Fund Manager's Tip of the Week

Event driven is among the top five most popular alternative investment strategies, according to BHA’s mandate data. Generally, analysts have found that investors gravitate toward this strategy to diversify their portfolios. Not only do investors have a wide assortment of strategies to choose from but also the number of potential events these strategies may trade on is huge. As an article in the Financial Times noted, “There are potentially thousands of strands.”¹ This bodes well for event-driven funds being able to provide returns that are usually uncorrelated to the equity and bond markets.

In addition to the broad category of event driven, BHA tracks investor interest in merger/risk arbitrage, special situations, and distressed credit. We break down interest in these event-driven strategies using several investor characteristics, including country, city, and category.

¹ Financial Times, “Little known hedge fund strategy now on the radar,” August 28, 2011.

Breakdown by Investor Location

Mandates stating an interest in event-driven funds broken down by the top five countries and cities

Breakdown by Investor Category

Mandates stating an interest in event-driven funds by the top five investor categories

Breakdown by Liquidity Preferences

Liquidity preferences specified in mandates with an interest in event-driven funds

Investors' Manager Requirements

Minimum track-record and asset-size requirements specified in mandates with an interest in event-driven funds

Investor Heat Map

Mandates stating either a past or current interest in event-driven funds broken down by the top five cities

These graphs reflect general investor demand for hedge funds employing an event-driven strategy. Managers can log in to the BHA MandateConnection database to identify investors whose mandates match the precise characteristics of their event-driven hedge fund, such as region and sector exposure, return and volatility profiles, and domicile. Click here for a PDF version.

A Look at Event Driven

Most alternative investors are familiar with the event-driven strategy, a hedge fund approach that looks to take advantage of market changes caused by corporate events. However, many investors are not aware of the large number of strategies that fall into the event-driven “bucket.” For example, activist, credit arbitrage, distressed credit, merger arbitrage, private issue/regulation D, and special situations can all be categorized as event-driven strategies.

Longer than the list of strategies, however, is the list of corporate events from which these fund managers try to profit. What all event-driven strategies have in common is that they look to profit from investors trading a security because of special circumstances (rather than, say, because investors believe a stock is undervalued or overvalued). These circumstances include, but are not limited to, legal reorganizations, leveraged buyouts, cash tender offers, proxy contests, acquisitions, corporate takeovers, mergers, restructurings, exchange offers, recapitalizations, spin-offs, asset sales, liquidations, bankruptcy, and regulatory changes.

Of all the event-driven strategies, merger arbitrage garners the most headlines. It is one of the four event-driven strategies for which BHA tracks investor interest. Managers that employ this strategy generally attempt to generate profits by taking advantage of a change in the price spread of two securities that are engaged in a merger or acquisition event. Merger arbitrage managers short the stock of the company that is making the acquisition and go long on the stock of the company that is being acquired. The stock of the target company generally trades at a discount to the announced merger price, a discount that reflects the risk that the deal may not be accomplished. As the likelihood of the deal increases, the spread between the market price and the announced merger price shrinks until the completion of the merger, when the company is, by definition, worth as much as the acquirer is willing to pay for it.

The risks associated with mergers, and thus faced by merger arbitrage funds, are many. The largest is event risk or the risk that the two companies will not complete a deal. This could happen for a number of reasons. Another company could bid for the target and start a bidding contest. Or a regulator, such as the SEC, could step in and not allow the merger to go forward. Antitrust concerns are often cited in these circumstances. Such inherent risks to a deal are why merger arbitrage is also sometimes referred to as risk arbitrage.

Whereas merger arbitrage managers trade based on announced mergers, managers employing a special situations event-driven strategy anticipate corporate events and try to position their fund to take advantage of pricing discrepancies should the event occur.

Rumors of mergers and acquisitions are one of these special situations. In these cases, funds purchase shares of companies that the portfolio manager anticipates may become involved in a transaction. As in merger arbitrage, however, they tend to short companies they expect to make an acquisition and go long on those they anticipate will be acquired. This strategy carries greater risk that the event will not occur, but that also means a better opportunity for large returns if it does.

