18.1.1 Insurance-Selling View of Event Strategy Returns

Consider the case of a proposed merger that, if completed, will result in a $100-per-share payment to the shareholders of the target firm in exchange for their shares. In this scenario, the shares of the target firm jumped from $70 per share to $90 per share when the proposed merger was announced. Although the news of the proposed merger is public knowledge, it will be several months before it will be known whether necessary approvals can be obtained. Thus, there is a period of event risk during which share prices will be expected to react to news on whether the proposed merger will be consummated. It is common for existing shareholders of a target firm to sell shares soon after the share prices jump as a result of the proposed merger announcement. It is also common for event-driven hedge funds to purchase shares during the period between the proposed merger announcement and the resolution of uncertainty regarding the event.

After the merger announcement, existing shareholders of the target firm need to decide whether to continue to hold their shares, in hopes that the merger will be approved and share prices will rise from $90 to $100 per share, or to sell their shares at $90, avoiding the risk that the merger will fail and that the share price will fall back to perhaps $70 or lower. Some shareholders wish to avoid the event risk and choose to sell their shares to hedge funds at a discount to this $100 offer, such as the $90 price described in the example. Presumably, they reinvest their sales proceeds in firms that are not subject to substantial event risk and, in so doing, reduce the total event risk of their portfolio. These shareholders are often viewed as having purchased insurance against the failure of the firms to complete the anticipated merger.

Event-driven hedge funds may be viewed as seeking to earn risk premiums for selling insurance against failed deals. Selling insurance in this context refers to the economic process of earning relatively small returns for providing protection against risks, not the literal process of offering traditional insurance policies. Further, a merger arbitrage hedge fund's portfolio typically consists of several potential mergers, and therefore its exposure to each deal might be relatively small, similar to an insurance company with relatively small exposure to each contract or set of contracts. Finally, a merger arbitrage manager is typically able to use derivative securities to manage its exposure to large deals, a relatively complicated alternative that other investors may not be able to employ because of legal restrictions on the use of derivative securities.

18.1.2 Binary Option View of Event Strategy Returns

Continuing with this example, the hedge fund purchases the shares at $90 and holds the shares until either the merger succeeds, in which case the fund receives $100 per share, or the merger fails, in which case the fund receives perhaps $70 per share. In this simplistic example, a long position in the merger target may be viewed as a long position in a riskless bond with a $70 face value and a long position in a binary call option that pays $30 if the deal is consummated and $0 if the deal fails. A long binary call option makes one payout when the referenced price exceeds the strike price at expiration and a lower payout or no payout in all other cases. A long binary call option would be priced at $20 in this example if it were assumed for simplicity that riskless interest rates were 0%. A long binary put option makes one payout when the referenced price is lower than the strike price at expiration and a lower payout or no payout in all other cases. A long binary put option pays higher cash when the referenced price falls and would be priced at $10 in this example, assuming a 0% riskless rate. Thus, using put options rather than call options, the hedge fund's long position in the merger target may be viewed as a long position in a riskless bond with a $100 face value and a short position in a binary put option that pays $30 if the deal fails. Note that whether the fund's position is described with long calls or short puts, the initial cost of $90 and the final payout of either $100 or $70 are the same.

The binary put option view of the hedge fund's position illustrates that the hedge fund has, among other things, written a put option on the event such that the hedge fund will bear a loss if the merger does not occur. In this view, event-driven hedge funds are writing put options and will tend to have payouts consistent with writing out-of-the-money options, meaning modest upside potential with large downside potential. In many cases, this asymmetric payout is an accurate description of the event risks that a hedge fund takes. It should be noted that in the previous merger examples, the downside risk of owning the target firm's stock was that the target firm's stock price could fall to a prespecified price. However, in practice, the downside risk could be substantial, and a long position in the target firm's stock could include losses due to a general market decline in addition to a failed deal.

Not all positions of hedge funds in event-driven strategies offer the potential for large losses and small profits. Thus, not all positions can be well approximated as being short an out-of-the-money put option. For example, event-driven hedge funds may play either side of an event such as a merger: the side that benefits if the event is consummated or the side that loses. The fund tries to use superior information or analysis to ascertain whether market prices overestimate, underestimate, or properly reflect the outcomes of various events. This may be possible because these are unique and rare events, and long-only investors may not typically have the skills and the data to make accurate predictions about the eventual outcome. The hedge fund seeks to earn higher returns from formulating better predictions of the event outcomes than are reflected in market prices.

