20/04/2011 Author: Tony Griffiths

Event horizon

An increase in M&A activity has seen event-driven funds leading the performance tables this year, and investors are beginning to take notice. HFMWeek looks at what is driving this activity, both in developed markets and throughout Asia.

Buoyed by a thriving M&A space, event-driven hedge funds have enjoyed a relative resurgence of late. Six-month performance – up 8.7% according to Hedge Fund Research’s (HFR) Event Driven (Total) Index – is among the best in the industry and opportunity remains rife, with rarely a day going by without news on a deal or word of fresh wrangling between corporate boards and a galvanised activist sector.    
    
“Mergers and acquisitions continue to increase,” said Ray Tierney, Bloomberg Tradebook’s president and CEO, announcing the results of a survey of institutional investors this week. “We have seen a jump of more than 115% in M&A trading in just the first quarter of this year.” M&A activity will remain strong in 2011 because of an abundance of attractive targets and valuation, Tierney added.

Indeed, many US corporations are now flush with cash following the sclerosis of the immediate post-crisis period. Previously crippled by uncertainty, and in some cases bankruptcy, firms are now putting money back to work. Hedge funds know this only too well – M&A activity in the sector’s admin space remains one of the industry’s strongest trends.     

Opportunities for corporate change meanwhile have had activist hedge funds back on the front foot. Elliot Advisors, a subsidiary of $17bn US hedge fund Elliot Management, made headlines this week with its efforts to drive through board-level change at Actelion Pharmaceuticals, in which Elliot is the largest shareholder, and National Express, the UK transport company. The activist actions of Laxley Partners and Sherborne Investors have also caused ripples in recent months.

The Lazard Rathmore Fund, a convertible-centric  event-driven strategy managed by Lazard Asset Management, has produced an annualised return of over 20% since its inception in 2007. “When we launched the strategy, there was an event we were able to take advantage of about once or twice a month,” says portfolio manager Sean Reynolds. “Today they’re happening at a rate of two to three a week. Even if you go back six months, it was only one to two a week.”

With the capital markets now more open, relative value events pertaining to debt, equity, IPOs, high yield and bank loans have become more frequent. For the Rathmore team – focused on special situations, particularly relative value – the most interesting trades in the markets are in the small-to-mid cap, and occasionally micro-cap, space, “typically, because the issuers of this paper are the most flexible in how they think about their capital structures”. Reynolds points to the US pharmaceuticals industry – where consolidation, even at the highest level, has been ongoing for about five years – as an obvious example.

“In 2009, just being long was the trade, while in 2010 the opportunity was provided by a mean reversion to normality. In 2011, special situations and events are still driving alpha opportunities in a market where there’s a lot of uncertainty around how to make money,” says Reynolds.

Rathmore’s performance may be particularly strong, but it is by no means the only event-driven fund to outperform the industry average. Over the last 12 months, HFR’s Event Driven (Total) Index is up 10.76%, more than a percentage point on the HFR composite index (9.42%).

Such performance has been noted. Swiss fund of hedge funds (FoHF) Reyl Asset Management, the fund management arm of Reyl & Cie, which oversees assets of over $4bn, boosted exposure to event-driven funds in one of its FoHF vehicles to 30% at the turn of the year, up from a minimal amount.  

“We’ve increased exposure to M&A in the US specifically,”says Fabrizio Ladi Bucciolini, the firm’s head of alternative investment. “In absolute terms, there might have been better periods for event-driven, but you’re currently more likely to make returns with a certain degree of certainty in the space than just taking directional bets.”  

The firm’s penchant for event-driven is long-standing however. “It always fits into our thinking,” Bucciolini continues. “You can create a stream of returns which is relatively uncorrelated to market direction, the reason being that certain events, whether legal, regulatory, related to M&A or bankruptcy, might produce advantageous situations independent of what’s happening in the market.”

Head of the event-driven research group at Stamford-based MKM Partners, Keith Moore, agrees that M&A deals are on the increase, but believes the big change has come at multi-strategy funds. In a number of cases, event-driven operations have recently been restarted, having been shut or kept running with minimal staff when M&A activity last declined.

“Funds are moving capital to different strategies including event-driven, depending on the opportunities,” he says. “Net-net this hasn’t changed and probably won’t going forward. The economics of the business, however, are more challenging than in the past.  Given the level of interest rates and the appetite for risk, deal spreads are at historical lows.”

Typically cash-intensive, M&A activity has received much attention in recent weeks, but for Bucciolini, the less-liquid event driven opportunities are of particular interest. “Some of these event driven trades might not be cash flowing at all. There are opportunities out there that are complex to analyse, procedure-intensive and the exit strategy is not necessarily a liquid one or might require long holding periods, and people are still shying away from that.”

Savvy investors have also cottoned on to the opportunities in event-driven. Select Asset Management, which manages A$650m ($683m) on behalf of Australian investors, made a 3% allocation to York Capital Management’s Asia-focused event-driven fund in February.  

