What is Event-Driven Investing?

Not all investment strategies depend on how the broader market is performing. Event-driven investing aims to isolate specific corporate events and express a view on their occurrence. Trades that occur before or after a corporate event is announced or completed can take advantage of price inefficiencies. The event may be merger and acquisition activity, a takeover, bankruptcy, a spin-off or other types of events.

In this article, Benzinga explores how event-driven investing works, the pros and cons and key investment strategies.

How Does Event-Driven Investing Work?

Event-driven investing takes a view on the completion of an event. After an event has been announced, a company’s share price may fluctuate according to how likely the event will actually occur. For example, if Company A plans to buy Company B at $6 per share, and Company B was trading at $2 per share before the announcement, the news alone may lift Company B stock. 

However, between the announcement and the actual completion of the deal lies a long road of due diligence and deal execution. Sometimes deals need regulatory approvals that take time to come through. As a result, Company B stock typically will trade less than the $6 per share purchase price before the deal closes. 

For example, an event-driven hedge fund may run numbers, speak to industry sources and analyze the probability that the deal goes through. As a simplistic way of expressing the view that the trade will complete, a fund may buy Company B stock and sell Company A stock simultaneously. The trade strategy is market-neutral, meaning that it doesn’t matter whether the overall market goes up or down. The goal is to profit from the trade if the event occurs.

Unlike traditional investing strategies focusing on the broader market, event-driven investment capitalizes on independent occurrences. The event is the driver for stock price changes. 

The main objective of an event-driven investor is to find mismatches between the intrinsic and market values of a share caused by an upcoming event. For instance, in a merger, the stock price of the target company usually rises, whereas that of the acquiring company drops. The investor buys shares at a lower price and sells them when prices stabilize later.

Key Types of Events

The following types of events may create opportunities for investors.

• Merger and acquisition events: In a merger or acquisition, one company absorbs another or both combine to form a new entity. As a result, the stock prices of both companies may move in opposite directions, at least in the short run.
• Bankruptcy and restructuring events: In the months leading up to a bankruptcy filing, the stock prices of distressed companies tend to decline significantly. Investors with good knowledge of debt and equity investing can capitalize on this decline, hoping for a potential turnaround from merger announcements or takeover bids.
• Litigation events: In a company, a litigation event is typically a lawsuit or regulatory investigation that may result in a financial penalty if found guilty. Event-driven investors follow legal cases closely and take positions in the affected company's options and stocks accordingly. For instance, a favorable legal outcome can lead to an increase in stock prices, while a negative one could result in stock prices dipping.
• Regulatory events: A regulatory event is a change in rules or regulations that can significantly impact a company's operations and overall value. Event-driven investment is reliant on companies whose business model is heavily regulated by the government, as changes can create profit opportunities.
• Special events: If a company is involved in a spin-off or a divestiture, its stock price may decline. Event-driven investors may determine a value for the assets spun off and use this opportunity to trade the parent company and the spinoff stocks.

Benefits of Event-Driven Investing

An event-driven investing strategy has the following benefits: 

• High return potential: If you make the right call at the right time, an event-driven investment can result in a significant return. For instance, if you purchase stock at a low price during a litigation event and the company is later vindicated, you can make a substantial profit when the stock price rebounds. 
• Lower market correlation: Event-driven investments are not as tied to broader market movements, making them potentially attractive in any type of market. Even if the overall market is volatile or down, event-driven investments can still perform well. 
• Profits in bearish and bullish markets: Since broader market events don't affect event-driven investments as much, investors can make profits in both bullish and bearish markets. 
• Short-term potential: Although timelines vary, an event-driven strategy may not always have longer-term horizons that tie up your capital.  

Risks and Challenges

Making a bet on an event can go either for or against you. Here are some of the potential risks and challenges associated with event-driven investing. 

• Inherently risky investments: The nature of event-driven investing makes it inherently risky. There is no guarantee that the anticipated event will occur or have the desired impact on the stock price. 
• Difficult to predict impact and timing: First, it's hard to predict the timing of an event. Even if the event occurs, it's challenging to predict how it will affect the stock price. 
• High transaction costs: Since frequent trading is required in an event-driven strategy, the transaction costs can add up quickly. It can eat into your potential profits.

Key Strategies in Event-Driven Investing

Here are some common strategies to use in event-driven investing.

Merger Arbitrage

In merger arbitrage, you may invest in a company in the middle of an acquisition, merger or some sort of restructuring. Investors mainly focus on the target company. A common trade is to buy the target company's stock at a discounted price and then sell it for a higher price once the deal is completed while shorting the acquirer’s stock initially and buying it back later. 

Distressed Investing

A company is in distress when it is selling at a deep discount and potentially close to bankruptcy. As the company gets closer to being insolvent, the stock price tends to decrease significantly. Investors buy stocks at a lower price in anticipation that the company can recover as a result of a financial turnaround or restructuring. 

Upon recovery, the stock price may increase, allowing the investor to make a profit. Distressed investing can apply to many types of assets ranging from stocks to physical assets. 

Special Situations Investing

A 'special situation' arises when a company experiences significant changes, such as management restructuring, spin-offs, legal settlements, divestitures or stock buybacks. Since the company faces a major business development, pricing and valuations may fluctuate depending on the situation. 

Each event must be carefully analyzed for investment opportunities that may be specific to the situation – hence the name special situations.

Convertible Arbitrage

Hedge funds often use convertible arbitrage to exploit the pricing differences between convertible securities and their underlying stocks. Convertible securities are financial instruments that can be converted into a predetermined number of shares of the underlying stock. 

In this strategy, investors buy convertible securities and simultaneously short the underlying stock. They profit when the price of the convertible security increases and when the price of the underlying stock decreases. The strategy aims to be market-neutral to make money irrespective of the market trend. 

Activist Investing

Activist investing involves an investor buying a significant number of shares in a company to try to influence the management's decisions to increase shareholder value. Typically activists may try to influence this by changing or influencing policies to change board seats or buybacks. 

Unlock the Potential of Event-Driven Investment Strategies 

In event-driven investing, the way a stock price moves doesn't primarily depend on the broader market conditions. Instead, it's driven by specific events and situations affecting the company. 

Investors who understand the intricacies of event-driven strategies can potentially unlock significant gains from their investments. However, note that these strategies carry higher risks from the unpredictability of events. 

Frequently Asked Questions