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Event-Driven Investing

Guide to Understanding Event-Driven Investing

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Event-Driven Investing

Event-Driven Investing Overview

The event-driven strategy is oriented around investments that seek to exploit and profit from corporate events that can create pricing inefficiencies.

Such events include operational turnarounds, M&A activities (e.g. divestitures, spin-offs), and distressed scenarios.

Corporate events can often cause securities to be mispriced and exhibit substantial volatility, especially as the market digests the newly-announced news over time.

In particular, event-driven funds tend to thrive in situations of greater complexity, especially around M&A and niche sectors.

Types of Event-Driven Investing Strategies

Merger Arbitrage
  • Merger arbitrage actively pursues M&A targets to purchase securities of companies subject to an acquisition or merger at a discount to the offer price, i.e. to trade the premium on announced acquisitions.
  • The investments can be in the form of going long coupled with a short position, reliance on derivatives for downside risk protection, and more.
Convertible Arbitrage
  • Convertible arbitrage refers to profiting from pricing inefficiencies between an issuer’s convertible securities and its common stock.
  • The strategy often pairs a long position in the convertible security with a short in the common equity.
Special Situations
  • The term “special situations” encompasses a variety of anticipated corporate events, such as divestitures (e.g. spin-offs, split-ups, carve-outs).
  • The securities of the underlying company could be purchased under the expectation of a long-term turnaround – or to profit from bets on events such as share buybacks, credit rating changes, regulatory/litigation announcements, and earnings reports.
Activist Investing
  • An activist investor attempts to be the catalyst for change in a company, which is typically underperforming and has fallen out of favor with the market.
  • The active engagement of the investor and implementation of recommended corporate changes can lead to high returns.
Distressed Investing
  • Distressed investors purchase steeply discounted securities, most often in the form of corporate bonds (e.g. debt-to-equity exchange in the post-restructuring entity).
  • The returns stem from the company’s long-term turnaround as it emerges from distress (or finding capital structure discrepancies, e.g. unsecured bonds trading at too steep of a discount compared to secured senior debt).

Event-Driven Investing Performance

Certain event-driven strategies such as M&A arbitrage and distressed investing can perform well independent of economic conditions.

  • M&A Arbitrage: Event-driven investing around M&A has historically performed well during periods of economic strength, as the number of opportunities (i.e. deal volume and count) is the highest, as well as the chance of purchase premiums.
  • Distressed Investing: Conversely, distressed investing performs best in recessionary periods, as more companies become prone to financial distress.

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Merger Arbitrage Investing Example

As an illustrative example, suppose that a company just announced its interest in acquiring another company, which we’ll refer to as the “target.”

Typically, the target’s share price will rise, although the amount will depend on how the market perceives the announcement at the end of the day.

The market attempts to price in various factors, such as the chance of closure, the anticipated synergies, and control premium, which creates a period of uncertainty in the market, i.e. the uncertainty among investors is reflected in the volatility of the share prices.

The market price tends to remain slightly discounted to the announced offer price, which reflects the remaining uncertainty on the close of the acquisition.

An event-driven investor could analyze the potential acquisition to determine how to maximize profits from the opportunity, with consideration towards factors such as the following:

  • Acquisition Rationale
  • Estimated Synergies
  • Deal Closure Likelihood
  • Potential Hurdles (e.g. Regulations, Counter-Offers)
  • Shareholders’ Reaction
  • Market Mispricing

If the transaction appears near-certain to close, the event-driven investor could purchase shares in the target to profit from the post-acquisition stock price appreciation and take a corresponding short position in the acquirer’s shares – which is the “traditional” merger arbitrage strategy.

But more efficient market pricing and increased competition among institutional investors have contributed to more complex strategies being employed.

For instance, hedge funds nowadays integrate options, utilize secular shorts, trade derivatives around the acquirer, and willfully target highly-complex scenarios with more contingencies (e.g. competing bids, hostile takeovers / anti-takeover).

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