21.2.2 Event-driven Strategies

Event-driven Strategies

Event-driven strategies seek to profit from unique corporate structure events. They typically encompass three main approaches:

1. Merger Strategies (Risk Arbitrage)
2. High-yield Bond Strategies
3. Distressed Securities Strategies

Merger (Risk Arbitrage) Strategy

A merger strategy, also known as risk arbitrage, involves simultaneously taking long and short positions in the common stock of companies participating in a proposed merger or acquisition. Generally, this involves going long on the target company and short on the acquiring company. The strategy aims to exploit the price differential between the target company’s current stock price and the offer price.

When a takeover or merger is announced, the target company’s stock usually rises but does not reach the offer price due to the inherent deal risk. Managed appropriately, returns on merger arbitrage are less correlated to the overall stock market since the outcomes depend more on specific transactions rather than broad market trends.

Example:

ABC offers to acquire XYZ for $50 per share, which represents a 25% premium to XYZ’s current price. ABC’s stock price drops slightly, to $10 per share, due to the earnings impact of the deal. Risk arbitrageurs short 5 shares of ABC for each share acquired of XYZ (Hedge ratio: $50/$10 = 5).

Since regulatory approval and shareholder agreements are pending, XYZ trades at $48 per share—a 4% discount to the $50 offer. Assuming the deal completes in six months, this represents an annualized return of over 8%, potentially enhanced by leverage.

Did You Know?

If the acquiring firm’s earnings per share decrease post-merger due to lower contributions from the target firm, the deal is considered dilutive. Conversely, if earnings per share increase, it’s deemed accretive. Mergers often start dilutive but may turn accretive once synergistic benefits materialize.

High-Yield Bonds

High-yield bond strategies invest in below-investment-grade debt securities, commonly known as junk bonds. These bonds, typically rated BB or lower by Standard & Poor’s and Ba or lower by Moody’s, offer higher returns through interest income and potential capital appreciation. However, they also come with higher default risks.

High-Yield Bonds:

types of bonds including their ratingBB or Ba.lower (Standard & Poor’s/Moody’s)potential for higher returnscome_somehigher-level of risk_transpose(toxic)

Investors in these bonds hope to benefit from the higher yields while closely monitoring the portfolio for any signs of default, which historically, tend to be higher for such securities compared to investment-grade counterparts.

Distressed Securities

Distressed securities strategies involve investing in the equity or debt of financially troubled companies facing bankruptcy or reorganization. These securities are generally heavily discounted due to their issuers’ precarious financial positions.

Strategy Outline:

1. Managers seek out companies on the verge of insolvency.
2. Positions are taken in company bonds with hopes that restructuring or liquidation yields higher returns than the buying cost.

Restructuring can be:

• Voluntary: Agreement between bondholders and management to new terms, allowing operations continuity.
• Involuntary: Court-directed restructuring following bankruptcy.

Note: Distressed securities are a subset of high-yield strategies, but focus more on insolvent or near-bankruptcy firms.

Key Takeaway:

Institutional investors often cannot hold non-investment-grade securities. Credit downgrades can thus lead to forced sales, pushing security values below fair market levels. Fund managers capitalize on such opportunities when true value is misunderstood or unappreciated.

Glossary

• Arbitrage: The practice of buying and selling identical or similar financial instruments in different markets to exploit price discrepancies.
• Dilutive: The reduction in earnings per share following an acquisition, due to lower contributions from the target company.
• Accretive: The increase in earnings per share following an acquisition, due to substantial contributions from the target company.
• Junk Bonds: Bonds with a credit rating lower than investment-grade, indicating higher risk and higher return potential.
• Restructuring: A process wherein a company’s affairs, structure, or creditors’ claims are reorganized to allow continued operations or liquidation.

Frequently Asked Questions (FAQs)

Q1: What is a Hedge Ratio?

A1: The hedge ratio is the proportion of the amount to be shorted in the acquisition company to the amount acquired in the target company. It’s calculated based on their respective share prices.

Q2: Can investors use leverage in merger arbitrage?

A2: Yes, leveraging can amplify returns in merger arbitrage, although it also increases risk.

Q3: Why do high-yield bonds offer higher returns?

A3: High-yield bonds provide higher returns due to the increased credit risk and likelihood of default, which investors require compensation for.

Q4: What makes distressed securities attractive investments?

A4: Distressed securities can be attractive because they trade significantly below their potential value, offering substantial returns should the company’s financial health be restored or reorganization be successful.