The binary call option view of the hedge fund's position illustrates that the hedge fund has, among other things, purchased a call option on the event such that the hedge fund will gain if the merger is consummated and lose if the event deal does not occur. This view of the transaction as a long position in a call option illustrates the expected risk premium that the hedge fund's position should earn. A long position in a call option on equity is a very bullish bet. In competitive markets, long positions in equities tend to have positive beta risk and should generally earn expected risk premiums. Long positions in call options in equities tend to have higher betas than their underlying stocks and in theory should offer even higher expected risk premiums. Thus, using this long binary call option view, it may be argued that typical event-driven strategies contain substantial systematic risk and that higher returns for this strategy may reflect bearing systematic risk, or beta, rather than alpha.

By their nature, events are primarily firm specific and cause idiosyncratic risks. However, some events, such as mergers, have probabilities of consummation that are positively correlated with the performance of the overall market. In bull markets and good economic times, mergers and other deals are more likely to be proposed and consummated. Thus, some of the event risk may be systematic. Event-driven fund managers may take both long and short positions in equity or debt securities. However, they will find it difficult to fully hedge against both the event risk and the overall movement in the market and thus achieve complete market neutrality. The result is a tendency to bear systematic risks in addition to the obvious idiosyncratic risks of the events. Therefore, event-driven funds typically profit during normal and healthy market conditions, when deals are consummated on a timely basis. However, substantial losses can result during times of market crisis and failed deals, when market participants back away from deals and, typically, sell off securities that exhibit illiquidity and high risk. The following sections examine each of the major subcategories of the event strategy more closely, starting with activist investing.

18.2.1 Background on Corporate Governance

The equity investors in a firm literally establish the corporation and legally own the corporation. But in major corporations, it is impractical for several thousand or million individual shareholders to manage the company on a day-to-day basis. Corporations are therefore set up with a corporate governance process, wherein shareholders elect a board of directors. The board of directors selects and contracts with the executive management team, and delegates the management of the company to the executive managers, who are compensated for running the day-to-day business. The top executive managers usually serve as directors of the corporation but with insufficient seats to form a majority.

The firm's executive management team typically provides information to the board regarding the firm's operations, and initiates proposals. Although the procedures and levels of consensus vary widely, it is common for the board's decisions to be agreeable with the management team. In other words, the management team and the board of directors tend to work cooperatively. To the extent that the management team is in substantial and irresolvable conflict with the majority of the directors, the management team will be replaced.

The board periodically conducts voting by shareholders for election of new board members and with regard to major proposals. Typically, proposals clearly identify those actions recommended by the board of directors. Shareholders approve the vast majority of board recommendations.

Although shareholders vote for the board of directors, and the board selects managers charged with serving the interests of the shareholders, there are typically substantial conflicts between the interests of shareholders and managers. The divergence between the preferences of shareholders and managers is the foundation for most shareholder activism. Shareholder activism refers to efforts by one or more shareholders to influence the decisions of a firm in a direction contrary to the initial recommendations of the firm's senior management. These efforts can include casting votes, introducing shareholder resolutions, and taking legal action. The divergence between the preferences of shareholders and those of managers is a critical issue in understanding shareholder activism and is discussed in detail in a subsequent section.

The terminology used to discuss activist investing overlaps with terminology used elsewhere in investments and is not used entirely uniformly in discussing shareholder activism. This book defines an activist investment strategy as any investment strategy with the objective of generating superior rates of return through shareholder activism.

One of the most important events of shareholder activism is a shareholder vote. Shareholder votes occur at regular annual meetings and at special shareholder meetings. Shareholders attend meetings to cast their votes, cast direct votes prior to meetings using ballots provided to them by the firm, or complete proxies that allow others to vote on their behalf—either with regard to a specific issue or in general. The outcome of these votes typically depends on the results of a proxy battle. A proxy battle is a fight between the firm's current management and one or more shareholder activists to obtain proxies (i.e., favorable votes) from shareholders. These proxies permit them to vote the shares of the other shareholders in support of their activism. The board of directors can also solicit proxies from shareholders for their support. The proxies help determine the winner of the shareholder vote.

