A major corporate event like a merger, bankruptcy or spin-off can sometimes cause temporary mispricing of a company’s stock. Event-driven investing tries to capitalize on that lapse while the rest of the market digests the news.
It’s a strategy that requires a lot of research and precise execution, which is why it’s largely favored by hedge funds or private equity firms that have the resources to handle it.
In this article, we’ll explore how event-driven investing works, its pros and cons, and some key investment strategies.
How Does Event-Driven Investing Work?
Event-driven investing involves making the most of price inefficiencies caused by a recent or upcoming corporate event that drives stock price fluctuations. Examples of events could include a takeover, merger and acquisition, spin-off, bankruptcy or liquidation, among others.
Event-driven investors will sometimes spot a mismatch between the intrinsic value and the market value of a stock caused by that event. If they think the shares will go higher, they may buy them at the lower price and then sell them once prices stabilize.
A good example of event-driven investing occurred during Microsoft’s acquisition of Activision Blizzard that closed in 2023. After the deal was announced in 2022, Activision’s stock dropped on antitrust doubts, but many investors who believed the deal would close bought shares and made a profit.
Benefits of Event-Driven Investing
- High return potential: Event-driven investing has the potential to generate solid returns if the right call is made at the right time.
- Lower market correlation: Because event-driven investments are not related to broader market movements, they can work in any market situation, even during periods of market volatility. This allows investors to make profits in both bearish and bullish markets.
- Short-term potential: Timelines may vary, but an event-driven strategy may not always have longer-term horizons that tie up capital.
Risks and Challenges
- Inherently risky investments: The nature of event-driven investing makes it inherently risky since it is hard to predict the timing of an event and even if it occurs, the anticipated event may not have the anticipated impact on the stock price.
- High transaction costs: Since frequent trading is required in an event-driven strategy, the transaction costs can add up and eat into your profits.
Key Strategies in Event-Driven Investing
Here are some common strategies that are used in event-driven investing.
Merger Arbitrage
A merger or acquisition is when a company absorbs another to form a new entity. As a result of the merger, the stock prices of both companies can fluctuate, at least in the short term. In a merger arbitrage, investors focus on the target company and buy its stock at a discounted price. They then sell it for a higher price after the deal is complete while shorting the acquirer’s stock initially and buying it back later.
Distressed Investing
Distressed companies are walking the path of liquidation or bankruptcy, and in the period leading up to a bankruptcy filing, their stock prices tend to dip. Investors who have knowledge of debt and equity investing can make the most of this decline, hoping for a turnaround in case of a merger or takeover announcement. Upon recovery, the stock price may increase and allow investors to make a profit.
Special Events Investing
If a company is going through divestiture, management restructuring, stock buybacks or a spin-off, its stock price could fluctuate. Investors can use this opportunity to buy the parent company and spinoff stocks. However, each situation should be carefully analyzed before investing.
Convertible Arbitrage
Convertible securities are financial instruments that can be converted into a predetermined number of shares of the underlying stock. Investors buy convertible securities and simultaneously short the underlying stock. They profit when the price of the convertible security increases and the underlying stock price decreases. The strategy is market-neutral, trying to make money irrespective of the market trend.
Activist Investing
Activist investing involves buying a significant number of shares in a company to try to influence the management’s decisions to increase shareholder value. It is commonly used by hedge funds or institutional investors to push for changes in operations, management or business strategy.
Unlock the Potential of Event-Driven Investment Strategies
Investors who understand the intricacies of event-driven strategies can exploit pricing inefficiencies before or after the event. However, note that these strategies carry higher risks from the unpredictability of events and there is no guarantee of a profit.
Frequently Asked Questions
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While event-driven investing can be lucrative, it’s not recommended for novices. The strategy is complex and carries a lot of risk.
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Events include bankruptcy, liquidation, spin-off, mergers and acquisitions, regulatory changes, share buybacks, earnings announcements, restructuring and litigation events.
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The stock market will respond to an event by adjusting the stock price based on the anticipated outcome of the event, creating volatility and trading opportunities.
