Considering Event-Driven Investing [EDI]

Event-Driven Investing Has Risks & Returns are Generally not Higher Than Stocks

Hurricane Katrina
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The returns for stock investing can be very open-ended. Returns from a given stock can range from super-high to losing it all. What if there was a way to make a moderately high return, but with greater certainty? If done right, EDI is a way to do that.

EDI is investing because of an event that may happen, has been planned to happen, or has happened already. Note the order: respectively, it can involve events that are speculative events, likely events, or past events.

But even with past events, there is always uncertainty about what the full effects of the event will be. Most ways of doing EDI can be done with events that are speculative, likely, or past. This article will focus on the most common timing for each type of EDI.

Different Types of Event-Driven Investing

1) Merger Arbitrage– Some people speculate on transactions that have not been announced. Others speculate when they hear of a letter of intent. The professionals invest when a binding deal is announced. The returns are smallest then, but are a lot less risky. It is unusual for a firm to terminate a merger once a binding deal is announced, and if it is not “for cause,” there are monetary penalties for termination.

Here would be an example: after the market closes, AB Corporation announces a binding deal to buy CD Corporation for $100/share. The closing price of CD was $80/share. The next day, when the market opens, the opening trade is $99/share.

 Arbitrageurs buy the stock there, locking in a likely $1/share gain over the next 90 days. That’s a 1 percent gain over three months. Why is that attractive? The arbitrageurs (typically quantitative hedge funds) typically have a stream of deals that they invest in, and so that 1 percent if repeated every three months becomes 4 percent annualized.

That is attractive because the yields on safe short-term bonds are low, and the odds of a deal-breaking is also low. The arbitrageurs think like high-yield bond managers, and only invest when the odds of a deal-breaking are low enough, and the returns are high enough.

Four additional complexities: some deals take longer to close because they are in regulated industries or are across national borders, which makes the price gap bigger, but not the yield, typically. Second, dividends have to be factored into the calculation. Third, some deals are a stock swap. In that case the arbitrageurs buy the target and sell short the acquirer in the same ratio as the terms of the swap, so when the deal closes, the shares delivered cover the short position. It is a perfect hedge. Fourth, this can also be done with bonds, when the yields of the target are higher than those of the acquirer.

2) Index Arbitrage– There are games that take place when the changes occur to indexes, because enough money is indexed, such that companies leaving the index get sold, and those entering the index get bought.  Some hedge funds focus on this.  The great example is the Russell 2000, which has mechanical rules for what stocks will get added and deleted.

  If an investor could temporarily depress the price of a stock near the edge of the capitalization needed to stay in the Russell 2000 by shorting it, while buying a stock like it with a lower market capitalization to push it into the Russell 2000, gains can be made if the investor succeeds and index investors sell the one that was shorted, and buy the one that was bought by the investor.  If the investor has fundamental reasons for doing the trades, it isn’t market manipulation.  With no fundamental reasons, the investor would have a hard time if the SEC calls.

3) Restructuring / Default / Capital Structure Arbitrage– this tries to take advantage of mispricing within various securities of the same company, typically in a period of financial stress.

After a default, distressed investors analyze the value of the company and its liabilities.

They look for the class of securities in the bankruptcy pecking order that is likely to only get partially paid, because the owners of that class of securities will likely control the company post-bankruptcy, and will be able to propose a plan to recapitalize the company, where old securities get replaced with new. The more senior securities will get paid off close to a full amount, whereas the more junior securities may get little if anything. The distressed investors assess what each class of securities should be worth, and buy the securities that seem the most undervalued.

This can apply in advance of a potential default as well. Also, rather than go through bankruptcy, a company can go to its banks, stock and bondholders and propose a plan to recapitalize the company, usually diluting the equity and make the bondholders take a small loss. Since it is voluntary, creditor committees negotiate the result with the company, and investors try to buy the securities that are the most undervalued.

4) Spinoffs– Companies may decide to spin off a subsidiary to shareholders. Typically, but not always, spinoffs do well, because the subsidiary in question typically doesn’t fit well with the parent company, and will receive closer management as a separate company. Investors analyze the spinoff company and the post-spin parent, to see if the spinoff makes the pair more valuable. If so, they buy the parent in advance of the spin. Also, if the spinoff company initially trades at a low valuation, perhaps because index funds or large cap managers can’t own the spinoff, other investors buy that company because it is cheap; fewer investors look at spinoffs than IPOs.

5) Hurricanes– There are many ways to insure property catastrophe risk. There is insurance, reinsurance (insuring insurers), retrocession (insuring reinsurers), catastrophe bonds, and industrial loss warranties. When hurricanes threaten damage, investors estimate the likely losses. They trade the stocks of insurers and reinsurers. They trade catastrophe bonds. Some specialized hedge funds offer industrial loss warranties to hedge the risks of insurance companies, with prices changing in real time.

6) Private Investment in Public Equity [PIPE]– Sometimes a firm needs cash, and as a last resort, they decide to issue equity at a large discount to the current market price and dilute existing shareholders. The buyers are qualified institutional investors who can buy a private placement, and the new shares can’t be sold for a month or more. The deal closes quickly after the announcement, but at the announcement the buyers start shorting and do other forms of hedging in order to lock in as much of the discount as possible.

7) Other events– A company can:

  • Get a new CEO/management team
  • Face regulatory changes, lawsuits, disasters
  • Have an earnings report
  • Have an M&A deal fail
  • And more

Once the event happens, investors estimate what the event is worth, and the stock will be noisy for a while. For a scheduled event like an earnings release, or an expected event like a credit downgrade from the rating agencies, the speculation will begin in advance of the event.

8) Activist investors create their own events- They try to convince management to sell off the company or a subsidiary, change the management team, buy back stock, increase the dividend, and more. When successful, the rewards can be considerable.

Who Invests Like This?

Hedge funds, private firms, and some mutual funds invest like this. They specialize in one or more of these areas. Some try to do as many of these areas as possible, because events come on their own schedule, and not when you want them. This is an area where strategy diversification can help.

Risks

The main risk is the same as that for high yield bonds and illiquid investments. When there is a market panic, it becomes more difficult to maintain financing, and many M&A deals get called off at such a time. More PIPEs get done, and at higher discounts, but hedging is tougher. All complex investing gets hit when the credit cycle gets bad.

Opportunities for Average People to Invest

Disclaimer: the following mutual funds are examples of what is easily available. They may do badly. Do your own due diligence. Only invest what you can afford to lose.

Simple EDI like merger arbitrage is crowded, and returns have been low. If EDI sounds attractive, consider a high yield bond fund as an alternative. If you can’t stomach the risk of high yield, don’t consider EDI.

Summary

Complex EDI can provide stock-like returns. Simple EDI can provide high-yield bond-like returns. A lot depends on manager competence. If you can’t assure competence, it is likely better to invest in stocks and bonds.

Postscript

Two other useful descriptions of EDI (one, two)