An event-driven strategy is a type of investment strategy that attempts to profit from the occurrence of pricing inefficiencies caused by a specific catalyst or set of events.
In the hedge fund industry, event-driven funds typically employ a team of specialists who analyze corporate events, including mergers, spin-offs, and bankruptcies, to form a view on the outcome of the corporate event. Once the view is finalized, the fund will place trades based on that view.
Such events that a hedge fund may focus on could have already occurred, but it can also be an event that they are predicting may happen in the future. The event may or may not ever occur, however, as this strategy is built on the basis that an investment decision is made from a manager’s view of this special situation.
The event-driven strategy generally aims to generate an uncorrelated return relative to the broader equity markets. They do this by attempting to identify a security mispricing tied to a particular event.
In many cases, these events are largely unrelated to the broader market, as the events are typically based on individual corporate proceedings.
To execute this strategy, it often requires a highly specialized team of investment professionals who are capable of understanding and forecasting how certain events affect different securities.
There are many events that event-driven strategy funds are seeking to take advantage of, and each event presents a unique set of opportunities.
The following are three of the more widely exploited corporate events:
Mergers & Acquisitions / Takeovers
- In a typical cash merger, the acquirer is often required to pay a premium price to purchase the target company’s shares. The announcement of the merger at a higher price tends to drive up the price of the target’s shares.
- An event-driven strategy will observe this opportunity and identify the spread between the current market price and the premium price. The manager may then purchase the stock of the takeover target, hoping that the price will increase as the merger approaches completion.
- The primary risk to this trade is when the merger is unable to be completed as expected.
- In a stock-for-stock merger, the acquirer offers to purchase shares of the target company by offering some of its own shares to the target company’s shareholders.
- In this scenario, the stock price of the acquirer will oftentimes decrease, driving an event-driven manager to not only purchase shares of the takeover target but also short the shares of the acquirer. This creates what is called a spread trade.
- As the deal approaches a successful close, the spread between the acquirer and the takeover target may narrow. Like a cash merger arbitrage, the spread will reverse course if investors anticipate that the merger is unable to be completed.
Divestitures and Spin-offs
- Companies frequently make changes to their corporate strategy, which may include spinning off a subsidiary or a business unit. When doing so, shareholders of the parent company may receive shares in the newly divested entity.
- Oftentimes, spinoffs can unlock embedded value because they either do not fit well within the existing structure or might operate more efficiently without the constraints of the parent company.
- If a manager forecasts that Company X may divest Asset Y, and they are attracted to Asset Y, the event-driven strategy may purchase Company X’s shares in anticipation of the event.
- If forecasted correctly, the manager will have acquired shares in the newly created entity at a discount to the market. If the divestiture is not completed, the investor risks owning shares in a company that they might otherwise not have owned.
- Event-driven strategies can also target securities, including corporate bonds and bank debt of companies in distress, such as bankruptcy. Companies might face these circumstances if they are poorly run or unable to compete in the current market environment.
- Managers perform robust risk analyses using modeling and test scenarios to form a view on the future of a company in distress. If a manager believes that a liquidation is looming, they might purchase the debt of the target company hoping the recovery value is greater than the price paid to own the debt. This is a common strategy as creditors are often some of the first investors to be paid back during a liquidation event.
- Conversely, a manager might anticipate a corporate restructuring, where the creditors of the company may become equity holders in the restructured entity. The expectation is for the new company to have an improved capital structure and a re-imagined outlook for future success.
- However, even when forecasted correctly, the bankruptcy process can be onerous and take a long time to complete leading to a lower rate of return.
The event-driven strategy is not without its own set of unique risks. A manager might make an investment decision in anticipation of an event, and it is possible that the outcome may not turn out as anticipated.
Even when the event has previously taken place, it is possible that the opportunity has already been seized or the market reacted differently than expected.
The strategy is also subject to liquidity risk because the fund’s capital might be tied up waiting for the event to occur. In this scenario, the opportunity costs increase over time as investor capital is not able to be re-allocated to another investment opportunity.
Event-driven funds may also employ leverage to capture what might be a narrow opportunity. The use of leverage presents its own set of unique risks that must be managed properly, especially when the outcome does not materialize as expected.
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 such as mergers, spin-offs, and bankruptcies.
As such, event-driven funds differ from their traditional counterparts in that their returns are sensitive to unique outcomes rather than company earnings and balance sheet considerations or macro-related factors.
This dynamic often leads to idiosyncratic returns because the strategy is dependent on a particular outcome. However, those employing event-driven strategies must be aware that when an outcome does not turn out as expected, the risk of loss can be substantial if not managed properly.
Barclay Hedge, 2012. Understanding Event-Driven Investing
Corporate Finance Institute. Merger Arbitrage - Overview, How It Works, Role in Mergers
Merger Arbitrage Limited. Event Driven Investment Strategies
Merger Arbitrage Limited. Spinoff
the balance, 2021. What is Distressed Debt Investing?
Trader HQ June, 2018. Event-Driven Trading Strategy 101