Hedge Funds: Event-Driven Strategies

The classification of hedge funds is important so that investors can select strategies to create a portfolio of funds, evaluate aggregate performance data, and develop appropriate performance benchmarks. Since hedge funds are driven by the skill of their managers, they are generally categorized by the strategies that their managers use. According to Hedge Fund Research, Inc. (HFRI), there are four basic categories for hedge funds: event driven, relative value, macro, and equity hedge. __Event-driven strategies__ are utilized when investors and companies are seeking to profit from major events occurring within a specific time in an organization. Event-driven strategies themselves can be broken down into four subsets that apply to specific events and occurrences.

__Merger arbitrage__ is the first of the four strategies, and its name defines exactly what it entails. It is the buying and selling of securities specifically at the point when a company has decided to or made an announcement of a merger. The main idea here is that the acquisition price is a little too high and so there's a "deal spread" to take advantage of by buying the target and shorting the acquirer. What do you think is the main risk investors should be aware of when using this strategy?

__Distressed/restructuring__ is another strategy that focuses on companies who may go bankrupt, but often results in restructuring. For example, Company B, the office-supply chain being bought, can be purchased well below its present value, and buyers might hope to profit when the company gets back on its feet.

The final two strategies include activist and special situations. As with the other strategies, they mean exactly what their names imply. The __activist__ hedge fund seeks to purchase enough of a stake to gain control or relative power of a company. The goal is to ultimately get into a position where it can pull strings in terms of leadership and policy. __Special situations__ are essentially everything else outside of mergers and bankruptcy. So, for example, if the chains merger of the two office-supply companies, A and B, fell through, an activist could seek to purchase large amounts of stock from the failing company in the hopes of gaining control, but also hoping for an upturn. This could also be considered a special situation.

You become aware that the merger has fallen through and that Company A is continuing on relatively well. Company B is struggling to stay above water and will likely file bankruptcy soon. In considering that you already have an investment stake in both companies, you desire minimal risk and want to be an active participant in whichever company you invest in. Which company should you purchase securities in based on the information provided?

Incorrect. While company B is likely going to be restructuring to avoid bankruptcy, there is no guarantee it will be able to avoid it. If it does avoid bankruptcy, you will have purchased the shares at a discount, but since you are trying to avoid further risk, this may be too volatile.

Correct! You would likely want to consider the activist strategy and buy enough equity to align yourself in a position to make changes that incorporate your best interests and strategies.

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Incorrect. The value of stock sold can increase if the situation of the merged companies changes, but this is not classified as a risk since there is technically no loss on the investment.

Incorrect. The company being acquired may initially lose value, but stock will be purchased at the discounted price, with the hope of the merger improving the financial situation. There is a potential for short-term loss, but this is not the primary risk.

Incorrect. There are advantages of purchasing stock in both companies, but this still could potentially mean a loss on one end.

Correct. This is the greatest risk involved in the transaction since the shares bought and sold were contingent upon a merger occurring.

That the merger never happens

That the value of stock sold increases

That the value of stock purchased decreases

Buy more securities in company B

Buy more securities in company A

Buy shares in both companies

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