Trading Strategy II: Event-Driven

Definition of Event-Driven 

Event driven hedge funds anticipate price changes in securities based on events in the corporate cycle of a company or perhaps news events that would affect the future stock price. Event driven hedge funds need to be on constant alert on news and company press releases as any potential profits could be “arbitraged” away after a short period after the event has taken place.

Types of Event-Driven Strategies

Merger arbitrage to a certain extent falls into the category of event driven as the announcement of a merger is an event. The trader that reacts to the news the quickest is able to profit the most from the spread converging. Merger arbitrage involves usually the trading of the acquiring company versus the selling company. An acquiring company can either offer its own stock or simply pay by cash. The direction of the trading depends mainly on whether the acquiring company is offering to buy the target for more than the current tradable price of the target or less. If the acquirer is offering its own stock for more value than what the acquiring company is trading for then if a trader is confident that the trade will go through he/she will short the acquiring company and buy the target company and profit from the spread closing on the completion date. If the trader anticipates the deal cancelling then the logical procedure is to buy the acquirer and sell the target. The reverse logic is also true if the acquirer is offering less than the tradable value of the target company. The reason for categorizing merger arbitrage under risk arbitrage is because the merger spread is a function of the risk and probability of the merger successfully being completed.

Other event driven strategies include corporate action announcements like buyback, splits, dividend announcements and new stock as well as bond issues. There are also some more macro driven events like equity index additions/deletions and rebalancing.

Trading equities based on macro variables would also constitute as event driven. For example a trader can have a model which predicts the amount and direction of a stock move relative to a surprise by the Fed in rate changes. Additionally, mean reversion trading post some macro changes could fall here, too. The premise of this type of trading is to be market neutral and at the same time profit by buying under priced stocks and sell overvalued stocks. Traders try to eliminate as much of the market risk by choosing pairs which are within the same industry and market cap. They are also known as sector specialist” funds. They only want to profit from the relative difference in price. Long short hedge funds very often test the pairs to make sure that there is a lot of correlation between the two stocks. Very often one of the legs of the pair could possibly deviate from its fair price due to some market panic (or irrelevant news) and profit could be made by entering into the pair trade. Very often pairs trade within ranges and traders can profit by what are known as “mean reversion trades”. Pair traders also use a technique called “co-integration” which is a statistical term using historical data to test if a pair mean reverts. Pair traders often trade pairs within the same industry but different countries to take advantage of short term macroeconomic influences – in this case, usually they would also hedge themselves in currency.

There are two other types of event-driven strategies: Distressed and Capital Structure Arbitrage (Relative Value and convertible bond arbitrage )

Very often a hedge fund can have a team of ex-corporate lawyers who are experts on bankruptcies. This team might be very successful in assessing the probability of a firm filling for chapter 11 or even getting into some financial difficulties. The analysts would also be good at determining how much value a company has after it has released news of its financial difficulties. Based on this knowledge a distressed arbitrage fund might be able to take advantage of a miss priced low credit rated stock. Very often a hedge fund or investment management company will need to sell a troubled company at a discount to its true worth. Very often a distressed company which isn’t public will sell its stock as a private placement using regulation D.

Another common strategy is the relative value between a company’s common stock and bonds. Bond holders are usually the first to receive the recovery amount of a bankrupt company. This could create potential mis-pricing in the market between a companies debt and equity. If the market place releases bad news on the credit of a company the equities could receive a disproportionate hit relative to the bonds because of the differences in risk. A trader can buy the common stock and short the bonds to profit from the mis-valuation. This is known as capital structure arbitrage. York Capital made a fortune on acquiring Enron bonds when the company announced bankruptcy. They also acquired Adelphia Communications, Tyco International and WorldCom bonds. Distressed funds on average returned 14.6% annualized with 3.6% volatility according to Bloomberg magazine.

A typical long equity short bonds strategy is also known as convertible bond arbitrage. Here the holder of the convertible bond has the right to swap the bond for common stock. Most often than not convertible bond arbitrageurs enter into the trades more as a statistical arbitrage strategy rather than assessing the fundamental capital structure of the company. CB arb traders have sophisticated quantitative tools that are able to price convertible bonds better than the market does. A typical strategy includes long the convertible and short the common stock on a delta neutral level if they feel that the “call option” component of the bond is trading cheap.

One more, if not the last, variation of Event-Driven Strategy is Activist Investing.

Activist funds generally buy a large enough chunk of the company to be able to participate in the management and decision making. Many blend in activist hedge funds with event driven, but in essense Activist funds are more closely related to value or private equity. Although there are many cases where a large shareholder of an acquiring or target company will have input in the pressure to go ahead or fight off a hostile takeover, generally merger arbitrage and other sophisticated news driven event- arbitrage are not driven affected by activists.