“Asia offers compelling opportunities for growth and corporate activity and inefficiencies, whereas a lot of the
developed markets when announcing M&A deals the spreads and the opportunity set in those areas can be limited,” Robert Graham-Smith, Select’s head of portfolio management told HFMWeek. “That was our decision to make it a more Asia-centric allocation, but it doesn’t rule out developed markets as well. The opportunity set in that space does wax and wane.”
A maturing market, Asia is proving a particular draw for event-driven enthusiasts – investors and managers alike. Recent reports suggest fresh inflows have taken Hong Kong-based Matchpoint Asia, the event-driven fund launched in October 2009 by former Och-Ziff partner Raaj Shah, passed the $200m mark. Nick Taylor’s Senrigan Capital Group, which debuted the month after Matchpoint, eclipses the achievement however, recently reaching $1bn.  

Asia-focused launches are on the rise too. There has been “a boost of activity in terms of new managers starting up and getting involved” in the Asia event-driven space, says Paul Smith, founder of Hong Kong-based consultancy Triple A Partners. Nicholas Wells, CEO of Carrington Fox, a recruitment firm that specialises in hedge fund portfolio managers, agrees. “Individuals with a background in event-driven trading, risk/M&A arbitrage and other catalyst strategies are increasingly in demand as systematic strategies become more saturated,” he notes.

Although the Asia-Pacific market is still relatively undeveloped when compared to the US, Wells believes there are certain regions where event-driven strategies can prove successful. “As a developed economy, Australia is a clear focus for event-driven funds in addition to Japan where the market can also facilitate this type of strategy,” he says. “Many event-driven funds are now looking towards China as the next big market for M&A. However the market there is still underdeveloped and significant investment is still required.”

“The main secular trend is that Asia is just growing up,” says Smith. “The markets are becoming more complex and companies are beginning to transition from being predominately family-owned to more publicly owned. There are more IPOs and there’s more divestiture of conglomerates in terms of being broken up into their component parts.

According to Smith, the opportunity set in Asia is right across the map. “Whether you’re looking at Japan, Korea, Hong Kong/China, I think these are general trends that one can see occurring and aren’t going to go away as Asia matures as a financial centre and wealth transitions from first-generational wealth to second.”

Current players in Asian event-driven tend to be larger managers with domestic experience; Select-funded York Capital and Och Ziff being two of the obvious examples. This is not a coincidence, says Reyl’s Bucciolini. “Many of these strategies have to rely very much on an understanding of legal procedures and jurisdictional factors, such as there being some kind of predictability linked to the re-organisation process,” he explains. “The more the jurisdiction is complex or difficult to understand, the harder it becomes to participate in it.”

Reyl’s focus on Europe and the US is because these are the markets on which the firm’s hedge fund expertise has been built. “If you go off to countries where the language is a problem, Asia or Russia for example, there might be great opportunities but it’s really difficult to find and execute them, because you need local presence and expertise,” Bucciolini adds. “This is why there are so few players out there.”

Smith agrees that local know-how is important for managers, but says that, because the definition of event-driven in Asia is “a lot more fluid” than it is in the US, foreign investors need to be wary too. “If you’re in America, an event would usually be defined as some sort of takeover or M&A activity,” he explains. “In Asia, it could be a demerger, stub trade, dividends, share buybacks, companies being taken private that were public. Often it may have something to do with an IPO.”

All of which are covered in the US of course. The salient point, Smith says, is that, because there are more M&A deals stateside, a US-focused event-driven fund is more likely to wear its speciality on its sleeve. “It’s a lot harder for an investor in an Asia fund to get comfortable because, potentially, you’re getting into things that you might not have thought fell into the event-driven category.”

Asia’s growth as a financial powerhouse is still in its nascence and, as such, event-driven opportunities are likely to be ongoing. Openings for event-driven hedge funds in general, especially in the US, aren’t set to dry up any time soon either, predicts MKM’s Moore. “As long as economic expansion is the most likely direction and interest rates don’t go up much, there is a huge pent-up demand for acquisitions.”

 For those that know where to look, the event-driven opportunity set is strong on both sides of the Pacific. Whether in the more-illiquid US deals the majority tend to shun, or the Asian opportunities few can access, hedge funds and their investors are making the most of fruitful economic conditions.

THE DRIVERS OF EVENT-DRIVEN
Lazard Rathmore portfolio manager Sean Reynolds explains the upsurge in opportunity for event driven funds, using the high yield market as an example of the journey.

“Interesting market opportunities started to develop when the credit markets began to freeze up in late 2007, and recently we’ve seen an acceleration of the sort of events that create value: in relation to refinancing and rolling over debt, including exchanges, flush outs, or sweeteners. Basically, companies continue to remain concerned about their ability to tap the financial markets optimally.”

“In early 2009, when the high-yield market re-opened to many issuers for the first time in 18 months, companies were eager to issue debt at any price. It was the same mentality a consumer might have when maxing out on a credit card: ‘I don’t care about the price, I just want the cash’.

“But nine months later into the early part of 2010, companies started to refinance even debt they’d issued in 2009 at more efficient and more optimal structures.  These are the sorts of events, driven largely by decisions in the board room, from which we can benefit.

“The trades that give you the best alpha opportunities are typically uncorrelated to the broader market given that they are idiosyncratic outlying events relating to one company’s specific capital structure.  So you have this opportunity to take advantage of an alpha event that can create value almost as a free option to the prevailing value in the rest of the market  and that, in our mind, is the sweet spot of the marketplace.”