When you think about it, most hedge fund strategies can be described in terms of going long on a specific security while simultaneously shorting another (outright or against the long). Long/short and market neutral managers go long on stocks they think will rise relative to their short picks. Similarly, global macro managers are generally interested in long appreciating markets with higher interest rates and short depressed markets with relatively low cost of borrowing. Meanwhile, convert arbitrage managers generally go long for converts and short the underlying equity. Emerging market funds are generally on the sidelines or are net-long emerging market equities. In other words, the basic construction of these strategies is pretty much constant.
A few other strategies cannot be so easily described. Chief among them is probably event investing. An “event” can be good, i.e. a merger or spin-off, or bad, a debt default. So the best approach to event investing really depends on the prevailing economic conditions. And as we are all now painfully aware, these economic conditions are constantly changing. But although economic conditions seem to be changing faster than ever these days, they still follow a natural business cycle. And this may determine the best way to undertake an event investing strategy at any given point in time.
In other words, look for a manager who can wear multiple hats or look for a fund of fund that allocates among experts at each stage of the economic cycle.
This is the basic thesis of a white paper by the alternative investment manager firm Investcorp, entitled “Alpha Opportunitiesin Event Investing.” The firm argues that the most appropriate way to undertake an event-driven investing strategy is to tailor it to one of four stages in the economic cycle:
Stage 1 – Economic Slowdown: A period of rising spreads and rising defaults when “being senior in the capital structure offers the best risk/reward when forced selling creates opportunities for distressed debt investors.”
Stage 2 – Corporate Restructuring: A period of operational improvements and cost-cutting when investors should move lower in the capital structure in order to capture the largest proportion of equity in a firm as it emerges from bankruptcy protection.
Stage 3 – Recovery: A period when a renewed focus on growth means under-followed companies emerging from bankruptcy protection can “trade at substantial valuation discounts versus peers.”
Stage 4 – Expansion: A period when companies put excess cash to work through acquisitions, dividends and one-time distributions.
Although this may sound a little like motherhood or apple pie, the firm backs up these ideas with hard data. We’ve overlaid each of the charts below with shading to denote the various phases of the economic cycle above using Investcorp’s dates.
The chart below shows debt recovery rates. (Click to enlarge)
As you can see, recovery rates for secured and unsecured debt rise in the “Recovery” stage (in green) and fall during the “Restructuring” stage.
Below is a chart from the report (again, with our added shading) that shows the reciprocal – the default rate. (Click to enlarge)
Both the default rate and spreads rise in Stage 1 – Economic Slowdown and in Stage 2 – Corporate Restructuring only to fall dramatically during Stage 3 – Recovery. While the first year of recovery offers the best returns for distressed funds, Investcorp’s data shows that in the past two cycles, out-sized returns continued several years into the ensuing recover and expansion.
Finally, the firm takes a look at M&A activity for clues to how to undertake event investing going forward. (Click to enlarge)
Naturally, merger arb opportunities are in ample supply during expansions and then fall off the radar screen during Stage 2 – Corporate Restructuring.
So what does this mean for investors? In a display of transparency rare for the hedge fund industry, Investcorp reveals their own historical allocation to event investing strategies Check out the chart below, shading added by us:
So the firm seems to be taking its own medicine: a healthy dose of distressed debt during restructuring and recoveries, merger arb and activism during expansions. They also seem to have laid on some opportunistic shorting during the slowdown.
It’s clear from reading this white paper that event investing isn’t just one strategy. Rather, it’s a group of strategies that require a dynamic allocation of capital in order to harvest opportunities without paying a price. If you stick around too long in any of these strategies, you run a higher risk of losing your shirt. While that may be true for all hedge fund strategies, it seems especially important when entirely different asset classes are required at each phase of the economic cycle. As an Investcorp manager of a fund of funds argues in the paper:
“…most event managers typically do not have the skill set to invest in all four stages of the event investing cycle. Therefore, an investor needs to dynamically allocate capital to the best-suited managers for specific event investing cycle stages…”