Adding Event-Driven Strategies to Portfolio Construction
As M&A activity reached a 20-year high in 2021 investors flocked to event-driven strategies. But 2022 proved to be a year of two halves for the opportunity set. In the second half of the year, activity collapsed and the year ended with a 36% decline in M&A deal values (Source Dealogic 2023). The big turning point occurred in June 2022, when an interest rate hike by the US Federal Reserve Bank, combined with heightened macroeconomic uncertainty, put a chill on the deal market.
The ‘Event-driven’ category comprises a significant part of the hedge fund industry. As a framework, we will be using data from Hedge Fund Research (HFR). HFR is a provider of +200 Hedge Fund indices, whose aim is to benchmark the Hedge Fund industry. According to HFR, event-driven hedge funds make up more than 25% of total hedge fund AUM as of December 31, 2022 ($3.83 trillion).
Hedge Funds AUM in $bn by Strategy (Dec 2022)
Hedge funds are Alternative Investment funds that offer more flexibility than traditional investment products. They can invest long and short with complex derivatives’ strategies, use leverage and can include illiquid or semi-liquid investment strategies. Almost fully dominated by institutional investors, hedge funds are part of a complex and diverse universe, which demands specialized resources and capabilities to successfully invest.
‘Event-driven’ is one of the four main categories used by HFR to classify this heterogeneous group of Alternative Investment funds. Event-driven has performed strongly and has, in fact, enjoyed more than double the amount of return generated per unit of risk compared with equity markets represented by the S&P 500 (total return). In absolute terms, this sector has also generated impressive gains, producing equity-like returns with only half of the comparable drawdown, all during a period with multiple real-time ‘stress’ scenarios (e.g., dotcom bubble, global financial crisis or the COVID pandemic, among others).
Hedge Fund Annualized Return & Maximum Drawdown by Strategy (1989 to 2023)
Many view this hedge fund category as limited to merger arbitrage or distressed debt, but there are some equally attractive opportunities in areas that fall outside of these traditional remits. These sub-strategies are able to deliver diversified returns, which can significantly improve a portfolio’s risk-adjusted performance in the long-term.
The graph below shows the evolution of the aggregate Event-Driven index, together with the only two sub-indices that have data since 1990: the Merger Arbitrage index and the Distressed/ Restructuring index.
Event-driven Indices vs S&P 500
Strategy-wise, the broad Event-Driven index has historically been correlated more strongly with the Distressed/Restructuring index than the Merger Arbitrage index. Drawdown numbers of the two subsectors are quite distinct and reveal that Merger Arbitrage is geared more toward capital protection.
Compared with traditional markets’ risk-adjusted returns, the difference is significant and, across all sub-sectors, the amount of return generated per unit of risk (proxied by volatility) doubles the amount generated by US equity markets since 1990.
Hedge Fund Annualized Return & Maximum Drawdown by Strategy (1989 to 2023)
What are the sub-strategies included in the Event-Driven index?
MERGER ARBITRAGE (OR RISK ARBITRAGE)
A merger has two parties: the acquiring company and its target. If the target company is a publicly-traded entity, then the acquiring company must purchase the outstanding shares of its target. In most cases, this is at a premium to what the stock is trading for at the time of the announcement, leading to a profit for shareholders. After the deal becomes public information, investors looking to profit from the deal may purchase the target company’s stock, driving it closer to the announced deal price.
However, the target company’s price rarely matches the announced deal price and, instead, often trades at a slight discount. This risk premium owes to some probability that the deal may fail. Deals fail for many reasons, including changing market conditions, a repudiation of the transaction by regulatory bodies, lack of financing or due to other competitive dynamics. In its most basic form, merger arbitrage involves an investor purchasing shares of the target company at a discounted price, then profiting once the deal is completed. This difference in price is called the “spread” and represents the remuneration that the arbitrageurs receive in compensation for the risk they assume related to the transaction.
Deal flow slowed from the second half of 2022 due to both higher market volatility and higher interest rates. The availability of leverage can be critical for the deals to close. But uncertainty about transactions and/or interest rates usually presents an opportune moment to allocate to this strategy. Higher interest rates are also positive for the strategy’s gross returns as the “spreads” are earned relative to risk-free base rates. Merger arbitrage can provide refuge for investors seeking to reduce beta in their portfolios and mitigate traditional equity risk premium. From our point of view, this is an “all-weather” strategy where modest returns can compound over time. On top of this, additional returns can be generated by exceptional managers and also by wisely allocating money to the strategy when markets are dislocated.
Distressed managers buy different types of securities, such as loans, bonds and trade claims, or equity securities of bankrupt or severely stressed corporates. The aim of these positions is to profit from either the restructuring of the company, in which case it will be rebuilt transforming its capital structure and/or its operations; or its liquidation.
In case of the latter option, the liquidator will proceed to dissolve the firm, taking care of creditors in order of priority.
Although default rates are still relatively low, the opportunity for the strategy is improving as interest coverage ratios are broadly deteriorating.
This sub-sector involves managers whose strategies pursue capital structure arbitrage. These funds invest in a variety of instruments across the capital stack of a company. For example, they can assume long positions in the most senior parts, such as loans or collateralized senior bonds, and simultaneously they short the more subordinate parts. (or vice versa).
Alternative, a ‘negative basis’ trade could be structured via a long position in a senior unsecured instrument in the capital structure of the firm together with a corresponding hedge accomplished through a credit default swap. We can also identify several multi-strategy credit funds that combine different strategies across the whole gamut of opportunities in the credit universe: loans, high-yield bonds, investment grade bonds, structure credit, trade finance or claims, and other more esoteric instruments.
