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Hedge Fund Monthly
Event Driven Investing
Stephen Rabin, Austral Capital

June 2004

What Is It?

Event driven managers seek to profit from security pricing inefficiencies that may occur when companies are involved in corporate events such as mergers, takeovers, restructures (including share buy-backs, spin-offs and capital returns) and capital raisings.

The investment focus of such a manager is directed to analysing the likely effect on security prices due to a corporate event, rather than analysing and researching company earnings or dividend streams, which is the focus of traditional equity investment funds.

Due to the types of investments made by such managers and the general short to medium term holding period of each investment, the returns of event driven investments are likely to be less sensitive to movements in the general equity market than conventional equity investments.

The aim is to produce consistent high risk-adjusted returns that are non-market correlated.

Types of Strategies

There are numerous investment strategies that may be used to profit from different corporate events. The timing and implementation of each strategy is a matter of manager judgement.

Merger or risk arbitrage is the most well known event driven strategy and involves the acquisition of securities that are subject to a takeover or merger at a discount to the takeover or merger price, or where a higher price is expected. If a takeover offer contains a security (or non cash) element, the event driven manager may short sell the securities offered as consideration or use derivatives to reduce the exposure to downward movements in the bidding company's security price.

Some less well known arbitrage activities that an event driven manager may implement include dividend and rights trading arbitrage strategies. For example, a company may raise new equity capital that is not entitled to an upcoming dividend. The event driven manager may be able to simultaneously buy the newly issued securities and short sell the existing securities at a price differential that exceeds the potential dividend and stock borrow costs.

If the newly issued capital is raised by way of a renounceable rights issue, the event driven manager may be able to simultaneously buy the rights and short sell the existing securities at a price differential that exceeds the amount required to subscribe for the newly issued shares and stock borrow costs. In both cases, low risk arbitrage profits may be generated that are independent of the direction of the security price and equity market.

Changes to the composition of stock indices and location of a security's primary exchange listing may also enable an event driven manager to profit from price movements that result from changes in shareholder bases.

The event driven manager will also assess other corporate events and arbitrage opportunities and take either long or short positions depending on the manager's view as to the risk/reward trade-off of the specific investment.

The Efficiency Conundrum

Although markets are generally efficient, certain securities at various times may be priced inefficiently from the perspective of an event driven manager. However, too many event driven managers operating in a small or illiquid market will tend to remove such inefficiencies fairly quickly and therefore reduce the risk-adjusted returns.

In such cases, running with the herd (ie putting on the same trades as other event driven managers) can be a recipe for mediocre risk-adjusted returns. Therefore, certain event driven managers may implement trades that are the opposite of the trades executed by the majority of event driven managers.

In summary, market efficiency may be welcomed by economists, but not by event driven managers - at least until the trade has been fully executed.

Manager Judgement

As with all investment strategies, successful implementation requires judgement. A skilful event driven manager should be able to analyse events and judge the relevant risk/reward characteristics of each potential trade. He or she must decide in which events to invest and, more importantly, he or she must decide in which events NOT to invest, as a losing trade may require multiple winning trades just to replenish the lost capital.

In addition, a successful manager must constantly assess and control risk - knowing what size investments to make, when to take profits and when to cut losing trades.

Event driven investing requires corporate activity and some level of inefficiency. There are few riskless trades - but the successful management of assessed risks should, over time, deliver superior returns for the event driven investment strategy.


If you have any comments about or contributions to make to this newsletter, please email advisor@eurekahedge.com

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