Shareholders can be inundated with multiple copies of the proxy from each side, since each shareholder's ultimate vote is governed by the latest dated or most recently submitted proxy, if any, that the shareholder completed. Proxy battles can be very expensive. Shareholder activists pay for their direct costs of these proxy battles in the hope of financial gains from success. The firm's current board of directors generally uses the corporation's financial resources to wage the battle, which, of course, ultimately belong to the shareholders. Thus, shareholder activists not only pay for their side of the battle but also pay their pro rata share of the other side.

18.2.2 Five Dimensions of Shareholder Activists

The players in the arena of shareholder activism differ on several dimensions:

1. FINANCIAL VERSUS SOCIAL ACTIVISTS: Efforts by shareholder activists can have social objectives or financial objectives. Social objectives include attempts to steer a firm toward behavior deemed by some as more beneficial to society as a whole, such as reduced pollution, better treatment of employees, better treatment of animals, or refusal to manufacture goods such as weapons, alcohol, and tobacco. Financial objectives may vary in some regards, but the underlying motivation is increased shareholder wealth through increased share prices. For the purposes of this chapter, shareholder activist investment strategies refer entirely to shareholder activism driven by financial objectives.
2. ACTIVISTS VERSUS PACIFISTS: Activists oppose current management and seek major changes in a firm's leadership or decision-making. Pacifists oppose the proposed activism. Instead, pacifists support current management, the status quo, and any proposed changes outlined by the current management. Activists attempt to intervene in the corporate governance process, whereas pacifists oppose making any changes. Pacifists, however, are not necessarily dormant; they may be aggressive in their opposition to the activists.
3. INITIATORS VERSUS FOLLOWERS: Some shareholders initiate activism, whereas others actively follow the activists. Activists can be followed through stories in the media or through required regulatory filings, such as 13D forms. Initiators of activism search for suitable targets, develop activist plans, establish positions, and implement the plans. Importantly, initiators pay for the direct expenses of activism. Active followers support the plans of the initiators and establish positions in the firms being targeted by activists.
4. FRIENDLY VERSUS HOSTILE ACTIVISTS: Activism is executed with different degrees of confrontation with management. Hostile activists tend to threaten managers with adverse consequences, whereas friendly activists tend to work with managers to develop mutually beneficial outcomes. Whereas some activists prefer to engage corporate management behind closed doors, others conduct very public campaigns, with their demands distributed through the media. When conversations are public, other large shareholders—both hedge funds and pension funds—may get involved in the conversation or voting process.
5. ACTIVE ACTIVISTS VERSUS PASSIVE ACTIVISTS: This dimension refers to the motive for investing. Active activists establish positions for the purpose of activism. Passive activists participate in activism when they happen to hold positions in firms that become targets of activism. It is also possible but less likely for passive activists to be initiators rather than followers. A passive activist can be an initiator by first establishing a position for purposes other than activism but then deciding to initiate activism, perhaps due to frustration with current management.

The key players in successful financial activism are active initiators, active followers, and passive followers. The role of active initiators is obvious, since they serve as the catalysts for the actions and typically bear the potentially large direct costs involved. But active initiators rarely have sufficient voting power to implement change unless others join in. Activists need to be careful about hunting in packs, as securities laws may be violated if activists work together without the proper regulatory disclosures. In order to avoid the appearance of working in groups, Orol encourages activists to choose separate law firms and to avoid emailing one another.¹

Active followers may be viewed as free riders. A free rider is a person or entity that allows others to pay initial costs and then benefits from those expenditures. An example of a free rider is a citizen who stands by while a subgroup pays for an improvement, such as the beautification of a park, and then enjoys the enhancement. Shareholder activism can have large direct costs, including legal costs and the costs of proxy contests. Active followers search public records and other sources of information to identify firms that are most likely to be profitable targets of shareholder activism. For example, active followers can directly or indirectly learn of potential activism targets from observing that known shareholder activists are acquiring positions in particular firms. Regulators often require information on large holdings by market participants. Active followers have a symbiotic relationship with active initiators. Although they act as free riders to the active initiators who pay the direct costs of activism, active followers typically help the initiators by voting in support of the activism, which serves to increase the influence of the initiators without their having a larger investment in the target firm.

