The objective of an event-driven investment strategy is to profit from investing in securities that are subject to corporate events. Significant corporate events can cause inefficiencies in the pricing of securities issued by companies undergoing such events (particularly in respect of the probability and timing of the event), which event-driven funds then seek to exploit. Such corporate events include mergers and acquisitions (M&A), capital-management initiatives, directors’ trades, earnings surprises and corporate distress.
Event-driven investing in Asia offers not only a high frequency of corporate events, but also a high incidence of mispricing across the various sub-strategies. This provides an ideal investment environment with the opportunity for attractive and sustainable risk-adjusted returns. Unlocking these returns, however, requires a combination of deep experience with respect to both event-driven investment strategies and knowledge of the various Asian investment markets.
Rubicon Asset Management’s focus and experience is in equity-based corporate events. These types of events include:
- Mergers and acquisitions. Merger arbitrage involves buying securities in companies that are subject to announce takeover or merger offers and, in the event of scrip-based consideration, short-selling the shares of the acquirer. Occasionally there are inefficiencies that lead to the share price of a target company trading at a premium, and this can be exploited by short-selling these shares. Investments may also be undertaken in the acquiring company after the completion of a merger deal.
- Capital-management initiatives. Capital-management initiatives include stock buybacks (where a company seeks to buy back some of its own shares either off-market or on-market), special dividends (non-recurring dividends that are exceptional in terms of either size or date issued), corporate reorganisations (including spin-offs and dual listings as well as capital restructuring) and capital raisings. Asian companies that have been inefficient in the use of capital have a good chance of encountering a period of continued outperformance on the announcement of a capital-management initiative.
- Earnings surprises. Earnings surprises occur when a company announces to the market a change to its profit forecast or a profit result that is above or below market expectations.
- Directors’ trades. The sales or purchases of equities by directors of companies can, on occasion, provide a valuable insight into the future prospects of a company.
- Index changes. Index changes refer to the trading of shares that are likely to or have been subject to the inclusion, exclusion or changes of their weightings within recognised stock indices. Liquidity demand from passive fund managers can create significant investment opportunities around index changes.
Highly Active Region
Asian markets provide an extensive source of investment opportunities as highlighted in the table below.
Summary of Asian Corporate Events in 2005
|Corporate events||2005 data|
|Value of mergers and acquisitions||US$381 billion|
|Value of spin-offs||US$36 billion|
|Value of stock buybacks (Japan)||US$31 billion|
|Value of primary and secondary equity offerings||US$176 billion|
|Number of true market surprises||404|
|Number of index additions||318|
|Number of index deletions||212|
Source: Rubicon Asset Management
While the opportunity set is already significant, we anticipate that the environment may become even more attractive as regulatory and cultural issues gradually improve across markets such as Japan, Korea and Taiwan. For example, regulators across the region appear to be slowly recognising the importance of an efficient M&A environment in increasing the value of their own stock markets. They are breaking down the corporate cultures that attempt to protect existing management at the expense of shareholders and are acknowledging that large cross-holdings, when combined with poor governance and culture, create inefficient equity markets. The result is that certain Asian markets have seen an increase in M&A activity, which is likely to continue. For example, in Japan, increasing levels of regulation have been associated with a 20% growth annually over the past seven years in both the number of M&A deals and the value of deals completed, and this growth is expected to continue.
In addition, the event-driven sub-strategies are subject to their own cycles, or take place independent of any cycle, implying that there will be large number of investment opportunities in all virtually market environments. For example, M&A activity is generally more prevalent around the top and bottom of market cycles, profit warnings are more prevalent in peaking and falling markets, the frequency of capital-management initiatives is typically higher in rising and consolidating markets and directors’ trading will occur in virtually any market environment.
Snapshot: Asian Merger Arbitrage
There are two fundamental questions that a merger arbitrageur asks when confronted with any investment opportunity:
- What is the likelihood of the deal succeeding?
- What is the probability of an increased offer?
Differences in regulatory and cultural environments across the region mean that Asian merger arbitrage investment opportunities can ‘march to different beats’, producing both differing completion rates and rates of increased offers throughout the region. There is definitely not one rule for merger arbitrage that fits all Asian markets.
For example, Australia is one of the more effectively regulated and culturally open M&A markets, not only within the region but also globally. It is characterised by very high deal-completion rates and high rates of increased offers. This combination provides the best of both worlds: inherent capital protection with significant upside potential. It also implies that target companies may trade above the offer price while still representing an attractive investment opportunity.
