A playground for event–driven managers
Event-driven hedge fund strategies have an obvious source of appeal: there is always something happening in corporation world. At the top of the confidence cycle, cash is abundant, CEOs go shopping and merger arbitrageurs thrive; when it all crashes, distressed debt managers pick over the cut-price securities that will leave them holding equity in newly-restructured companies; and as the recovery picks up, capital structure arbitrageurs help companies tidy up battered balance sheets. That may be why event-driven has hovered at 25% of total hedge fund assets for years, while sub-strategy allocation has ebbed and flowed through the cycles.
Until now. Anecdotally, funds of fund allocations have risen fast recently - in some cases doubling to 30-40%. “We have the highest exposure we have ever had in event-driven,” says Michele Gesualdi, a portfolio manager at Kairos Partners - and he is not alone.
There is a feeling that the sheer size of 2008 shock and consequent monetary loosening may have delayed the distressed cycle and led to huge pent-up M&A potential - and that both could roll out over the next few years.
The case for M&A looks open-and-shut. S&P500 companies currently hold $1.2trn of cash; private equity is re-emerging, desperate to put money to work; and company management is putting shareholders before bondholders again - which means acquisitions, higher dividends and share buybacks. When commercial printer R R Donnelly (market-cap $4bn) announced a $1bn buyback recently, Moody’s downgraded it while equity markets cheered.
But that’s hardly the environment for distressed. Clearly, some big 2008-09 bankruptcies like Lehman, Nortel or Tribune Co were complex enough that work is still being done on them, and some structured credit work-outs persist - but new opportunities are scarce. Some managers are positioning for what could be an emerging cycle in Europe, particularly around the beaten-up long-books of banks that face the constraints of Basel III, but even that seems a way off. The long period of low rates and the opening of high-yield markets have meant that the anticipated wave of distressed opportunities simply hasn’t materialised.
“Several managers raised large funds in 2009,” says Anne-Gaelle Pouille, a portfolio manager at PAAMCO. “Some have returned the money, others have invested in, for example, M&A. There just isn’t enough distressed right now.”
David Brail, senior analyst at event-driven fund Para Advisors, agrees: “New filings tend to be small companies with significant operational problems, like Blockbuster or Great Atlantic & Pacific. We haven’t seen value.”
But he also points to a population of 2006-07 LBOs that can service their interest, flirt with insolvency but avoid bankruptcy, but will eventually have to restructure. Indeed, the credit side of event-driven isn’t always about outright distress - often, it is capital structure arbitrage or long/short credit around refinancings. “It’s clear from what managers are doing that this special situations opportunity-set is increasing,” notes Sean Molony, senior investment specialist at IAM.
An example is Innophos, which carried about $246m of debt at the beginning of 2010. It paid down $100m over the course of the year and then refinanced, reducing its interest burden from about $22m to $6m. In the meantime, its share price doubled. Rob Feingold, lead portfolio manager for Babson Capital’s event-driven Somerset Special Opportunities strategy, began holding the bonds in 2008 when they traded at stressed levels, before rotating into the equity.
Many cite so-called ‘post re-organisation equity’ as a favoured sub-strategy of distressed. If you can’t beat the equity guys, join them: an equity still carrying the taint of bankruptcy tends to trade at a discount until the market recognises how well the company has been restructured. Because of the big market rally and the lack of alternatives, managers have been holding these stocks for longer during this cycle and are now beginning to overlap with merger-focused trades. Brail held Smurfit-Stone Container through its mid-2010 bankruptcy, for example, and recently saw it bought by RockTenn. “We wouldn’t be surprised to see more of our portfolio merge-out in the next year. Creditors can have a large presence on the boards of newly-restructured companies and they are often anxious to see their value realised in the M&A market.”
But making money in this way (where the spread expresses an informational advantage) is not the same as making money from classic merger arbitrage (where it expresses only the risk of a broken deal). Ironically, all that cash and confidence sloshing around is great for M&A, but not so great for merger arb.
“The probability of deals getting done is very good just now as companies have a clear rationale for bidding, and it’s all pretty plain-vanilla because there is so much cash around,” says Scott Macdonald, co-founder of Carduus Capital, which will launch an event-driven fund of funds later this year. That has pushed average spreads down to 5-6% - not bad when interest rates are stuck around 1%, but not enough to pay the bills. “Pure merger arb funds’ returns are really quite dull at the moment,” says Derek Stewart, Carduus’s other co-founder. “But that’s why we’d rarely invest with managers who can only do pre-announced transactions.”
Again, that’s a consensus. Double-digit spreads are available to those prepared to take some risk on ‘softer’ events like spin-offs, share buybacks and dividend hikes; pre-deal announcement trades; complex crossborder or hostile acquisitions; or deals with anti-trust risk. It also helps if some competitive bidding boosts those premiums - and the recent battle between Avis and Hertz for Dollar Thrifty, or Danaher fighting off private equity consortia for Beckmann Coulter, might be signs of things to come.
“In sectors like tech, healthcare or resources we could see competitive bidding if an acquisition target has strategic assets, patents or technologies,” says Bert Rigter, portfolio manager on LGT Capital Partners’ Corporate Activity fund, citing last year’s Dell and HP tussle for the essential cloud-based storage technology at 3Par.
For Amit Shabi, these tight spreads on consensual merger arb are here to stay. Shabi is a partner at merger strategy specialist Bernheim Dreyfus, which splits its portfolio into classic merger arb and pre-event trades - and at the moment it is allocated 35% to pre-event “and growing”. “As the M&A cycle matures, spreads tighten for merger arb and managers need more leverage,” he says. “We might expect to see the top of the M&A cycle in a couple of years, at which point we would be 100% in pre-event.”
In that formulation, this merger arb phase is over almost before it has begun. Shabi’s seems to be a minority view, however. Most put current tight spreads down to the fact that so far deals have been relatively small (so spreads get arbitraged away by modest inflows of capital). “We have yet to see the mega-cap deals that would take a lot of capital to tighten the spreads,” as Tim Beck, senior research analyst on relative value and event-driven strategies at Stenham Advisors, puts it. The $39bn sale of T-Mobile USA by Deutsche Telekom to AT&T could turn out to be the starting gun for that trend.
Which raises that intriguing prospect of a divergence between large-cap merger opportunities and small and mid-cap distressed as we move through the monetary tightening cycle. The credit-quality of high-yield issuers has been deteriorating over recent weeks as investors have been chasing yield and, particularly in Europe, a long tail of weaker companies have only extended their loan financing out by a few years. “Given that floating rate loans make up a significant portion of European high yield capital structures, companies are exposed to rising rates as well,” says Jeff Majit, head of event-driven & relative value strategy research at Neuberger Berman.
An environment of industry consolidation and competitive bidding combined with a new supply of distressed securities would be a playground for event-driven funds. The fact that event-driven has already been outperforming many other strategies could be a good sign - and might explain why investors appear to be positioning themselves ahead of the game.