Event-Driven Strategies

A favourable environment

TEUN JOHNSTON, CHIEF INVESTMENT OFFICER, CAAM AI

Event-driven strategies are equity oriented strategies involving investments, long or short, in the securities of corporations undergoing significant change such as spin-offs, mergers, liquidations, bankruptcies and other corporate events. Substantial profits may be generated by managers who correctly analyse the impact of the anticipated corporate event, predict the course of restructuring and take positions accordingly. Depending on the nature of the corporate event, either relative value or directional positions will be taken. Event-driven strategies are therefore intimately linked to the level of corporate activity. Despite a correlation with corporate activity and stock market performance, both investors and managers aim to capture consistent absolute levels of returns.

As investors become more concerned about their risk-adjusted returns amid bearish and flat market environments, interest in such strategies has gained momentum. The performance achieved over the past years and especially in 2006, has given rise to great interest in event-driven strategies among investors. On average, the share of net capital flows into alternative investments directed to event-driven funds has exceeded 20% over the last five years and has been close to 26% over the last three years.

Over the last three years, the growth in assets under management attributable to net capital flows in event-driven strategies has been over 18% per year on average (versus 14% per year for alternative investments over the same period). In 2006, AUM growth in event-driven strategies attributable to net capital flows remained close to 11%. These figures illustrate investors’ soaring appetite for event-driven strategies. The performance achieved by event-driven managers over the last few years has been supported by a favourable environment both at a macro economic and corporate level.

What makes a favourable environment for event-driven strategies?

Event-driven strategies aim to exploit any special situation in corporate life that may affect the valuation of a security. Such events could be at management, strategic or operational levels. Although most event-driven managers’ performance is driven by specific situations, one can highlight the criteria in Fig.1 as favourable for event-driven strategies.

Risk inherent to the strategy

Even though event-driven strategies have the ability to produce performance that has limited correlation with equity markets, there is a dependence on external factors and in the short term, there can be equity market relation. One of the major risks inherent in event-driven strategies is that managers’ portfolios can be concentrated. Strategies such as merger arbitrage or corporate restructuring are highly correlated to corporate activity and economic cycle.

Whilst economic growth is positive, further consolidation is likely to occur in various strategic sectors (banks, pharmaceutical, mining industries). 2006 has been a year where economic indicators were favourable to corporate activity across the board. This high level of M&A activity experienced last year was in line with solid fundamentals both at corporate and macro economic levels. In a recessionary environment, strategies such as investing in restructuring and distressed securities are favoured. Merger arbitrageurs have an important exposure to deal risk when a merger fails to go through and managers must assess deal risk prior to entering risk arbitrage. Distressed securities managers are exposed to a high degree of risk as restructurings are not always successful and losses can be significant if they fail. A certain degree of diversification at the position and industrylevel is important.

Event-driven and, more specifically, merger arbitrage strategies tend to flourish when the economy is growing whilst distressed investments benefit from a weak economy. To maintain consistent performance, some managers shift the portfolio between risk arbitrage and distressed securities at different stages through the cycle. Both activities tend to be counter-cyclical and show low correlation. Figure 2 illustrates the uncorrelated rolling returns of event-driven and distressed securities returns in a multi-strategy fund.

In order to be successful, a hedge fund manager focusing on merger arbitrage and event-driven strategies needs to correctly assess the future course of price movements of specific securities, as well as correctly assessing the probability of proposed or announced transactions actually being completed. Good managers tend to create positions that maximise the risk reward as this relates to a particular situation. There is no guarantee that a manager will be able to predict accurately these price movements or correctly assess whether such transactions will be effective. Managers have to take into consideration these event risks. Merger arbitrage and event-driven investing is also subject to market risks with regard to the price of securities and investments. Performance may fluctuate from period to period due to the inherently speculative nature of risk arbitrage transactions. The strategy may employ leverage and other investment as well as hedging techniques. Moreover, the strategy invests in vehicles which, in most cases, have medium to long-term horizon. Because managers can take significant positions in the securities of companies they may be exposed to liquidity risk.

Review of 2006 drivers of performance

2006 was a tremendous year for most equity markets and certain alternative investment strategies, including event-driven strategy. The success of the strategy has been in part driven by the record level of corporate activity, particularly in Europe and the US. This was driven both by corporate acquisitions and private equity acquisitions.

