Event-driven Strategies: Merger Arbitrage

Event-driven (E.D.) hedge fund strategies involve the practice of taking positions in corporate securities and derivatives. These positions are taken with the aim of profiting from various corporate events, such as mergers and acquisitions, bankruptcies, share issuances, buybacks, capital restructurings, reorganizations, accounting changes, and similar developments within a company. The ultimate objective of these strategies is to generate profit based on the outcomes of these specific corporate events.

E.D. hedge fund managers engage in comprehensive analyses of companies' financial statements, regulatory filings, and corporate governance aspects, which encompass management structure, board composition, shareholder matters, and proxy voting. They also evaluate the company's strategic objectives, competitive position, and other specific factors relevant to the firm. These analyses are conducted to make informed investment decisions.

In E.D. strategies, investments can take two primary approaches. The first is a proactive approach, where investments are made in anticipation of an upcoming event (referred to as a soft-catalyst event-driven approach). The second approach is reactive, where investments are made in response to an already announced corporate event, and security prices related to the event have not yet fully adjusted (known as a hard-catalyst event-driven approach). Generally, the hard-catalyst approach is considered to be less volatile and carries lower risk compared to soft-catalyst investing.

Common event-driven strategies include merger arbitrage, where hedge funds aim to profit from price differences between a target company's stock and the acquiring company's stock during a merger, and distressed securities, which involve investing in the debt or equity of financially troubled companies with the expectation of a turnaround or recovery in value.

Investment Characteristics

In cash-for-stock acquisitions, a merger-arb manager may buy only the target company (T), expecting its value to rise after the acquisition. In stock-for-stock deals, the manager usually buys T and sells the acquiring company (A) in the same ratio as the offer, aiming to profit from the spread upon successful deal completion. If the acquisition fails, the manager faces losses if T (A) has already increased (decreased) in anticipation. Occasionally, managers anticipate a failed acquisition, often due to regulatory concerns, in which case they would sell T and buy A.

In most acquisitions, the initial announcement causes the target company's stock price to approach the acquisition price while the acquirer's stock price tends to fall. There is often a significant time gap between deal announcement and closing, leaving room for potential failures for various reasons like lack of financing, regulatory hurdles, or failed financial due diligence. Hostile takeovers, which lack the target company's management agreement, are typically less successful than friendly takeovers.

Around 70%–90% of announced mergers in the United States eventually closed successfully. However, due to the possibility of some deals not closing, the costs of establishing a merger arbitrage position (e.g., borrowing, acquiring stock, commissions), and the risk of changed merger terms due to market conditions, merger arbitrage generally offers a return spread of 3%–7%, depending on deal-specific risks. A precarious deal may offer a more extensive spread. With an average time for deal completion of 3-4 months and managers applying leverage to their positions while recycling capital into new deals multiple times a year, this strategy can generate attractive net annualized returns ranging from 7%–12%, with low correlation to non-deal-specific factors. Diversification across various mergers, deals, and industries helps mitigate the risk of any deal failing, making this strategy a valuable uncorrelated source of alpha.

When merger deals fail, the initial price movement of the target (acquirer) company typically reverses, and arbitrageurs who entered after the initial announcement may incur substantial losses on their long (short) position in the target (acquirer), often ranging from negative 20% to 40%. Therefore, this strategy carries left-tail risk.

Merger arbitrage is essentially a form of insurance on the outcome of an acquisition, where the manager collects a spread as compensation for bearing event risk if the acquisition succeeds or faces losses if it fails. The strategy's payoff profile resembles a riskless bond and a short put option. Additionally, the investor can be seen as owning a call option that becomes valuable if another interested acquirer (a White Knight) makes a higher bid for the target company before the initial merger proposal is completed.

Risk Profile and Liquidity

• Merger arbitrage is a relatively liquid strategy, offering defined gains from unique single security takeover situations but occasional unexpected setbacks when merger deals fall through.
• This strategy has market sensitivity and left-tail risk characteristics since deals are more likely to fail during periods of market stress. Its return profile and a short put option resemble that of insurance.
• Cross-border mergers and acquisitions (M&A) and M&A deals involving vertical integration often require two governmental approvals. They may face antitrust scrutiny, leading to higher risks and more comprehensive merger spread returns.
• Some merger arbitrage managers exclusively invest in friendly deals with relatively narrow spreads. In contrast, others are willing to embrace riskier hostile takeovers with wider spreads, sometimes with expectations of a higher bid from a White Knight.
• The limited partnership is the preferred vehicle for merger arbitrage due to its substantial use of leverage. Still, there are also low-leverage, low-volatility liquid alternative merger arbitrage funds available.
• This strategy is attractive, offering relatively high Sharpe ratios, typically yielding low double-digit returns with mid-single-digit standard deviation (depending on the level of leverage applied). However, it carries left-tail risk while maintaining an otherwise stable return profile.

Leverage usage

• Moderate to high leverage is commonly applied by managers in the range of 3 to 5 times to achieve substantial target returns within this strategy.