Activists are generally viewed as locusts sacrificing the long term prospects of a company for short term price and dividend gains.

This was definitely true in the 80’s and 90’s when they were labeled as corporate raiders. Study has shown however that they boost S.T and L.T price performance and actually work with management to improve corporate situations. In the post Enron period activisms are being viewed as hero’s. Since the Enron collapse laws such as Sarbanes-Oxley Act of 2002 have made corporate management more accountable and this has led to a boost in shareholder activism. The study shows that announcement of hedge fund activism adds over 5% to the price of the stock and the most impact is when the activism is focused on change of strategy and selling inefficient parts of the business. A change in management and capital structure has less impact. Activists however are still not always popular in the board rooms. Study has shown that activists have on average decreased CEO pay by over 800’000 USD and management turnover has increased by 9%.

One of the most well known activists is Carl Icahn. Although he is mainly a private equity investor, he opened up two hedge funds: – Icahn Partners and Icahn Fund. With them he has bought stakes in major companies such as Blockbusters and Time Warner. In 2005 he won board seats at Blockbusters and is now a director of the company. He also teamed up with Jana Partners to break up Time Warner Inc in 2006. Although the attempt failed, Time Warner’s share price did rise over 12% in 2006 through November. Icahn is well known for his aggressive approach in influencing the financial strategies of the companies that he owns a stake in.

Activists hedge funds also come in blends. For example Omega Advisors is a value activist. In 2005 he berated MCI for accepting a takeover bid by Verizon which he thought was offered at a price too low. Activists have performed the least well relative to other major equity hedge fund types and they have not done immensely well relative to market. The most well known activist hedge funds is ESL Investments which is an 18 billion USD hedge fund founded by Edward Lampert. ESL is the largest shareholder of Sears which owns KMART, where Lampert serves as the chairman. 

“Hard” event (trading)

– company specific

– announced

– numerically defined maximum upside or minimum downside

– reasonable time horizon

“Soft” event or pre-events (investing)

– sector/macro/market related, rather than company specific

– not officially announced (but making sense if it’d happen)

– even if company-specific and announced, but not numerically defined maximum upside or minimum downside

– uncertainty regarding timing of event

Types of investment

I. trade (strictly defined “event”, based on officially announced event news and upside/downside quantifiable, if not fixed; fundamentally dependent or not)> “event-driven”

– merger arb

– index component shift

– distressed (bankruptcy, restructuring, etc.)

– recapitalization (buyback, special dividend, spinoff/splitoff, etc.)

II. trend (announced or unannounced) > “value + catalyst”

– accelerating or decelerating momentum, which could implicate some breakout down the road due to fundamental changes

– revert-to-mean

– contrarian/controversial/complexity => inefficiencies caused by under-research, under-following or misunderstanding

– relevant value (or one-side trade ahead of public listing of comp) btw. comparable stocks or different components of capital structure for the same company, with mkt leadership switch btw #1 and #2 being the single most profitable idea source for some seemingly crowded areas (e.g. CU/CM, Anta/LiNing, Golden Eagle/Parkson, etc.)

– new management actions (passive event in absence of official announcement, but having shrhlder friendly management on investors’ side)

– new products/new markets

– inside transactions

III. tail => thematic investing

– policy (industrial, monetary, fiscal, etc.)

– regulatory

– political

– demography

– cyclical

– liqudity

– any other structural factors

=> HK, and more so in China, tends to discount both tail risk 6-9M ahead AND immediate events in a significant way, leading to seemingly high volatility. However, fundamentally it’s no different than the US mkt, i.e. Individual stock price eventually reflecting its own fundamental. Given the wide variation among different  Chinese cities/provinces, from time to time, mkt volatility within either the overall mkt or a specific sector creates superior risk/reward oppportunities for stock pickers.

Investment process (for event trading)

– screen via public news and private connections to identify events to work on

– assembly SWAT team, dedicating responsibility for different functions (legal, financial, Street contact, management due diligence, etc.)

– fundamental research as a base to work with, which leads to event premium/discount to fair value as well as market price

– PM to determine

1) probability of event completion (soliccited or unsolicited, history of buyout effort, mgmt incentive, etc,);

2) if the 1st question is answerable, then determine how to maximize return from the event as it’s announced (structuring of trade via options, equities, CBs, HY, CDS, speicalty lending, etc);

3) availability of any extra upside not captured by the announcement (competing bids, mkt disruption by external factors, etc);

4) how to hedge risk as cheap as possible if we were wrong;

5) internal comparison with other working ideas/trades to determine how big positioin this trade’s risk/reward profile could justify.

– Always check if the stock price level still leaves enough money on the table to justify the maintaining of a trade

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