Most investors are passive in the context of this analysis; that is, these investors, like those in mutual funds, established positions in the equity of public companies for reasons other than anticipation of activism. Passive followers, or the lack thereof, often make or break shareholder activism. Passive followers are a subgroup of the passive investors who happen to be holding stock in a firm that becomes the target of activist initiators. These existing shareholders who retain their shares must ultimately decide whether they will support the activist proposals as passive followers or vote against the proposals as pacifists. They can become the object of intense battles between activist initiators and agents of the firm's management, receiving mailings, overnight correspondence, phone calls, and even personal contacts from both sides soliciting their support.

The key players in unsuccessful financial activism are pacifists. These shareholders do not establish equity positions in the target firm for the purposes of supporting or opposing activism. They are brought into the fray from holding previously established positions in firms that became the targets of activism. They opt to support current management due to confidence in the management or a belief that the activists would be harmful. In addition, some shareholder pacifism results from concerns that support for the activists might damage their business relationships with current management and other entities that oppose the activism. Shareholder votes are not secret ballots; thus, corporate management generally has direct knowledge of which shareholders vote to support their position and which shareholders oppose them.

18.2.3 Why Managers Are Not Viewed as Maximizing Shareholder Wealth

As their name implies, activist investors believe that value can be unlocked within a public company through active engagement with the executive management of the corporation or its board of directors. A common question is why the executive management of the company does not undertake the necessary changes to unlock the intrinsic value of the company without pressure from activists. The fundamental reason is the existence of conflicts of interest between managers and shareholders. Simply put, managerial goals can differ from shareholder goals.

Agency theory studies the relationship between principals and agents. A principal-agent relationship is any relationship in which one person or group, the principal(s), hires another person or group, the agent(s), to perform decision-making tasks. The principals enter this relationship with the objective of having their utility maximized, while the agents seek to maximize their own utility. Preferences and goals generally differ among all people and all groups of people. Therefore, conflicts of interest typically exist within all organizations and among all groups within those organizations.

Shareholders are the principals, and the executive management team members are their agents. It is generally reasonable to assume that as principals, the shareholders wish to have the managers pursue shareholder wealth maximization (share price adjusted for dividends), whereas the managers wish to pursue their goals, including salary maximization, bonus maximization, prestige, career opportunities, job security, job satisfaction, and perhaps improved leisure time and other aspects of their lives. To the extent that shareholder wealth maximization is inconsistent with the goals and preferences of managers, there will be conflicts of interest.

Agency theory focuses on optimal contracting in the presence of conflicts of interest—specifically on the process of designing managerial compensation schemes that maximize shareholder wealth. An agent compensation scheme is all agreements and procedures specifying payments to an agent for services, or any other treatment of an agent with regard to employment. A perfect compensation scheme would be costless to implement and would maximize shareholder wealth by resolving all conflicts of interest between shareholders and managers at minimal cost.

In practice, however, perfect compensation schemes do not exist, resulting in agency costs. In a nutshell, agency costs are any costs, explicit (e.g., monitoring and auditing costs) or implicit (e.g., excessive corporate perks), resulting from inherent conflicts of interest between shareholders as principals and managers as agents. These agency costs have two sources: (1) the costs of aligning the interests of shareholders and managers when those interests can be cost-effectively aligned, and (2) the costs to the shareholders of unresolved conflicts of interest between shareholders and managers. Regarding the latter source, not all conflicts of interest can be cost-effectively resolved; therefore, in an optimal compensation scheme, agents will generally not always act in the best interests of the principals. Simply put, in some cases, it is cheaper for shareholders to accept managerial actions that conflict with their best interests than to try to bring managers' interests into perfect alignment with their own interests.

