Introduction

An event-driven investment manager is typically looking to invest in situations where there is some form of corporate activity or catalytic change taking place. Corporate activity can include mergers and takeovers, restructuring, reorganisations, spin-offs, asset sales, liquidations, bankruptcy and many others.

When companies are involved in corporate activity the prices of the securities of the companies involved can become artificially inflated or depressed as the market in general finds it more difficult to evaluate and value securities subject to corporate activity. By specialising in building strong knowledge-based or sophisticated models of corporate events and complementing this with deal- and company-specific research, an event-driven investment manager seeks to identify mis-priced situations where he believes he can achieve superior risk-adjusted returns.

Merger or risk arbitrage

Merger or risk arbitrage is probably the most commonly known event-driven investment strategy. Taking a very simple example; a company is subject to a cash takeover at 50 Euros a share. Prior to the deal announcement the company share price was 30 Euros per share. The deal is subject to a number of conditions including financing, shareholder approval and regulatory clearance, and is expected to take six months to complete. After the deal is announced the company's shares trade at 45 Euros a share. The market in general has some doubts that the deal will complete as expected (i.e. there is some deal risk). The original shareholder may not wish to wait until deal completion, he is already up 50% (45-30)/30 on his original investment and could lose all this and some more if the deal were to fail.

The event-driven investment manager will view this differently; by buying the shares at 45 Euros his known upside is 5 (50-45) Euros; equivalent to an annualised return (ex funding) of:

(50-45)/45*12/6= 22.2%

The returns can be attractive and he may also believe there is a good chance of a second bidder emerging at a higher price, but he also faces the same risks that the deal may fail for any number of reasons. His risk can, therefore, be considerable and he must rely on his specialised knowledge and research to identify those opportunities where rewards adequately compensate for the risks taken. Deals can be considerably more complex than the one above; share for share exchanges, share and cash exchanges, deal collars and many other features can be present, which can add substantially to the complexity of a trade and the ability to effectively hedge the trade.

Other event-driven investment strategies

An event-driven investment manager is typically looking for a corporate event such as a catalytic change. Depending on the manager's style and/or mandate, these catalytic events may be very definitive (such as an announced takeover) or they can be much more subtle in nature. In addition to merger or risk arbitrage he may employ many other types of investment strategies; a few examples are explained below:

Capital structure arbitrage: this involves taking long and short positions in the same issuer, for example long debt versus short equity in anticipation of a rights issue or long senior debt versus short junior debt in anticipation of a debt restructuring or bankruptcy which will favour the senior debt holders.

Holding companies versus subsidiary companies: in some countries there are a number of holding companies which hold assets in quoted subsidiaries and it is possible to calculate a net asset value for the holding companies and from there the discount or premium at which the holding company shares are trading. If the event-driven manager believes he has identified a corporate catalytic event that will change this discount or premium he may take a position at the existing discount or premium to profit from this change.

Distressed Debt: this involves taking positions in the debt of distressed companies; these companies may be experiencing severe operating or financial difficulties or even have started the process of restructuring through the sale of assets, a debt-for-equity swap or a filing for bankruptcy. The event-driven investment manager is seeking to identify situations where he believes the market is undervaluing the potential returns to the stakeholders of a successful restructuring, a sale, or a liquidation of the company.

Source of returns

As you can see from the above, event-driven investing can take many different forms. The main source of returns for an event-driven investment manager is identifying situations where the market, in general, is mis-pricing the securities of companies involved in some form of corporate activity. The returns can be very attractive, but there may also be significant downsides if transactions fail. Many event-driven investment managers will seek to make their investment strategies as market-neutral as possible, leaving the bulk of a portfolio's exposure to specific corporate events. What the strategy does offer is a potential stream of absolute returns, which are not correlated to the market, a multi event-driven manager can also find interesting opportunities throughout the economic cycle, from takeovers to bankruptcies.

Some event-driven investment managers screen a large universe of risk-arbitrage deals and rely largely on market-driven probability models to identify attractive investment opportunities. Others perform detailed and extensive analysis of the companies involved, including the rationale, nature and terms of the transactions, legal, competition and regulatory issues before making investment decisions. Whichever methodology is used, those event-driven investment managers that perform well will be those that consistently invest in transactions that offer superior risk-adjusted returns.

Risks

The risks for individual transactions can potentially be significant. Many corporate events can be extremely complex in nature and require many steps and layers of approvals before they can be completed. Transactions can fail at any of these steps or layers for a wide variety of reasons.

The event-driven investment manager can seek to mitigate some of these risks, by analysing and studying the events to obtain a better understanding than the market in general, by investing in a diversified portfolio of event-driven situations, by being aware of the risks and downsides if transactions fail, by having effective risk-management controls and systems and by monitoring very closely developments in the underlying transactions.

Summary

The success of any investment strategy is highly dependent on the skills and implementation ability of individual managers. A good event-driven investment manager is a useful addition to a diversified portfolio of investments, capable of producing absolute non-market correlated returns throughout the economic cycle.