Funds that employ a distressed credit event-driven strategy take long positions in the debt of companies that face a major reorganization, bankruptcy, or some other kind of financial distress. Interestingly, funds that have a high-yield or junk bond strategy generally invest in debt that has a rating of BBB or below. By contrast, funds that use a distressed credit strategy invest in bonds that have a rating of CCC or below. The funds generally invest in junior and subordinated debt, senior secured bank debt, mezzanine debt, letters of credit, convertible bonds, subperforming real estate bonds, common and preferred stock, and trade claims. As the seniority of the bonds decrease, their level of risk increases.

In 2011, BHA collected 707 mandates for event-driven funds, which represented 32.8% of the 2,157 total hedge fund mandates collected. Of these, 254 (35.9%) were for merger/risk arbitrage funds, 169 (23.9%) were for special situations funds, and 339 (47.9%) were for distressed funds.

Event-driven funds look poised to experience significant gains this year. Both merger arbitrage and special situations should benefit from the currently strong M&A environment, particularly in the tech space. In 2011, companies spent about $219 billion on tech-related merger activities, and sectors such as cloud and mobile computing are expected to see consolidation in 2012.¹ Some fund managers also expect merger activity in Europe to pick up considerably.² Distressed funds should also continue to have strong returns as a result of the European sovereign-debt crisis. Thus, BHA analysts expect funds employing event-driven strategies to fare well this year and experience significant interest from investors.

For past installments of this series, please click here.

¹ The Street, “Bankers Bullish on Tech M&A for 2012,” January 30, 2012.

² FINalternatives, ”Diva Synergy Event-Driven Fund Ends 2011 In Black,” January 9, 2011.

Fund marketers typically spend 20% to 30% of their time generating new investor leads and qualifying new investor prospects. Managers often comment to BHA staff that an inordinate amount of time is required because the marketers are looking for the proverbial needle in the haystack—active investors who are interested in their type of fund. Whether raising capital for a fund with the ever-popular long/short equity strategy or some of the more niche and esoteric products, marketers spend an enormous amount of time trying to find good investor prospects.

Conversely, investors spend much time trying to find top-quality managers. Traditionally, investors have had three ways to ferret out and vet fund managers: prime brokers’ capital introduction teams, websites that aggregate fund manager performance statistics, and their internal research staff. Still, it’s a time-consuming effort.

More than five years ago, BHA began offering the MandateConnection database, enabling marketers to effectively and efficiently connect with investors. Since then, BHA  has become a trusted source for both constituencies.

Every week, BHA’s team of 20 research analysts makes more than 3,000 phone calls and interviews more than 300 investors. During these one-on-one interviews, BHA analysts document the mandates and search criteria investors convey. This information is called “declared data,” and it is the most valuable type of data in the field of data analysis.

Some investor data companies track historical contacts and previous fund investments. Marketers buy this data and attempt to determine investors’ current plans based on past allocations. This sort of data can serve as an indicator—unless there has been turbulence in the market, such as the kind the industry experienced from 2008 through 2011. Then historical data becomes less relevant, as investors reevaluate failed strategies and reshuffle disappointing portfolios.

Other companies gather data through electronic polling or surveys. Although this method is acceptable, it is hard to authenticate who filled out the form and validate investors’ current allocations plans, since there is no dialogue in the process.

For years, managers have told BHA that they purchase these investor databases and contact lists because that’s what’s available, but they are only a starting point at best. Their marketers still must call or e-mail investors to determine if the investors are good prospects. Fund managers have consistently noted that the only information marketers really need to do their job is a list of active investors looking for their type of fund.

This is why BHA identifies the subset of the investors in the market with a declared active interest in fund types and strategies. This data can save marketers 20% to 30% of their time. Marketers save even more time when they contact investors. Mentioning that their fund is a fit according to BHA’s MandateConnection database preemptively qualifies a fund for investors.

In essence, BHA’s innate value is found in the increased efficiency and effectiveness of marketers’ prospecting and fundraising efforts and investors’ ability to find top-quality managers and fulfill their mandates.

Strong Marketing Materials: The Secret to Success

By Robinson Crothers