The misalignment between shareholders' and managers' interests stemming from unresolved conflicts of interest often results in potentially major and inefficient consequences, including the following:

• Managers being overly risk averse in their decision-making for fear of being associated with large failures and possibly losing job security
• Managers receiving excessive compensation from running the corporation for their own personal entitlement at disproportionately large costs to shareholders
• Managers making decisions (with disproportionately large costs to shareholders) based on the comfort they obtain from protecting their jobs and existing pay packages
• Managers imposing risk preferences in corporate decision-making based on their disproportionate participation in the upside of the company's fortunes and their limited downside exposure
• Managerial preferences to avoid hard work or reject optimal change, such as updating the business plan or model of the company, which disproportionately harm shareholder wealth
• Managerial preferences to avoid sharp conflicts, such as challenging unions, demoting employees, firing employees, or closing divisions

In each case, there is nothing suboptimal about a manager receiving generous compensation or avoiding a personally undesirable outcome as long as there is not a net unnecessary cost to shareholders. To illustrate, it may be economically efficient for a firm to offer free parking to a manager in exchange for reduced taxable salary if there is a net benefit to that combination that increases shareholder wealth. Further, it may serve the best interests of shareholders to offer first-class airfare, or even corporate jet travel, to managers if such actions ultimately create value and a net benefit to shareholders, perhaps through employee satisfaction and resulting improved performance. The examples were designed to emphasize conflicts of interest that tend to be inefficient when managers receive benefits or engage in behavior that has high costs without offsetting benefits to shareholders. Shareholders are not averse to paying generous financial and other benefits to managers who are thereby incentivized to offer services that provide net benefits to shareholders. Rather, shareholders are concerned with compensation to managers or behavior by managers with costs deemed excessive or disproportionate relative to the benefits these managers generate.

In large public corporations, the practical ability of shareholders to understand, monitor, and correct conflicts of interest with managers may be very limited. As a result, conflicts of interest may emerge and grow that are inefficient and, in aggregate, may become highly costly to shareholders. As a result of these conflicts based on managerial preferences dominating shareholder interests, a public company's stock price may trade substantially below its intrinsic value. Therein lies the source of untapped value that shareholder activist strategies pursue.

18.2.4 Corporate Governance Battles

Rather than waiting for untapped value, or alpha, to be exploited through external events, activists attempt to accelerate the realization of the alpha by seeking to expedite change to the operations of a corporation. The intense engagement required to be an active initiator means that activists must typically hold very concentrated portfolios of 5 to 15 equity positions in publicly traded corporations. These positions are long, are large, and usually represent 1% to 10% of the outstanding stock of the company. There is a considerable amount of systematic and idiosyncratic risk embedded in the resulting portfolios. Although the fee structures and liquidity risks clearly categorize activist fund managers as hedge fund managers, some investors may view investments in activist funds to be sufficiently similar to traditional long-only equity investments that they include the activist fund holdings in the computation of their allocation to equity.

Activist hedge fund positions in target firms can be kept secret as long as the activist owns less than 5% of the target firm. In the United States, Form 13D is required to be filed with the Securities and Exchange Commission (SEC) within 10 days, publicizing an activist's stake in a firm once the activist owns more than 5% of the firm and has a strategic plan for the firm. Many activists will acquire a 4.9% stake in the firm, just below the threshold for filing a Form 13D, to keep their holdings secret and to allow time for conversations with the firm to progress. A toehold is a stake in a potential merger target that is accumulated by a potential acquirer prior to the news of the merger attempt becoming widely known.

In addition to Form 13D, several other forms that can provide investors with additional information regarding potential mergers may be required. In the United States, Form 13G is required of passive shareholders who buy a 5% stake in a firm, but this filing may be delayed until 45 days after year-end. Form 13F is a required quarterly filing of all long positions by all U.S. asset managers with over $100 million in assets under management, including hedge funds and mutual funds, among other investors. These forms must list all long positions; however, disclosure of short positions is not required.

Many investors regularly track these filings, some taking positions in the holdings of famous or profitable activists and other hedge fund managers. Brav, Jiang, Partnoy, and Thomas show that companies listed as holdings of activists on Form 13D have a one-month excess return of 7% during the month of the 13D disclosure while earning returns similar to the market in the following year.² This return is not consistent across activist objectives, as activist goals of mergers earn 10% returns and exploring strategic alternatives earns 5.9% returns, whereas corporate governance issues have no statistically significant excess returns.

