In the hedge fund arena, one quality that managers highlight is their ability to generate alpha. Alpha can be described as the return a manager is able to generate by putting together a portfolio ofsecurities that will outperform the market within a specified time frame. He or she is able to do this by ensuring that this portfolio has little correlation with the overall market. Generatingincremental returns above the market while hedging the market exposure, known as beta, is a delicate balancing act that a manager has to carry out. This is even more difficult for managers who employthe event driven strategy.
Event driven hedge fund managers have found that, to deliver positive alpha to their clients, they have to be ready to change their approach to suit the circumstances (this could be the deal or themarket), and they need to take fewer positions, control the liquidity of their fund, and, more importantly, play an activist role.
An event may be the issuing of a press release by a company, a company making an earnings announcement, or a political or general world event. Traditionally, eventdriven hedge fund managers are those who take significant positions in a certain number of companies with ‘special situations’. This could mean companies with distressed stock prices, mergers,takeovers, share buy-backs or capital returns. The objective of the manager is to analyse the effect the corporate action would have on security prices, instead of focusing on the company’s earningsand dividend streams. The hedge fund would normally take a long position on the company being acquired and a short position on the acquirer. Owing to the position they have taken, they are not assensitive to market movements. They tend to consistently generate high risk-adjusted returns that have little correlation with the market.
In the past, an imbalance of buyers and sellers of stocks was created when mergers were announced; several of the main stockholders were compelled to sell by their mandate. This created anopportunity for the event driven manager to predict both the outcome of the transaction and the best time to commit capital to it. However the use of mandates for arbitrage by event driven hedgefunds has now changed because there are more participants in this field. To realise good returns, managers have had to alter their approach.
This uncertainty about the resolution of corporate events creates investment opportunities for hedge fund managers who can adequately anticipate the outcome. Opportunities are also created in thedebt arena, when companies that have issued bonds file for bankruptcy and the asset managers holding these bonds usually clean up their portfolio at the end of the year by selling them or markingdown their value. The standard used to determine the value of these bonds is not normally consistent, which is something that distressed arbitrageurs take advantage of.
Event driven managers also implement arbitrage with some company’s dividend and rights issue. They use a variety of tools, such as leverage, short selling, etc. They will put together a portfoliothat will give them the best risk-adjusted return with low correlation to the market. Some event-driven managers use a consistent strategy, while others make investments across a range of events. Thechange of the composition of an index gives them the opportunity to profit from price movements that occur because the shareholder base has changed.
In some markets, there are holding companies that hold assets in subsidiaries that are quoted. Event driven hedge fund managers will calculate the NAV (net asset value) for the aforementioned holdingcompany and then the premium or discount at which the holding company’s stock is trading. If they believe that there are circumstances that will change the premium or discount, they will normallytake a position to generate profit from the change.
Many event driven managers aim to take positions that will make them as market neutral as possible, ensuring that the major part of their portfolio is exposed only to the event theyare participating in. This is why they will describe their return as absolute and not relative.
Like all investors that take positions in the market, event driven hedge funds incur their own unique risk. With those involved in merger arbitrage and risk arbitrage, the main risks are wideningspreads (market to market) and deals breaking. They reduce this by keeping a well diversified and less concentrated portfolio, and by in-depth research and wise active management. A lot of dealsbreak because of pressure from shareholders, a change of heart by management, regulation, market action and exogenous factors. Scenario-based analysis at deal and market level is much better thanlooking at VaR (Value-at-Risk) for merger arbitrage and risk arbitrage funds.
Generating alpha by means of this strategy used to be facilitated by the event driven manager’s having access to superior information and the ability to take advantage of the buyers’ and sellers’imbalance. With more event driven managers operating in an area in which there are mispriced securities, the opportunities to generate good risk-adjusted returns are now being removed much fasterthan in the past. Some managers now adopt contrarian positions, in contrast to most of the event driven managers. As for the access to superior information (which used to be available because thehedge fund manager had a stream of contacts such as bankers, brokers and lawyers, who would give information much faster than other investors), this has changed because advancements in technologyhave made this information accessible in several quicker formats around the world.
