Event-Driven Investing

Profiting from both boom and bust

Chris Jones, CIO & Emily Porter, Portfolio Manager, Key Asset Management
Originally published in the February 2007 issue

Event-driven investing – under which we include everything from merger arbitrage to distressed – is a particularly attractive set of hedge fund strategies for two main reasons. Firstly, there is a strong economic rationale for why returns exist – event-driven investors generate a premium from being niche market participants exploiting areas of inefficiency that exist beyond the remit and understanding of traditional equity and bond managers. Secondly, it is an 'all weather strategy' in as much as merger arbitrage and distressed are countercyclical.

Given that event-driven funds tend to thrive from more complex situations, such funds are quick to evolve into new areas where there is less understanding of regulation and valuation by the market in general. For example, we have recently seen event-driven hedge funds take positions in carbon credits, freight rates and airplanes.

Merger arbitrage

Merger arbitrage involves a hedge fund manager taking advantage of market inefficiencies that tend to surround corporate events such as mergers, acquisitions, spin-outs etc. Generally, traditional equity managers will avoid the advanced stages of such event-driven situations as a result of the complexity surrounding the deals, creating inefficiency and hence return. However, despite merger-arbitrage having been in existence for over half a century, the traditional form of this strategy, involving a simple long position in a company to be acquired and a corresponding short position in its acquirer is rarely seen nowadays.

Hedge fund managers in this strategy are increasingly looking at innovative ways of taking positions in the pricing inefficiencies surrounding merger and acquisition activity. Managers may implement trades using options both to profit from the resulting position and a likely increase in volatility if the deal is likely to be contested or see competing bids, and can use sector shorts to hedge a long position in an acquirer company that will see significant synergies being created in the recently augmented business model.

Distressed investing

As with merger arbitrage investing, distressed investing is an approach based on corporate events that has a strong economic rationale for generating returns. Distressed investing involves investing in the debt (and sometimes equity) of companies that are 'distressed' e.g. have defaulted on debt payments or coupons, filed for Chapter 11 in the US, etc. Often, a distressed company's debt will trade at an overly diminished price as a result of market inefficiencies in the traditional investment management world.

Traditional corporate bond investors generally liquidate positions when they become distressed either due to the guidelines in their mandate or due to human nature – a traditional manager would rather get rid of a 'nightmare position' in his portfolio than have it hanging around as evidence of a bad decision. As a result of this sell off by the institutional world, the debt of distressed companies falls to irrationally low levels and at this point, distressed investing hedge funds, who have no constraining rules on owning distressed debt, can take advantage of the mis-pricing and generate a good return.

The current environment for investing in distressed securities is weak purely based on the supply of new investments – the current default rate is historically low in the US and non-existent in Europe. However, the outlook for this strategy is improving as the US economic cycle moves further towards a cooling phase which should see an increased default rate leading to a growing opportunity set of distressed companies. Simple maths based on recent historic corporate bond issuance multiplied by typical expected default rates would also support this argument.

In the meantime, distressed hedge fund managers have been finding returns from the adjacent high yield market and the anomalies that exist within the evolving credit derivatives market but it will be when the economy turns and the default rate increases that will give the opportunity for the 'home run' returns characteristic of this strategy.

Combining strategies

Merger arbitrage and distressed combine very well together to create opportunities throughout an economic cycle. Merger arbitrage based strategies and their variants always perform better in times of economic strength. In such times, credit spreads are tight, stock markets are booming and fast expansion and growth is needed. As a result, acquisitions by cash (borrowing) or stock are easier to facilitate and more desirable, transactions are more common and premiums paid are generally larger, making merger arbitrage-based strategies particularly profitable. When the good times end, however, there is less to be made in merger arbitrage but more in distressed investing. Conversely, distressed performs best when economic times are tough since this is when companies tend to become distressed and stressed the most.

Given that the returns from these strategies have a strong fundamental rationale for their existence, it is possible to look ahead to calculate which strategy is expected to outperform, on the basis of fundamentals. This is particularly relevant at present with all eyes looking for changes in the US economic cycle. Value can be added by rebalancing the allocation between the two strategies with changes in the economic cycle but historically this has not required too much predictive skill – there has generally been a lag of months and years between the increase in default rate and subsequent improved returns in distressed. Furthermore, the widening remit for hedge fund managers in both strategies and the development of the European market with its slightly displaced economic cycle will both diminish the cyclical reliance for each strategy.

As we have seen above, merger arbitrage and distressed strategies are desirable for their ability to generate returns from market inefficiencies and the nature of both strategies to evolve continually ensures such returns are sustainable going forward. Furthermore, given that merger arbitrage outperforms in a strong economy and distressed outperforms in a weak one, the combination of the strategies can result in an 'all weather' strategy that has potential to generate returns in times of boom, bust and in-between.