Well-respected activists may have a strong following or wolf pack of other hedge funds (active followers). A wolf pack is a group of investors who may take similar positions to benefit from an activists' engagement with corporate management. This wolf pack investment team can magnify the activists' influence, as the combined positions of similarly minded investors serve to make the target firm's management more responsive to the activists' agenda.

Activists typically publicize a single issue that is believed to add substantial value to the shares of the target firm. Activist agendas have targeted a wide variety of corporate governance issues, including executive compensation, composition of the board of directors, potential mergers or divestitures, and capital structure issues such as cash positions that are too large and debt loads or dividends that are too low.

Activist investors usually demand a meeting with the target company's board of directors or senior management to discuss and publicize the desired change in corporate governance. In addition, activist investors may attempt to work with management to implement their preferred business plan. This manner of investing is friendly and is also called corporate engagement, as activist investors pursue a direct dialogue with management and the board of directors. Alternatively, or subsequently, activist investors may resort to hostile actions, such as attempts to remove senior management who are perceived as unresponsive or ineffective.

Although activists have been accused of thinking only about short-term stock price movements, the management of the target firm may be more inclined to agree to the activists' agenda when it is perceived to be likely to lead to longer-term creation of value for the corporation. Activists can have quite lengthy holding periods, frequently owning a stock for one to three years before the value has been unlocked.

The success of investors such as CalPERS and Hermes has encouraged other investors to engage corporation management to reap the rewards of better corporate governance. Using a large hand-collected data set from 2001 to 2006, Brav, Jiang, Partnoy, and Thomas find that hedge fund activists succeed in at least part of their agenda at two-thirds of the target firms.³ Target firms in the United States experience increases in operating performance, payout, and CEO turnover after activism from hedge funds.

It can be more difficult for activist investors to earn a large number of board seats when the terms of the board members are staggered. Staggered board seats exist when instead of having all members of a board elected at a single point in time, portions of the board are elected at regular intervals. For example, if one-third of the board seats are elected each year, it would take at least two years to elect a majority of the board. Corporations are more vulnerable when the entire board is up for election in a single year, as activists can more quickly take control of the board.

18.2.5 Activist Agenda 1: CEOs, Compensation, and Boards of Directors

Good corporate governance efficiently resolves those conflicts of interest that are worth resolving. Interlocking boards occur when board members from multiple firms—especially managers—simultaneously serve on each other's boards and may lead to a reduced responsiveness to the interests of shareholders. Interlocking boards and exorbitant CEO compensation are typical conflicts of interest that merit resolution and are near the top of the activist agenda. Conflicts of interest and resulting agency costs can become particularly inefficient when a CEO effectively controls the board of directors in one of two forms. First, the CEO might also be the chairman of the board of directors. In such a position, the CEO-chairman controls both the company's operations and the board of directors, with limited checks and balances. Second, the board of directors can become too comfortable or friendly with the CEO. This can lead to excessive pay packages for the CEO.

An unfortunate example of the latter situation is UnitedHealth Group of Minnesota. For years, UnitedHealth Group's board of directors lavished compensation on William McGuire, the company's CEO and founder. However, more egregiously, the board granted McGuire stock options that were backdated to a point in time when the stock price of the company was lower. The result was that McGuire received a stock option payout in 2006 of $1.6 billion, the largest payout for a U.S. corporate CEO at that time. Outrage by activist investors led to a class action lawsuit filed by CalPERS in 2006, which was joined by several other state pension funds. The class action lawsuit was filed against UnitedHealth, 20 executives, and the board of directors, and was quickly followed by an SEC enforcement against McGuire. The result was a settlement reached by the company to return to share owners approximately $900 million from backdated stock option grants. Of this amount, $300 million came from current executives of UnitedHealth, who agreed to forfeit amounts previously paid. McGuire personally agreed to return more than $600 million of his backdated stock option gains. In addition, the SEC fined McGuire $7 million and barred him from being a director of a public company for 10 years. McGuire also lost his job at UnitedHealth.

Although it can be appropriate for CEOs to earn large salaries and bonuses, activists believe that total compensation should be incentive based and appropriate relative to the value generated by the management team. For very large corporations, the direct cost of generous compensation schemes is often minor when viewed as a percentage of the firm's equity or income. The concerns with high compensation in very large firms are often more a matter of other issues and can include information signaling and agency costs. Information signaling is the intentional or unintentional conveying of information through actions.

