Underscored by the activities of celebrity activist investors, 2014 was a busy year for strategic corporate events. A surge in boardroom confidence, continued low interest rates and a rising stock market led to the highest level of deal making since 2007, with global volume surpassing $3 trillion. 
 
This trend began in late 2013, as companies began to explore various types of transactions in addition to run-of-the-mill deals, or as they are referred to in the hedge fund community, “plain vanilla” mergers. 
 
Activist investors in both buyer and target companies accelerated the rampant activity. Investors rewarded companies that opportunistically deployed capital in mergers or even split themselves into independent entities. 
 
Deal value creation, a metric that tracks stock price movements before and after deal announcements to measure the shareholder value that has been created, recently hit an all-time high, with more than 80 percent of acquiring company stock prices reacting positively after deal announcements.
 
Event-Driven Investments
 
Traditionally, access to event-driven strategies has largely been limited to institutional investors and high-net-worth investors utilizing hedge funds. 
 
Recently, however, the surge in liquid alternative mutual and exchange-traded funds has led to the introduction of several vehicles that provide retail investors with the ability to access these institutional strategies.
 
But do these trendy funds belong in your clients’ portfolios? As usual, it depends on the client and their investment goals. Let’s start with the basics: 
 
Understanding Event-Driven Strategies 
 
Broadly defined, event-driven strategies are designed to capitalize on corporate events, including mergers, acquisitions, asset sales or divestitures, restructurings, refinancings, recapitalizations, reorganizations or other special situations.
 
When we talk about “event-driven strategies,” we’re actually describing a general category of investing that covers a wide range of sub-strategies, each with their own set of characteristics. This wide focus gives event-driven managers broader investment options and a variety of ways to make a profit. 
 
With record M&A growth, many funds that employ event-driven strategies have utilized merger arbitrage, which requires a specialized portfolio-management skill set, including: 
 
- Analyzing public information regarding the companies implementing the transaction and the markets in which they compete.
 
- Evaluating the probable outcomes of government antitrust and other regulatory investigations.
 
- Monitoring litigation by governmental and private parties. 
 
- Mitigating potential deal risks, such as transaction termination, timing delay, material adverse changes to parties in the transaction, shareholder vote risk, tax consequences and financing concerns. 
 
 
- Analyzing the target company’s ability to fend off a hostile transaction. 
 
 
How Event-Driven Strategies Can Enhance Portfolios 
 
Investors should not assume that alternative strategies such as event-driven funds will beat the S&P during a strong bull market, but instead use it to diversify their traditional equity and bond exposure through a relatively conservative approach. Each investment in the portfolio typically trades with unique deal dynamics and is normally not correlated with other holdings. The outcome of a single transaction does not typically impact the outcome of other portfolio investments. 
 
In contrast to traditional long-only strategies, investment returns are predominantly driven by the outcome of the specific transactions rather than the direction of equity or bond markets. However, when coordinated with bond allocations, an event-driven fund can potentially provide a hedge against increased market volatility and rising interest rates. Unlike bond portfolios, the returns of event-driven strategies have historically correlated positively with interest rate movements. 
 
Event-driven investing can provide a number of portfolio benefits: 
 
- Performance has traditionally had low correlation (beta) with the stock and bond markets. 
 
- Returns have historically been less volatile than equity markets (as measured by standard deviation). 
 
- The strategy should be positively correlated with interest rates or one’s cost of capital; therefore, if interest rates rise, the strategy’s performance may provide a hedge against the decreased value of bond holdings.
 
The primary risk the event-driven investing is individual transaction risk, should a planned corporate event not occur. If a deal is terminated, the target and acquiring companies’ securities tend to revert to price levels prior to the transaction announcement, possibly erasing gains or causing losses. Therefore, a sophisticated and experienced manager is essential to employ an event-driven strategy in a cohesive, diversified portfolio. They must have a proven track record, expertise and skills to accurately assess whether the announced corporate events will be successfully completed. 
 
Michael Shannon, CFA, is managing member and co-portfolio manager of Westchester Capital Management’s The Merger Fund and WCM Alternatives: Event-Driven Fund.