Event-driven investing is a hedge fund strategy that strives to capitalize on opportunities that arise following distinct corporate events such mergers, restructurings, spin-offs, and acquisitions. The event-driven investment strategy allows hedge fund managers to spot price inefficiencies and benefit from the short-term downward trend in a company’s stock.
Hedge fund managers use event-driven investment strategies to exploit the mispricing of securities that follows the announcement or the anticipation of major corporate events, including M&As, refinancing, restructuring, spin-offs, recapitalizations, tender offers or bankruptcy. By using fundamental analysis, fund managers aim to determine the impact of the corporate event at hand on the company’s stock price without taking into consideration the market mechanisms. In this context, they implement a highly-specialized hedge fund strategy that requires a high level of expertise for the analysis of corporate events. An event-driven strategy requires the implementation of other hedging strategies, such as merger arbitrage, credit opportunities, and equity special situations.
A Quick Example
Typically, when a company expresses an intent to buy out another company, its stock price rallies close to the acquisition price, but always lower, reflecting investor uncertainty about the corporate event. Investors are concerned when a company is going through a merger, acquisition or spin-off, leading the stock price to decline until investor confidence rises again, and the price stabilizes at its former or higher levels. Therefore, fund managers who want to implement an event-driven strategy following a spin-off, need to take into account potential regulatory issues, the reasons behind the spin-off, and how it will affect the stock price based on the company’s fundamentals. If they feel that the spin-off will actually take place, and it’s worth investing in, they will buy the company’s shares without considering investor aversion and they will sell them when the stock price stabilizes.
Event-driven hedge fund strategy tends to perform the best when the economy is strong because the corporate activity is high and companies tend to buy out other companies or spin-off their business. Conversely, when the economy is weak, hedge fund managers invest in distressed securities such as corporate bonds and bank debt because the corporate activity is low. Although the funds in the event-driven strategy are not homogenous, they all seek to profit from a corporate event. For instance, most event-driven strategies profit from taking a long or a short position in a firm’s capital structure, including convertible bonds, common stock, preferred stock or debt, which are all mostly working in an equity bull market.
Event-driven investment strategy has historically generated high results, proving the strategy’s upside potential. Because the strategy is based on specific corporate events that may or may not take place, event-driven investing has a low correlation with the stock performance in the equity market. Therefore, it generates risk-adjusted returns regardless of the performance of the broader markets. Furthermore, the execution of sub-strategies, i.e. merger arbitrage, credit opportunities, and equity special situations, seek to mitigate portfolio risk and achieve long-term growth. Therefore, a proper allocation of these strategies on an investment portfolio is likely to generate long-term growth.
The main risk associated with an event-driven investment strategy is the level of experience of the hedge fund manager. If the merger or the spin-off does not take place or the company goes bankrupt, the event-driven strategy will prove worthless, causing the fund manager to lose a lot of money. Event-driven strategies should be implemented by highly-skilled fund managers, who are able to evaluate whether a corporate event will actually take place or not.
The Bottom Line
Event-driven investing strategies use the high level of expertise of a fund manager to take advantage of price inefficiencies of a stock to realize long-term, risk-adjusted returns. Often, such opportunities are not instantly identified, but skillful fund managers are able to evaluate a corporate event and undertake the corporate risk associated with it.