Some event-driven managers utilize a core strategy while others opportunistically make investments across the range when different types of events occur. Dedicated merger arbitrage and distressed securities managers should be seen as stand-alone options, whereas event driven is a multistrategy approach. Instruments include long and short common and preferred stocks, as well as debt securities, warrants, stubs, and options. Managers may also utilize derivatives such as index put options or put option spreads to leverage returns and hedge out interest-rate and/or market risk. The success or failure of this type of strategy usually depends on whether the manager accurately predicts the outcome and timing of the transactional event. Event-driven managers do not rely on market direction for results; however, major market declines, which would cause transactions to be repriced or to break apart, and risk premiums to be reevaluated, may have a negative impact on the strategy.

Proponents of event-driven investment strategies argue that by focusing on corporate events rather than market direction, these strategies will produce more consistent returns through various market environments than traditional approaches that depend on general trends in market price levels. Because corporate events are cyclical in nature, the prevailing corporate event activity fluctuates over time. For example, there are more mergers during periods of economic expansion and more bankruptcies during economic downturns. Event-driven strategists use specialized knowledge of all the significant events in the corporate life cycle and the flexibility to invest in the outcomes of a variety of corporate events to extract investment profits from the mispricings caused by uncertainty about the outcomes of these events.

Event-driven specialists look for three elements in any investment situation. First, they seek a disparity between the current market value of an instrument and the value that they anticipate for it after the event is completed. Second, they look for a near-term event to act as a CATALYST that will change the market’s perception of the company and therefore its valuation of the company’s debt or equity instruments, and they assess how likely it is to become visible. Third, they estimate the amount of time that it will take the catalyst to become fully visible to investors and how long the market will take to correct the valuation disparity.

SIGNIFICANT CORPORATE EVENTS create profit opportunities because the outcome of the proposed changes is uncertain. Investment managers must ask: Will the event be completed? What will the result be if it does occur? How long will the process take? What effect will the event have on the prices of the securities of the involved companies? After a corporate event is announced, the price of the securities of the involved company reflects the market’s uncertainty about whether the event will be completed. Event-driven specialists will make profits by correctly anticipating the outcome of these events.

For event-driven specialists, the investment process is triggered by the public announcement of an impending corporate event. The manager must be convinced that a significant corporate event will take place during a definable period of time. Rather than try to anticipate corporate events, a process that is extremely speculative, event-driven specialists analyze the possible outcomes of events once they are announced. Once a proposed event is announced, the market revalues the securities of the companies involved on the basis of how it perceives the proposed event and the possible outcomes. Event-driven specialists research situations by using industry contacts, the advice of legal and banking experts, information from the financial newswires and magazines, and previous experiences and expertise. They understand the complex legal, interpersonal, and strategic forces that may affect the event and the probabilities of different potential outcomes. If a careful evaluation of the event indicates favorable risk-reward criteria, the position is taken. Successful event-driven specialists can synthesize FUNDAMENTAL VALUE ANALYSIS, EVENT ANALYSIS, and TIME HORIZON ANALYSIS.

Given the new strategic initiatives, Hudson Highland was to be spun off from TMP Worldwide. For every 13 1/3shares of TMP Worldwide owned, holders would get 1 share of Hudson Highland. Hudson Highland was in the midst of a cyclical downturn, which translated into operating losses for this business. In addition, the company had been saddled with an excessive cost structure for employees and facilities that were built in the frenzy of the Internet peak as Monster inundated Hudson Highland with high fixed expenses at a time of seemingly endless growth. There was ample opportunity for costs to be rationalized as well as the likelihood that business conditions would improve as the economy improved. Therein lay the opportunity for the event-driven manager.

Often in spin-offs there is a technical trading element that can work to the event-driven manager’s benefit. When the parent is a large-cap stock included in many indexes, often, as in this case, the spun-off entity would not be a constituent of such indexes, therefore, holders of the parent who seek to match the performance of an underlying index won’t or can’t hold on to the spun-off entity. As a result, they become forced sellers, regardless of price. And this dynamic is ideal for an event-driven manager in that it creates a structural mispricing. Hudson Highland was a relatively small company that was completely ignored by Wall Street research analysts and at a cyclical low, thereby making it the perfect spin-off for an event-driven manager.

The stock began trading at about $10 per share at the time of the spin and worked its way to the high teens after a short time; as of this writing it is trading in the high 20s.¹

FIGURE 9.2 shows the total strategy assets and net asset flows per year from 1990 to 2004 for event-driven strategies. The year-end asset total equals the previous year’s asset size plus annual performance plus net asset flows. Since the end of 1999, approximately $70 billion in net inflows has helped increase the strategy’s total assets under management to over $128 billion as of the end of 2004. Event-driven funds now manage over 13 percent of all industry assets, representing the second-highest total strategy assets in the industry (behind equity hedge).

FIGURE 9.3 shows the return distribution for event-driven strategies compared to the overall hedge fund industry, stocks, and bonds. Since 1990, almost half of the strategy’s monthly performance falls in the 0 to 2 percent return range, while more than 26 percent of the monthly performance returns have registered between 2 and 4 percent, the second-highest percentage in that range of any hedge fund strategy.

FIGURE 9.4 shows the average upside and downside capture since 1990 for event-driven funds. The strategy’s performance during down months is better than those of the overall hedge fund industry and the stock market. Although the strategy reflects negative performance during down months, its loss of 0.24 percent during such a period is better by nearly half than the total hedge fund industry, which loses 0.45 percent under the same circumstance.

Catalyst. A near-term event, such as a press release or a new product launch, that will heighten investor interest in or change the market’s perception of a company.

Event analysis. The process by which an analyst assesses the probabilities of all the possible outcomes of a corporate event.

Fundamental value analysis. The process by which an analyst establishes a theoretical value of a company from an examination of its financial statements, operational history and forecasts, business climate, and the like.

Significant corporate events. Major public events, such as mergers, bankruptcies, and spin-offs, that have the potential to dramatically change a company’s makeup and as a result the valuation of its debt and equity instruments.

Spread. The valuation disparity between two related financial instruments caused by uncertainty about the outcome of a corporate event.

Time horizon analysis. The examination of the time frame for completion of a corporate event (if the event is going to happen, then when will it occur?).