Hedge Fund Strategies Event Driven Originally Published Q4 / 2014 Page 1
Hedge Fund Strategies Event Driven 3 4 5 6 7 Introduction What are Event Driven Funds? Event Driven Sub Strategies The Advantages of Event Driven Funds Conclusion Page 2
Customized Hedge Fund Portfolio Soutions for Advisors Introduction The event driven hedge fund strategy is a catalyst-driven investment approach where managers seek to profit from pricing dislocations brought about by a corporate event. Event driven investing is considered one of the more opportunistic hedge fund strategies in that managers pursuing this investment style have the flexibility to invest across a company s capital structure. As a result, the portfolios of event driven managers are fairly balanced between investments in both equities and credit; although holdings will shift somewhat depending on the stage of the economic cycle. The success of the event driven strategy is highly dependent on a manager s ability to accurately predict the potential outcome of various corporate events and, to some degree, the volume of investable corporate activity. This distinguishing factor translates into a return profile for event driven funds that is predominately idiosyncratic in nature and considerably less susceptible to directional market moves. Page 3
What are Event Driven Funds? Event driven hedge funds seek to capitalize on potential mispricings of securities related to specific corporate events. These events can entail such actions as mergers and acquisitions, spin-offs and asset sales, regulatory and litigation changes, as well as restructurings, recapitalizations, and bankruptcies. Event driven investing is characterized as an opportunistic investment approach that offers managers the flexibility to invest across a company s capital structure and the ability to rotate their portfolios to the most compelling risk/ reward opportunities. This fairly broad mandate allows event driven funds to exploit opportunities irrespective of the market environment. For example, during expansionary times, corporate activity tends to surge as a result of increased confidence at the executive level, which generally results in event driven managers allocating a majority of their portfolio to equities in order to capture the potential wave of deal activity. In other instances, strong market conditions have a greater tendency to expose companies who are underperforming their industry peers. This underperformance creates an opportunity for an event driven manager to initiate a position in the company and capitalize should that company undertake value enhancing actions. Such catalysts to unlock value include, among other steps, separating stable free cash flow segments from high growth, capital intensive business lines, spinning off non-core, legacy assets, or assuming incremental leverage at attractive rates in order to buyback outstanding shares in the marketplace. However, in periods of economic contraction, event driven managers often become increasingly active in distressed investments in an attempt to extract profits from the bankruptcy cycle. During these times, the aim is to invest in the debt of companies experiencing financial or operational distress. In these situations, it is not uncommon for event driven managers to act as quasi-liquidity providers whereby they convert their debt holdings into eventual equity stakes and benefit as the company emerges from the restructuring process with a much more manageable capital structure. Nonetheless, whether in expansionary or recessionary times, successful event driven managers generally possess vast deal experience, deep industry knowledge, and strong legal capabilities in order to assess the outcomes of a wide range of corporate events. Page 4
Event Driven Sub Strategies Merger Arbitrage Merger arbitrage, also known as risk arbitrage, is a commonly implemented event driven sub-strategy. Merger arbitrage comprises a simultaneous long and short investment in two companies involved in a merger or acquisition. When the merger is executed via a stock transaction, a risk arbitrage manager will commonly purchase the stock of the target company and sell short the equity of the acquirer. In cash tenders, the manager aims to capitalize on the difference between the price at which the target company s shares are trading and the value of the tender. Ultimately, an investor pursuing a merger arbitrage strategy seeks to exploit pricing inefficiency caused by the transaction. For obvious reasons, the success of the merger arbitrage strategy is closely tied to corporate deal flow. Another key driver of profits for risk arbitrageurs lies in capturing the deal spread. Deal spreads are influenced by several idiosyncratic factors, but always bears a close relationship to a risk free rate such as the U.S. 10 Year Treasury. In a low interest rate environment, deal spreads for plain vanilla transactions are more likely to be rather tight and unlikely to meet the return thresholds of the more institutional-quality event driven hedges funds. Merger arbitrage is not without risk, and the primary concern for managers is deal break. Arbitrageurs must gather as much data as possible in order to most accurately assess a deal s risk, reward, and probability of closing. The most common cause of deal failure is regulatory scrutiny due to antitrust concerns. Regardless of the cause, deal uncertainty is an integral factor in the market s determination of a deal spread; the higher the risk, the wider the spread. Activist Investing Activist investing is a more specialized sub-strategy of event driven investing where a manager acquires a sizeable stake in a target company and seeks to effectuate extensive change through operational improvements or capital structure enhancements. Activist investors see hidden value in a company and may work with management teams constructively to unlock it. In other cases, activist managers will push for the ouster of an entrenched management team if they believe current leadership is incapable of improving the prospects of the company. Activist investors generally rely upon highly intensive, sometimes forensic, research to identify companies suffering from poor cost structures, mismanagement, underperformance, or any other problem they believe can be remedied. Page 5
The Advantages of Event Driven Funds Event Driven Compared to S&P 500 (January 2010 - May 2015) Attractive Absolute and Risk-Adjusted Returns Event driven managers have historically delivered attractive returns from both an absolute and risk-adjusted basis. Over the past 10+ years, the CS Event Driven Hedge Fund Index has produced annualized gains of 6.57% with a volatility of 6.24% and a Sharpe Ratio of 0.83. In comparison to the S&P 500, over the same time period, the CS Event Driven Hedge Fund Index has produced over 110 basis points of outperformance while assuming less than half the risk of the broad equity markets. CS Events Driven Hedge Fund Index S&P 500 Index 6.57% 14.53% 5.45% 6.24% Annualized Return Annualized Volatility 70.40% 19.15% 62.48% -52.56% Portfolio Return Enhancer with Less Market Influence Within the context of a diversified hedge fund portfolio, the event driven strategy is commonly considered an enhancer to returns and less of a diversifier tasked with reducing overall portfolio volatility. The success of managers in the event driven space is largely predicated on the ability to take advantage of pricing discrepancies arising from corporate activity. As a result, the performance of the event driven strategy is deemed to be less dependent on the overall movements of the markets as compared to other equityfocused hedge fund strategies. This aspect of the event driven strategy can be quantified through an analysis of the strategy s beta coefficient, which over a rolling 36 month period stood at 0.28 in relation to the S&P 500. Max Drawdown % Months Positive 194.10 0.83 173.89 0.34 Cumulative Value Sharpe Ratio 1.05 0.11 0.28 N/A Sortino Ratio Beta to S&P 500 Page 6
Customized Hedge Fund Portfolio Soutions for Advisors Conclusion The event driven investment strategy seeks to capitalize on mispricings in securities linked to specific corporate events. Managers who pursue the event driven strategy benefit from an opportunistic mandate that allows them to take advantage of the most compelling opportunities across a company s capital structure. Advisors who incorporate the event driven strategy into a diversified hedge fund portfolio have the ability to potentially capture meaningful upside returns that are independent from broader market moves. Page 7
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