Benchmark

• Sub-indexes comprise the HFRX or HFRI Merger Arbitrage Index, the CISDM Hedge Fund Merger Arbitrage Index, and the Credit Suisse Merger Arbitrage Index.

Strategy Implementation

Merger arbitrage strategies typically employ common equities for their positions. Still, they can also utilize other corporate securities like preferred stock, senior and junior debt, convertible securities, options, and derivatives for positioning and hedging. In cash-for-stock acquisitions, hedge fund managers may employ leverage to buy the target company, and in stock-for-stock deals, leverage is often used. However, short-selling the acquiring company may pose challenges due to liquidity issues or constraints, particularly in emerging markets.

Derivatives can be employed in merger arbitrage strategies to overcome short-selling constraints or manage risks in the event of a deal's failure. For example, managers can purchase out-of-the-money puts on the target (T) and/or out-of-the-money call options on the acquiring company (A) to cover the short position.

Convertible securities offer exposure with asymmetrical payoffs. For instance, the convertible bonds of the target company (T) would increase in value if T's shares rise due to the acquisition, providing a cushion if the deal falls through, causing T's shares to decline. When the acquiring company's credit quality surpasses the target company's, trades may use credit default swaps (CDS). In this case, protection (shorting the CDS) on the target company is sold to benefit from its improved credit quality and the decline in the price of protection and the CDS after the merger's completion. Alternatively, buying protection (going long the CDS) on the target can partially hedge against a merger deal failure. Additional short equity index ETFs/futures or extended equity index put positions may be used to hedge the overall market risk that could potentially disrupt a merger's completion.

Event-Driven Strategies: Distressed Securities

Distressed securities strategies revolve around companies facing financial distress, bankruptcy, or potential bankruptcy for various reasons, such as diminished competitiveness, excessive debt, governance issues, accounting irregularities, or fraud. Hedge funds, unbound by institutional requirements on minimum credit quality, are often well-suited to invest in such situations. The securities of distressed companies are often discounted and have been divested from long-only portfolios.

Hedge funds typically offer investors only periodic liquidity, making the illiquid nature of distressed securities less problematic than if held within a mutual fund. Hedge fund managers may identify inefficiently priced securities before, during, or after bankruptcy proceedings and aim for faster returns than private equity firms' longer-term approach. However, some distressed investments, like sovereign debt (e.g., Puerto Rico, Venezuela), may require extended payout time horizons.

Distressed hedge fund managers may sometimes seek to acquire a majority or all of a specific class of securities within a company's capital structure, allowing them to exert control in bankruptcy or reorganization processes. Their approach varies by country based on local bankruptcy laws and procedures. Some managers actively build concentrated positions and place representatives on company boards to effect turnarounds. In contrast, others take a more passive approach, relying on external parties to manage legal costs involved in corporate capital structure reorganizations.

Distressed debt and other illiquid assets often take years to resolve and are challenging to value. Therefore, hedge fund managers handling distressed securities portfolios typically require relatively long initial lock-up periods (e.g., no redemptions allowed for the first two years) from investors. They may also implement fund-level or investor-level redemption gates to limit quarterly withdrawals. Valuing distressed securities, especially those with little or no liquidity, may necessitate the involvement of external valuation specialists to provide an independent fair value estimate, often utilizing “mark-to-model” price determination.

The bankruptcy process generally leads to one of two outcomes: liquidation or firm reorganization. In a liquidation, the firm's assets are gradually sold off, and claimants, prioritized by their claims, are paid sequentially. This order typically follows senior secured debt, junior secured debt, unsecured debt, convertible debt, preferred stock, and common stock. In a reorganization, the firm's capital structure is revamped, and the terms of current claims are renegotiated and revised. Debtholders may agree to extend debt maturity or exchange their debt for new equity shares. Existing equity holders may see their equity canceled, with new equity issued and sold to new investors to raise funds for improving the firm's financial health.

Investment Characteristics

Investing in distressed securities involves unique risks and opportunities, demanding specialized skills and vigilant monitoring. Institutional investors, such as banks and insurance companies, often face mandates that prevent them from holding non-investment-grade securities in their portfolios. Consequently, these investors may need to divest holdings in financially troubled firms, potentially resulting in illiquidity and significant price discounts during trades. However, this situation also creates appealing opportunities for hedge funds. The progression from financial distress to bankruptcy can be lengthy, and the intricacies of legal proceedings lead to mispriced securities.

To excel in distressed securities investing, hedge fund managers must possess the expertise to navigate complex legal proceedings, bankruptcy processes, creditor committee negotiations, and reorganization scenarios. They must also anticipate market responses to these developments. Depending on relative pricing, managers may establish “capital structure arbitrage” positions, taking long positions in securities expected to yield acceptable recoveries while shorting other securities, including equity, with less favorable value-recovery prospects.