Specials Situations portfolio managers generally look for opportunities to invest in primarily equity-like paper of companies that are involved in relatively complex corporate processes. Examples would include spin-offs, issuances, repurchases of securities, asset sales, litigations and pending fines, or any other proceeding with a clearly defined catalyst (or potential catalyst) attached.
Here we could also label those managers which invest in post-reorganization equities, i.e., companies that have emerged successfully from a bankruptcy processes, or managers who invest in pre-IPOs, i.e., managers who take stakes in non-listed companies before those businesses complete their listing process.
Activist fund managers acquire large stakes in listed companies generally in order to influence strategy and day-to-day operations. Managers attempt to establish large stakes as shareholders to subsequently appoint member(s) to the board of directors, with the aim of submitting proposals that should be heard by the company’s management.
These funds are deeply concentrated in small groups of positions and do not usually have short positions, and/or the use of shorts is quite limited.
Their main objective is to create shareholder value through some combination of the following approaches:
1) Optimizing asset allocation processes of the corporates by implementing share buybacks and/or paying dividends.
2) Restructuring of the distinct business units through spin-offs, divestment, asset sales, etc.
3) Taking charge of the company to lead a sale or a merger process.
4) Improvement of corporate governance policies.
5) Impacting ESG topics from different angles, such as energy transition or diversity and inclusion.
Unfortunately, we only have data for all event-driven sub-strategies since 2008. Although event-driven strategies are understood to be directional in aggregate, there are pockets of protection in areas such as merger arbitrage.
In contrast, activist strategies, special situations and distressed are far more sensitive to market movements.
Event-driven Performance under Various Approaches
Hedge Fund Annualized Return & Maximum Drawdown by Sub-strategy (2007 to 2023)
A common perception is that event-driven strategies are highly beta-driven. However, as we have discussed, event-driven is, in fact, quite heterogenous. In fact, the universe of opportunities in merger arbitrage or corporate restructuring is highly correlated to corporate activity and the economic cycle.
Hedge Fund return Dispersion by Strategy (1970 to 2023)
Furthermore, different managers and styles can offer additional layers of diversification. When an investor is looking to allocate to the strategy, we suggest that he consider the following:
• Evaluate one’s own appetite for risk, and determine the need for capital protection vs. capital appreciation.
• Gain a fundamental understanding of the different soft and hard catalysts of the prospective managers.
Due to their fundamental characteristics, most event-driven managers’ performance is determined by specific situations and corporate events. Even though event-driven strategies have the ability to produce performance that has limited correlation with equity markets, there is a dependence on external factors and, in the short term, there can be an equity market relationship and even a short volatility component.
One of the major risks inherent in event-driven strategies is that managers’ portfolios can be concentrated, and as we learned during the GFC or during the COVID-19 crisis, these strategies can be acutely affected in periods of dislocation due to a lack of liquidity. It is precisely during these periods of extreme uncertainty when the most compelling opportunities emerge.
Based on the observations and arguments explained above, at Klarphos, we believe that event-driven hedge funds are likely to perform well over the coming years. The skill of managers to benefit from the current environment will depend on their capacity to extract performance and adapt to any abrupt reversal in the cycle by being sufficiently well-diversified. Klarphos´ opinion is that a multi-strategy, event-driven approach is the right investment decision to take. Being diversified across strategies may serve to smooth variability and allow for improved capital allocation.
Correlation Matrix - Diversification Benefits within Hedge Fund Strategies (2007 to 2023)
At Klarphos, our performance expectations for Event-driven managers are 7-9% net returns over a full market cycle. The strategy’s capacity to generate such returns with volatility below those figures makes the case for allocators to improve their risk/reward in the long-term by an allocation to this HF sub-sector. But like with all alternative investments, implementation is critical and portfolio construction in association with manager selection is key for the strategy to reach its goals.
As part of a holistic hedge fund program, we believe that Event-driven serves as a powerful tool that will help reach risk/reward targets so long as a long-term approach is utilized in order to take advantage of opportunities which may appear through periods of crisis and dislocation.
At Klarphos, we have developed the processes, the skills, and the resources to enable LPs to efficiently allocate to hedge funds and, in particular, Event-driven Alternative Investment funds. As a specialist Alternative Investment Manager, we can incorporate such exposures into client Strategic Asset Allocations through a robust portfolio construction process and into different functional structures such as a fund of fund, a separately managed account (SMA), or an advisory relationship.
This document is informative purposes only. It does not constitute research, investment advice nor solicitation to invest in any investment product or service that Klarphos offers or may offer in the future in any jurisdiction. The information contained herein is based on projections, estimates and/or other financial data and has been prepared internally by Klarphos. Opinions expressed therein are current opinions as of the date of this document only and are subject to change at any time without notice.
No representations are made as to the accuracy of the observations, assumptions and projections. No subscriptions to any Klarphos products are possible based solely on this document. Any investment decisions should be made in accordance with the legal documentation of a fund such as its offering memorandum.
Klarphos is not entitled to provide any tax or legal advice.
Past performance is not indicative of future returns. There can be no assurance that the strategy objectives will be realized or that the strategy will not experience losses. Target returns are hypothetical and are neither guarantees nor predictions of future performance. There can be no assurance that the target returns will be achieved.
Klarphos is an Asset Manager specialized in customized portfolio solutions and advisory services for institutional clients based in Luxembourg. Klarphos concentrates its asset management on Alternative Investments and also provides advisory services for strategic asset allocation and ALM optimization. The asset manager employs an international team of specialists and is regulated by the Luxembourg financial regulator CSSF as an Alternative Investment Fund Manager (AIFM).