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Event-Driven Investing - September 2013

    CPD
    Approx.40min

    Introduction

    Nokia’s shares rose roughly 35 per cent on the news, while Microsoft’s fell 5 per cent. The market’s reaction to this type of event is how event-driven hedge funds make, or lose, their money. Managers use analysis of corporate transactions to determine the likely impact on securities pricing.

    As with many arbitrage strategies, subtlety is important – if everyone knows about a trade, the opportunity disappears. That said, event-driven strategies came to prominence during the credit crisis, when a select few bet against the subprime mortgages market and made a killing. Perhaps the most notable was Charlie Ledbury at Cornwall Capital, who was made famous by Michael Lewis’s The Big Short. Mr Ledbury made a fortune from the disintegration of the subprime mortgage market and those who served it.

    Daniel Capocci, a senior investment manager at Architas multi-manager and author of The Complete Guide to Hedge Funds & Hedge Fund Strategies, says that event-driven strategies aim to profit from important events during the lifecycle of a company: “Such events include recapitalisations, reorganisations, bankruptcies, balance sheet restructuring, mergers and acquisitions, dismantlings, initial public offerings or share buybacks. The uncertainty regarding the outcome of these events creates an opportunity for the specialist able to correctly anticipate it.”

    Although investing in the acquiree is one way to implement an idea, event-driven managers will use other strategies. Mr Capocci says managers will usually combine long and short positions, but may use equity, preference shares, bonds, certificates or other securities that they see as mis-priced as a result of the event.

    The types of deals usually divide into three categories: distressed securities – firms that are at, or near, bankruptcy or liquidation, where managers will see whether the recovery value of a firm exceeds the current price placed on its assets; mergers and acquisitions, where investors bet on the winners and losers from a deal, also known as risk arbitrage; and then a box loosely labelled ‘other special situations’, which encompasses all other potential transactions.

    An event management strategy will start with the announcement of the event. The specialists will then try to predict the likelihood of the event happening and the resulting impact on securities pricing. This will include an analysis of the strategic, financial and operational implications.

    It will also incorporate an analysis of the legal and regulatory implications of the deal, whether it might run into competition issues, for example. They will then analyse the extent to which that is priced into the bonds, equities or other securities linked to a company and take positions accordingly. Managers may go long, on the basis that the outcome will be favourable, or short, on the basis that it won’t.

    Different events will have different time horizons and Mr Capocci says that event-driven managers will strive to keep a balance in the portfolio: “Investment in a friendly merger will have a much shorter horizon than an investment in a bankrupt, distressed company... at the same time, managers will analyse…volatility, liquidity, market and sector risks.”

    The risk for investors is that the course of a corporate event is not predictable: a deal may not be finalised, a counter bid may emerge, the deal may take longer than expected, and even when the outcome of the deal is clear, it may not have the expected impact on securities pricing. As a result, the difference in performance between event-driven managers can be significant.

    Performance will also depend on the leverage within a fund. Amit Shabi, a partner at Bernheim Dreyfus, a Paris-based event-driven hedge fund house, says: “Returns from a market-neutral, event-driven fund are unlikely to exceed 10 per cent per year. If there is a fund with a 40 per cent long bias and three times leverage, returns could be 20-30 per cent per year, but the volatility will be much higher.”

    Ultimately, the success or otherwise of an event-driven manager will depend on their ability to predict the outcome of a deal. This is likely to be less about flair and more about experience in the natural progress of corporate transactions historically. There will always be events on which an event-driven manager can trade, but it is unearthing those that will make real money that separates the good from the bad.

    Cherry Reynard is a freelance journalist

    Investor Sentiment

    John Lowry, chairman of ML Capital, suggests investor sentiment has been very clear – investors have begun to make a big return to equities and intend to continue to do so in the coming quarter

    “As investors continue to flock into equities after capitalising on extraordinary profits in bonds, allocations into multi-strategy continue to dry up. However, tactical arbitrage situations will inevitably start to open up as companies look to borrow, restructure or support M&A.

    “For the third straight quarter investors have exhibited a desire to increase allocations to merger arbitrage strategies.

    “Global markets were previously built on pillars of an unsustainable resource-intensive model reliant on untenable levels of debt. Banks and governments have unwound all but the most toxic distressed products and, as a result, attractive opportunities are now few and far between. Six per cent of investors indicated an intention to increase allocations to distressed products, the lowest levels since the barometer began.”

    In this special report

    CPD
    Approx.40min

    Please answer the six multiple choice questions below in order to bank your CPD. Multiple attempts are available until all questions are correctly answered.

    1. When did the event-driven strategy come to prominence?

    2. What did Charlie Ledbury at Cornwall Capital do that made him famous?

    3. Vodafone recently sold its stake in which company?

    4. Which company recently bought Nokia’s handset business?

    5. What type of funds was the event-driven strategy traditionally used by?

    6. Event-driven strategies display what kind of correlation to traditional equity indices?

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