In spite of the fact that there are no restrictions with respect to the markets or what regions are traded, most event driven funds tend to focus on a particular geographical area, country ormarket; covering the entire market would be an onerous task. To get capital from institutional investors, event driven hedge fund managers now specialise in a particular style to distinguishthemselves clearly. This enables them to generate capital much faster from institutional investors, but restrains them from profiting from opportunities that are outside their style of expertise.Alpha is now generated by those event driven hedge funds that are able to continually alter their approach to take advantage of new buyer/seller imbalances and to construct a portfolio with lowcorrelation to the market. Those that take positions early in these new markets will generate alpha before their competitors come along with the herd.
To attract institutional capital, event driven hedge fund managers tend to show that their diversification facilitates risk management. It is now an accepted maxim that diversifying your positions isa safe way of balancing risk (both the upside and the downside). The institutional investor seems to place as much premium on how diversified the fund is, as well as the return. This has a negativeeffect on event driven funds that distinguish themselves by their ability to carry out incisive research on potential investments. Some event driven funds with better returns have obviated this bycarrying out much deeper analysis, research, and making fewer investments. To balance this, they reduce the amount of leverage used to make the investments.
Event driven hedge fund managers have also found that, in order to generate high alpha, they have to control the liquidity of their fund. This runs contrary to the trend, according to which hedgefunds have to be more liquid to satisfy their clients. Some transactions require the managers to have a reasonable source of capital that they can rely on to make investments. Some lucrativeinvestments for event driven funds take a much longer period to obtain returns. They then need less redemption to preserve their investment in the aforementioned deal. Less redemption means less needfor the manager to use leverage, which is in the best interests of the subscriber, because the fund retains its value (higher NAV). The event driven hedge fund manager now has to prioritise eitheraccumulation of asset or performance.
To produce positive alpha, some event driven hedge fund managers are focusing on new markets outside the US, suchas Western Europe, Asia, Central and Eastern Europe. In these markets, they can find a lucrative buyers/sellers imbalance. Globalisation is one reason why there is an inflow of capital into these newmarkets. The regulations in these markets are not as rigid, and the hedge fund managers take advantage of the leeway this gives them.
As with global macro funds, one finds it difficult to define event driven funds by one risk/return profile. Some event driven strategies are very aggressive – employing leverage and derivativesrather excessively – while others are conservative. However, the risks and returns of event driven managers tend to be higher then the average because their success rests on the hedge fund managers’ability to interpret an event correctly and to employ the model that will best carry out the necessary task.
Of all the changes in style that event driven hedge fund managers have undergone, the most important is playing the activist role. Being ‘activist’ means searching for the transaction andparticipating in the process of bringing about good performance. Managers play this activist role when the risk–reward ratio indicates that it is profitable to do so. They utilise their expertise inthese situations to ensure that they get the best outcome for their clients. Participating in the process means assessing whether deals are properly priced (overvalued or undervalued) and takingpositions to ensure efficiency. A typical situation in which they might play this activist role is with distressed companies. The hedge fund managers would invest new capital that would help theirrecovery. They would do this with tools such as mezzanine loans, bridging loans and CLOs. In some cases they might launch a CLO fund or SPV to play this role. They would participate in therestructuring of these companies by lending them money, which would enable them to avoid bankruptcy. The loan might be in the shape of a bond, which would be converted to equity, and the event drivenhedge fund managers would thus have a stake in the company. In other cases they have followed the equity stake by placing a member of the hedge fund on the board of the company. Activist hedgefunds have shifted the focus to shareholders’ interests. When there is speculation that two companies will merge, they take positions in both companies and monitor the process. They watch out forproper corporate governance and make sure the merger goes through at the appropriate price. In addition, the activist hedge funds expose underperforming companies to market pressure, make companiescut costs, and mobilise shareholders to change circumstances when management will not. There have been occasions when they have prompted public companies to go private because they estimated beingprivate would enable them to unlock more value than they could when public. There are fewer than a hundred of these activist hedge funds worldwide.
As producing profit with this strategy requires managers to be able to predict the outcome of transactions, as well as decide the best time to commit capital. The event driven hedge funds that givetheir subscribers the most positive alpha are those able to adapt their style to capture new buyer/seller imbalances, to maintain a low correlation to the market (market-neutral where possible), toremain diversified but reduce the number of positions (by superior research and analysis), and to balance that with reduced leverage. Also those that remain liquid but concentrate on performancerather than asset accumulation. Most important of all, playing the activist role enables the managers to monitor transactions and to participate in them, which is the best way of ensuring that theseeds planted produce the best fruit.
Written by Francis Akpata
