#Investments — 22.07.2016

Event Driven Strategies: Patience Is A Virtue

Gilles Flament & Michael Baughan

Following on from our post published in March, An introduction to alternative strategies, here is a flavour of some specific strategies that are broadly grouped together under the name “Event Driven strategies”.

I like to cook.  It’s no surprise – I am French after all.  I also appreciate haute cuisine as, for me, it represents (based on my simple culinary skills) the unattainable, the crème de la crème, and I feel the price reflects the quality of the experience and the know-how.

Much like professional chefs, Event Driven fund managers have different fields of expertise, but they all share in the idea that with the right combination of ingredients and cooking time, the result should look, taste and smell better than the sum of the initial parts.

In Event Driven strategies, like cooking, patience is a virtue, as long as the time is used effectively. Preparation time in this case is synonymous with liquidity.  

Within Event Driven, many associate Merger Arbitrage as a more traditional cooking method deployed to obtain an interesting investment experience, and a specific school of fund managers will deploy their skills to invest in companies that are either expanding or being consolidated through acquisition (i.e mergers and acquisitions).  For a Merger Arbitrage fund manager, the cooking time is usually shorter (or at least more definable) than other strategies, and his or her principle concern is the likelihood of whether the two components will combine within the timeframe. 

Special Situations managers look exclusively to seasonable produce available on the market for their inspiration, i.e. they will act upon a company announcement (known as a catalyst).  Be it an arbitrage between two companies with the strong probability that one will restructure in the future; an inevitable break of a public utility; or a spin-off of a division of a large conglomerate; in each of these cases, the fund manager will seek the right ingredients that could produce positive value-creation for stakeholders in the long term.  

For the most patient among us, Distressed strategies offer a very long preparation time as ideas are left to braise over a lower temperature to improve the flavour and to optimise tenderness.  Specialists in this area will ensure they have very specific expertise within their teams who completely understand the specific risks related to this sort of cuisine.

Some fund managers prefer a more “hands-on” approach and like to baste their investment ideas through regular interactions with the companies’ Boards or fellow shareholders on how to improve shareholder value through long-term turn-around strategies.  These “Activist”   managers usually invest for relatively long periods of time, but may also prefer a shorter, more dynamic cooking method by suggesting more short-term exit strategies (for example, buyouts that usually occur at a premium to market value).

Event-driven investment risks & opportunities – the choice of ingredients

An environment that is burdened with political uncertainty, inconsistent regulation policy and limited growth prospects are all risks and barriers for investing in Event Driven strategies.  The longer the cooking time, the more chance there is that one of these specific risks could upset the outcome.   There is  the additional risk related to the chance a “deal” falls through, for example through incompatibility of the principal ingredients (the two companies merging), too many cooks that don’t get on (senior management), or even ingredients that have passed their sell-by date (anti-trust decisions).   Like all well-disciplined chefs, avoiding getting burnt is inherent in their risk management process.

On the other hand, Event Driven strategies are less correlated to traditional investment strategies (in particular equities) as they focus on specific company events that could have an impact on that company’(s share price.  As an opportunity set, in a period where companies are running low levels of leverage and high levels of cash reserves, combined  with consistent growth over a medium-term, create an environment at home and abroad conducive to merger and acquisition activity and other company restructuring events for both growth sectors seeking expansion and industrial / commodity-related sectors seeking consolidation.  The proof is in the tasting.

Bon appétit! And until next time…


Some definitions  

Merger arbitrage is a strategy in which the stocks of two merging companies are simultaneously bought and sold to create a profit. Due to the uncertainty that a deal might not close on time or at all, the target company's stock will typically be sold at a discount to the price that the combined company will have when the merger is closed.

An activist is an opportunistic investor who tries to effect a major change in a company by accumulating a holding in the company’s shares.  A company can become a target for activist investors if it is mismanaged, has excessive costs, could be run more profitably as a private company, has seemingly excessive amounts of cash in its balance sheet, dividend payments that don’t meet expectations or has another problem that the activist investor believes it can fix to make the company more valuable.

Investing in distressed securities involves buying debt (for example) in companies  that are either experiencing short term cash flow difficulties, the inability to pay back long term debts or some other working capital issue. In some cases, investors are able to build positions in a company while they are in the process of bankruptcy, and ultimately exchange old debt for new equity should the company be restructured.

Special situations can broadly be defined as any specific corporate event (also known as a “catalyst”) that would have a direct impact to the value of the securities issued by a specific company.   For example, corporate spin-offs, share class exchanges and security issuances are all examples of activities that could be defined as a “special situation.”