An event-driven hedge fund strategy seeks to take advantage of special situations that change the value or price of an underlying asset. These special situations can include transaction announcements, such as mergers or acquisitions, or if a company is in financial distress.
There are three sub-strategies within the event-driven approach: risk arbitrage, distressed debt investing, and a combination of both (multi-strategy).
Rick arbitrageurs are equity traders, and seek to take advantage of opportunities that arise when one company wants to buy or merge with another. The acquiring company will usually offer a substantial premium over the current trading price of the target company’s stock. For example, if Company B was trading at $60, Company A, the acquirer, may offer to $80 a share for outstanding stock.
When the deal is announced, Company B’s stock will immediately rise but not all the way to the $80 offer price. That’s because there are still some risks that the transaction will not be completed.
Many stockholders in Company B and traditional equity investors will sell their shares after the announcement and enjoy a healthy increase in value, say, from $60 to $70. However, the risk arbitrageur steps and buys the shares at $70 and seeks to earn the spread between that price and the final offer price of $80.
The risk to the arbitrageur is that the transaction could get bogged down in lengthy negotiations or disagreements about management of the new company. General market conditions could deteriorate. There could be surprising bad news about the company, or regulators may decide to get involved and block the transaction. The acquiring company could back out, the deal could fall through or be substantially delayed, or the price could be reduced. The price of the stock could potentially fall back to what it was trading at prior to the announcement. So a risk arbitrageur must continually assess the situation during the transaction period and decide whether to take or hold a position in the target company’s stock.
There could be positive developments, too. For example, another company could step in with an offer and a bidding war ensues. Or the board of directors decides Company A’s offer is too low, and forces them to raise their bid.
Risk arbitrage is a highly volatile strategy that seeks to profit within the short time frame of an expected merger, acquisition or other corporation event. Risk arbitrageurs feed off the deal flow created by companies that are trying to expand via mergers and acquisitions, rather than organic growth. Thus, the current economic climate that has put a damper on M&A activity will mean fewer opportunities for risk arbitrageurs as well.
Next time we’ll look at the other major event-driven strategy, distressed debt investing.