Corporate Life Cycle Investing

Outlook for event driven strategies

Originally published in the September 2007 issue

The event driven hedge fund strategy, also known as ‘corporate life cycle investing’, involves investing in opportunities created by significant transactional events, such as spin-offs, mergers and acquisitions, bankruptcy reorganisations, recapitalisations and share buybacks.

According to Hedge Fund Research, this strategy is currently one of the most popular hedge fund strategies, with flows of US$15.7 billion year to date through Q2 2007. This made it the third leading single hedge fund strategy, led only by equity long/short and relative value arbitrage.

Event driven returns were particularly high as well, with the HFRI Event Driven Index posting gains of 8.43% YTD through Q2 2007. This made it the second-best performing hedge fund strategy on the year. 92% of the past 12 month returns on the index have been positive. One aspect of this which became particularly profitable earlier this year, due to the high number of mergers, was merger arbitrage, in which hedge fund managers try to exploit the movements in the stock price of companies undergoing corporate activity. According to the Dow Jones Hedge Fund Index, merger arbitrage posted a return of 2.45% in March, moving it into the index’s top-performing spot for the year with a cumulative return of 13.27%. (This same index reported less positive results for the overall event driven strategy, which is listed as returning -1.12% in July.)

Merger opportunities look set to continue at strong levels, though with a slight pullback due to the recent ripple effect of the Bear Stearns fund collapses and other problems caused by the crisis in the sub-prime loan market. This combined with high levels of liquidity leads HSBC Alternative Investments Limited to believe that the event driven sector, and the merger arbitrage sector in particular, is likely to be a strong performer in the next 18 months.

“[HSBC believes] the event driven sector, and the merger arbitrage sector in particular, is likely to be a strong performer in the next 18 months”

Notable merger activity in Europe this summer included the London Stock Exchange, which was in the news as the acquiring party in a £3.9 billion deal with Borsa Italiana, the Italian exchange operator. The dealwas largely viewed as an attempt to prevent further suitors for the LSE.

Other deals in the merger space included EWS, the largest freight operator in the UK, which was acquired by Deutsche Bahn, the largest operator in Europe. In Switzerland, Roche, the Swiss drug maker, made a hostile approach for Ventana Medical Systems.

In the US, LBO buyouts continue to dominate takeovers. Guitar Center agreed to be bought out in a cash deal from a private equity group, while Komag, a digital data storage component manufacturer, has been in the news as the SEC investigates a surge in option trading in the stock prior to the announced takeover deal by Western Digital.

Where event driven and special situation managers dynamically move exposures, investments in these funds continue to be profitable, and should continue to do well. In the news in the global automotive industry, DaimlerChrysler finally decided to sell off the Chrysler unit in a move that most market participants have been awaiting since the ill-fated merger took place.

On the distressed opportunity side, there continues to be limited opportunity for new investments at present following the continued lack of new defaults. The distressed securities hedge fund strategy posted negative returns of -1.82% in July on the Dow Jones Hedge Fund Index, but is still up 4.75% for the year. Most managers are expecting this strategy to pick up towards the end of 2007 and into the beginning of 2008 as the effects of excess leverage work their way through global markets.

The leveraged loan and high yield bond markets had several deals repriced substantially or cancelled altogether during June. Managers see positive fundamentals buoying the credit markets, but technical issues are adversely influencing the forward primary issuance pipeline. Most managers are expecting a follow through repricing of the high yield market and a slowdown in CLO demand going forward.

As expected, credit strategies have recently struggled and will likely continue to do so, as both correlation and curve trading were challenged by market sentiments.

Managers involved in specialty financing have delivered small positive returns with most noting that the effects of the deterioration in the sub-prime mortgage markets have started to trickle into their credit markets.

The low levels of default and continued tight credit spreads have proved challenging for managers historically active in the distressed space. We continue to view volatility levels in the equity markets as benign, providing little traction for managers, while convertible issuance continues to be positive.

However, due to overwhelmingly strong activity in the merger space, with a full pipeline over the course of the next three to six months and high levels of liquidity, we remain confident on the overall strategy and maintain a positive outlook. The sub-prime credit market meltdown has created volatility in the corporate credit market. Despite strong corporate balance sheets, spreads have widened. We continue to believe that this move is healthy and that longer terms spreads will trade wider than the past 18 months.

Though reading the standard newspapers may not emphasise this, there are many positive opportunities stemming from the sub-prime crisis that can be exploited. For example, we are already seeing some of the more credible managers proposing specialist vehicles to profit from the opportunities thrown up by the recent dislocations in the US sub-prime sector.