Such an environment has been favourable for event-driven strategies, which returned on average 15.2% according to Hedge Fund Research indices. In 2006, the value of announced deals increased by nearly 41% globally to $3.80 trillion. The US was the most active region with $1.57 trillion of deals announced, followed by Europe with $1.43 trillion. This buoyant M&A activity in 2006 created a myriad of opportunities for managers. The takeover boom in 2006 was mainly driven by consolidation momentum in different sectors, such as telecommunications, banks, utilities and the pharmaceutical industry.

The year has been punctuated by large deals such as the Boston Scientific Corp.’s $25 billion offer for Guidant Corp. or Mittal Steel’s $18.6 billion hostile bid for its French competitor, Arcelor SA. Another key driver of the performance in 2006 relied on LBO activity, which had a significant impact during the year, representing 27% of all US deals. Private equity firms continued to participate in ever greater deals, raising a record of $404 billion globally (Source: Private Equity Intelligence). The market environment was favourable thanks to robust equity markets and readily available financing from bank and bond markets at low interest rates. Another development is the more activist role played by hedge funds in shaping corporate activity.

ARRAY OF OPPORTUNITIES IN 2007

First quarter analysis

The positive factors outlined above in relation to 2006 are persisting in 2007. The first quarter ended with record levels of corporate activity, driven by consolidation in certain sectors including banking that is currently attracting a lot of interest from event-driven managers.

The year started well for event-driven with January being positive for most managers in the class. However, the sharp sell-off at the end of February led to small losses or muted performance for many managers during the month. These losses were primarily due to a fall in global risk appetite caused by sub-prime mortgage worries in the US and weaker markets in Asia.

For many of our managers, March was the strongest month this year. Some participated in upside from the ABN Amro takeover after a well known fund began agitating for restructuring of the group in mid-March. Other managers also recognised the value in ABN and have been active in this stock.

Other prominent deals announced over the quarter were the takeover of Alliance Boots by KKR, Imperial Tobacco’s takeover of Altadis and Porsche’s takeover of Volkswagen.During the second quarter and for the rest of the year we expect to see a continuation of the strong M&A activity as credit is abundantly available and private equity money remains a driving factor in global markets. One of the key negatives for such a strategy’s assumption would be either a ‘shock’ to the market or a significant change in the risk appetite of the buyers of equity securities.

Future outlook

Event-driven strategy: merger arbitrage, special situation, restructuring…

Many operators in this space continue to predict a high level of corporate activity. In 2006 event-driven activity increased significantly due to corporate cash reserves, a strong economy, high levels of private equity activity and a rising equity market. In 2007, similar factors still exist and many expect an equally good year. In contrast with 1999-2000, the M&A boom is not confined to particular sectors (telecom and financial) but widespread within the banking, pharmaceutical, utility, energy, and mining and telecom sectors, and is driven by companies looking for global scale through acquisition. Indeed, the mining industry continues to be one of the most active sectors for M&A. M&A activity is robust in Europe and is likely to continue as companies seek to consolidate further. Furthermore, the percentage of cash on US corporate balance sheets is at record high levels and is generally deployed for M&A, special dividends and/or share repurchases.

The outlook of the stock market in 2007 continues to look attractive, not withstanding the sell off observed in March which demonstrated that sentiment can change quickly. Though strategists remain divided on the outlook for future earnings, the first quarter earnings in 2007 have generally been quite strong.

Worldwide M&A activity increased by 41% in 2006, reaching its highest level since 2000. This momentum is expected to continue or even accelerate in 2007 as ongoing positive economic factors, as well as increasing hedge fund and private equity interest, set the stage for an another strong year for M&A activity.

Moreover, since the relatively low level of interest rates and abundance of cash create significant financial capacity for M&A deals, the volume of deals will remain strong. In addition, a slowdown in growth in the US will push companies to search for new productivity gains via M&A rather than capital expenditure.

Corporates have above average balance sheet strength, strong free cash and there is an ample supply of private equity buyers interested in buying large companies. In such a context, private equity is likely to remain a catalyst for M&A activity in 2007. According to Credit Suisse, at the beginning of 2007 there was approximately $280 billion of ‘un-invested’ private equity money held in cash by LBO firms. Credit Suisse assumes this amount to be leveraged up to 6.5x net debt to EBITDA reaching $1.3 trillion in potential LBO funds for investments.

Based on these observations, we believe that event-driven strategies are likely to perform well in 2007. The ability of managers to benefit from this favourable environment will depend on their ability to extract returns and adapt to any abrupt change in the economic cycle by being sufficiently well diversified and hedged to deal with adverse developments, either at the position or market level.