Japan exhibits the highest completion rates in the region, inter alia, due to the large number of cross-holdings and friendly deals. However, these large cross-holdings combined with the relatively lower levels of regulation, as they relate to M&A, mean that the rate of increased offers is the lowest in the region. In the absence of meaningful optionality, the internal rates of return (IRRs) based on discounts to offer prices represent the primary component to deal returns in Japan. Korea, Taiwan and China have similar investment characteristics to Japan.
The rest of Asia ex-Japan represents a diversity of regulatory and cultural regimes that fall somewhere between the markets mentioned above. The rate of increased offers sits somewhere between that in Australia and Japan, whereas the completion rates are lower than in both Australia and Japan.
The Investment Process
The starting point in making an investment decision around Asian corporate events is to fully understand how each event is likely to behave. This knowledge can only come from hands-on investment experience supported by extensive market back-testing of the performance characteristics of companies that have been the subject of the same events (such analysis helps to identify additional characteristics that may reduce risk or increase the return profile). These characteristics could be stock specific (such as stock momentum or market capitalisation) or event specific (such as optimal investment holding periods).
Upon the announcement of an event, a conviction analysis needs to be undertaken. This analysis combines the factors set out above with some strategy-dependent fundamental analysis to produce the manager’s view of the risk-adjusted return potential of the investment opportunity. For example, when a merger is announced, an event-driven fund manager will combine its understanding of the environment for M&A transactions in the particular market (whether it is Japan, Australia or Asia ex-Japan) and the target and acquiring companies to produce a probability weighted risk-adjusted return. The analysis is similar to the decision tree analysis illustrated in the figure below. The manager assesses the probability for potential outcomes (represented by W, X, Y and Z in the figure) against the prices expected for the various outcomes (represented by P1 to P5). The result is the present value of the investment opportunity, which is compared against the current price of the target, with a positive difference providing a buy signal.
One of the key questions that a potential investor should be asking an event-driven fund manager is: “What is your beta adjusted net and gross exposure?” The purist equity-based Asian event-driven fund managers are focused on isolating the attractive alpha within an investment and construct portfolios with low beta-adjusted exposures. Accordingly, Asian event-driven investing should be predominantly undertaken, either implicitly or explicitly, on a beta-adjusted market-neutral basis. For scrip-based M&A transactions, the hedge is implicit in the short-selling of the acquirers stock (in the case of a cash bid, the beta of the target is typically close to 0). For other event-driven strategies, market neutrality may be derived from either index hedging or pair trades.
In addition, our observation is that the various event-driven sub-strategies exhibit very little cross-correlation. For example, there is no reason why the stock price performance of a Hong Kong-listed company subject to high levels of directors’ trading should be in any way related to a Singapore-listed company that is subject to a capital reduction.
The combination of these factors implies that equity-based event-driven funds should deliver returns that are lowly correlated with underlying markets.
There is no short-cut available for aspiring investment professionals seeking to establish an Asian event-driven hedge fund. The precondition for any portfolio-management team is extensive experience in investing and trading in Asian equity markets and, more specifically, Asian corporate events. This is due to the fact that each individual Asian market has wide-ranging regulatory, cultural and operational (for example, transactional) issues to factor into any investment decision. Many of these factors are taken for granted in more developed markets but in Asia, they can be the difference between realising a significant opportunity and inadvertently causing a significant loss. Transaction processes in Asia are often complex and differ from country to country. For example, it is important to have a firm understanding of settlement cycles, which vehicles are required to access various markets or stocks, how to access hard-to-borrow securities, how to transact in foreigner-restricted markets and what custodial processes are available.
As stated earlier, there is an increasing prevalence of regulation in certain Asian markets. Increasing regulation not only leads to an increase in the level of M&A activity (via improved market efficiency), but it also increases deal complexity. Deal complexity can take many forms including multiple acquirers, multiple acceptance options, multiple regulator approval and deal conditionality. This is great news for the experienced and dedicated event-driven fund managers who have the investment expertise to accurately price risk and construct diversified investment portfolios.
Asian markets provide an ideal backdrop for equity-based event-driven investing. The frequency of corporate events and market mispricing and the improving investment environment across Asia underpin the opportunity for attractive and sustainable risk-adjusted returns. The key precondition for harnessing this opportunity is investing in a manager with extensive Asian experience. Only such managers understand how each event (and, accordingly, investment opportunity) should behave in the context of the cultural and regulatory environments across the region, as well as recognise that the optimal portfolio is one exhibiting low levels of market exposure. Other managers might expose investors to unnecessarily high levels of risk.
Matthew Cooper (based in Sydney) and Scott Collison (based in Singapore) manage the Rubicon Asia Special Events Fund.
Rubicon is an independent investment and advisory firm with strong capabilities in the creation, syndication and management of specialist funds. Rubicon has assets under management of approximately US$2 billion.