Current market conditions significantly impact the success of distressed securities strategies. Quickly selling assets at discounted prices in liquidation scenarios can reduce the overall recovery rate. The sale of illiquid assets under time constraints may lead to fire-sale prices and liquidity spirals. In reorganization situations, market conditions determine the firm's ability to raise capital from asset sales or the issuance of new equity. Exhibit 6 provides key attributes of distressed securities investing.

Risk Profile and Liquidity

• Distressed securities investing typically offers returns on the higher side among event-driven strategies, but these returns can be more variable. While outright short or hedged positions are possible, investing in distressed securities often leans toward long ones. Specific security outcomes influence it but are also sensitive to the overall macroeconomic conditions.
• Distressed securities investing usually involves relatively high levels of illiquidity, particularly when adopting a concentrated activist approach. Pricing may rely on “mark-to-model” methods, which can result in return smoothing. Outcomes are generally binary, leading to either very favorable or unfavorable results.
• Regarding attractiveness, returns from distressed investing tend to be irregular and somewhat cyclical. This strategy becomes particularly appealing during the early stages of an economic recovery following a period of market upheaval.

Leverage Usage

• Moderate to low: Given the inherent volatility and the predominantly long position orientation in distressed securities investing, hedge fund managers tend to employ conservative leverage levels ranging from 1.2 to 1.7 times their Net Asset Value (NAV). Some of this nominal leverage may come from derivatives used for hedging purposes.

Benchmarking

Hedge fund sub-indexes encompass the HFRX and HFRI Distressed Indices, CISDM Distressed Securities Index, Lipper TASS Event-Driven Index, and Credit Suisse Event-Driven Distressed Hedge Fund Index.

It's important to note that alpha generated by distressed securities managers tends to be unique to their approach. The strategy leverages information inefficiencies and the limitations of traditional managers in holding such securities.

Strategy Implementation

Hedge fund managers employ different strategies when investing in distressed securities. In a liquidation scenario, their primary focus is assessing the recovery value for various classes of claimants. Suppose the manager's estimate of the recovery value is higher than the market's expectations, potentially due to illiquidity issues. In that case, they can purchase undervalued debt securities with the expectation of realizing a more favorable recovery rate.

In a practical example, consider a situation where a company has filed for bankruptcy, and its senior secured debt is being traded at just 50% of its original value. A manager, relying on their research and cash flow estimates, believes that when the bankruptcy process concludes, they will recover around 75% of their initial investment. Therefore, with this anticipation, the manager decides to purchase the senior secured debt at the discounted 50% price, with the goal of benefiting from the positive difference in recovery rates.

However, even if the manager's assessment turns out to be accurate and the company eventually recovers 75% of its debt value, external factors can still influence the actual profit realization. This can happen if the liquidation process of the bankrupt company drags on longer than expected or if market conditions worsen over time, affecting the debt’s actual market value and potentially reducing the manager's profit.

In a reorganization situation, the hedge fund manager focuses on understanding how the firm's finances will be restructured and evaluating the value of the business enterprise and different classes of claims. There are various avenues for investing in a reorganization, with the manager considering the undervalued securities based on the likely reorganization outcome. The choice of security depends on whether the manager seeks a controlling position. If they do, they become actively involved in the negotiation process and aim to identify fulcrum securities that provide leverage in the reorganization. Fulcrum securities are claims that are partially in the money and are expected to be repaid only partially, ultimately leading their holders to become owners of the reorganized company. A financial restructuring may occur if the financial distress results from excessive leverage, but the company's operating prospects are still promising. In this scenario, the hedge fund manager could swap senior unsecured debt for new shares, with existing debt and equity being canceled. New equity investors would inject fresh capital into the company. As financial distress dissipates and the reorganized company's intrinsic value increases, an initial public offering (IPO) is typically conducted. The hedge fund manager can then exit the investment, realizing the difference between the purchase price of the undervalued senior unsecured debt and the proceeds from selling the new shares in the IPO of the revitalized company.

Question

In what scenarios could a distressed securities hedge fund arbitrageur, who takes a position in unsecured debt hedged against short equity (or long puts on the equity), potentially make money?

1. When both the unsecured debt and equity prices rise.
2. When the unsecured debt prices rise, the equity prices fall.
3. When the unsecured debt prices fall, the equity prices rise.

Solution

The correct answer is B.

The hedge fund arbitrageur has a long position in unsecured debt, so when its prices rise, it will profit from that part of the investment. Simultaneously, if the equity prices fall, the short equity position or long puts on equity would also be profitable, resulting in a net gain.

A is incorrect. This would not be profitable for the arbitrageur because losses in the short equity position or long puts may offset the gains from the unsecured debt.

C is incorrect. In this case, the gains from the unsecured debt may be eroded by losses in the equity position, resulting in potentially no profit or even losses.

Reading 38: Hedge Fund Strategies

LOS 38 (c) Discuss investment characteristics, strategy implementation, and role in a portfolio of event-driven hedge fund strategies.