its hedge fund business, a distinguishing feature to the strategy is that it encompasses several sub-strategies with different characteristics.

THE SUB-STRATEGIES:

DISTRESSED INVESTING

Distressed debt managers purchase and profit from the debt securities of companies that are either already in default, under bankruptcy protection or heading towards it. These securities often trade at a significant discount to their par value and are considered attractive because substantial profits can be potentially generated through receipt of a higher settlement during the liquidation process, or by accepting an equity stake in the restructured business.

ACTIVISM

Activist fund managers examine a public company, which they consider to be mis-managed, and acquire a managing equity stake in order to actively engage in its management. Their aim is to push for effective management changes and consequently improve the share price of that company significantly.

MERGER ARBITRAGE

During a merger arbitrage, an event-driven manager may consider buying stocks in a target company and selling stocks in the acquiring company. Once the merger is anticipated, the prices will begin to converge until the deal is announced and the prices align fully. The manager profits from their long positions appreciating in value and their short positions declining in value. Profitability depends largely on managers’ industry knowledge and securities selection expertise and the correct identification and diversification of risks associated with the securities. Returns are event rather than market driven and as such funds tend to show low correlation to traditional investments.

Source: Man Group