What sort of information signals can large compensation packages to top managers send to the firm's other employees, lenders, and customers? Does a huge managerial compensation package encourage the firm's stakeholders to negotiate more aggressively with the firm or to be less cooperative?

Large non-incentive-based compensation schemes can exacerbate agency conflicts and costs. Managers who are generously paid without serving shareholder interests may focus their energies on serving the stakeholders and the corporate cultures that sustain their pay. The costs to shareholders of ineffective management, from their perspective, may greatly exceed the direct costs of compensation.

18.2.6 Activist Agenda 2: Capital Structure and Dividend Policy Issues

Another popular agenda among activists is to request a change in the capital structure or dividend policy of the firm. As a profitable firm accumulates cash, managers have an incentive to reinvest the cash inside the firm so that the firm grows in size and profitability, and presumably the compensation and prestige of the manager will similarly grow. Investors want the firm to exploit those opportunities for which the firm has a comparative advantage through managerial expertise or other capabilities. However, due to unresolved conflicts of interest, managers may have an incentive to invest in opportunities even if they do not exploit the firm's advantages and do not maximize shareholder wealth. Perhaps some investments diversify the firm's assets and thereby provide job security. Improperly incentivized managers may intentionally or inadvertently advocate reinvestment of earnings into projects that are not in the best interests of the shareholders.

Shareholders may believe that it is better to use the cash to pay dividends or execute stock buybacks as share repurchases rather than to reinvest the cash in new businesses through retained earnings. Both dividends and stock buybacks return cash to shareholders. In theory, both can generate equivalent outcomes, since they both reduce the firm's cash and the total market value of the firm's equity. In practice, tax laws often favor share repurchases because personal income taxes on capital gains are usually lower than taxes on dividends. Activists frequently call for increases in dividends or stock buybacks, believing that the cash can be better deployed in the hands of the shareholders.

Consider the case of Microsoft, which came under attack after amassing cash of more than $56 billion while not paying shareholder dividends. Shareholders were benefiting from the software business, a business that is extremely profitable but usually not capital intensive. Shareholders feared that Microsoft's management would use the cash to expand into unrelated capital-intensive businesses, such as video game consoles and cable television boxes. Microsoft initiated its dividend in 2003, shortly after U.S. tax laws changed to reduce the tax on dividend income. In 2005, Microsoft paid a one-time dividend of $32 billion, announced a stock buyback of $30 billion, and doubled the amount of the quarterly dividend. Would retention of the cash have allowed Microsoft to exploit valuable new opportunities, or did the distribution of the cash allow shareholders to deploy the capital more effectively? To the extent that large unresolved conflicts of interest and resulting agency costs exist between shareholders and managers, shareholders have an incentive to serve as activists and intervene to assure the efficient deployment of excess cash.

Activists may also criticize firms for not having enough debt on the balance sheet. In some cases, it is argued that the after-tax cost of debt capital can be below that of the risk-adjusted cost of equity capital, due, for instance, to the tax deductibility of interest expense from corporate taxable income. However, higher leverage increases the risk of the firm's equity and generally increases the probability of the firm experiencing financial distress or bankruptcy. The reason is that, unlike equity financing, debt financing obligates the firm to make mandatory principal and interest payments, which may push the firm into bankruptcy.

Interestingly, once debt has been issued, a firm that is struggling may find that risk taking that causes higher probabilities of financial distress can increase shareholder wealth. As detailed in Part 5, equity in a corporation can behave like a call option on the firm's assets. Option theory demonstrates that increased volatility in an option's underlying assets increases the value of a call option. Therefore, shareholders may benefit from high levels of risk taking. Simply put, shareholders can receive full upside benefits from gains while enjoying limited downside exposure to losses because of their ability to declare bankruptcy and leave further losses to be borne by debt holders.

Managers are very likely to have different preferences than shareholders with regard to risk taking, meaning there is a conflict of interest. Managers would typically be expected to prefer lower probabilities of corporate financial distress so that their compensation packages and careers are protected. The result can be that managers underutilize debt, leaving wealth-increasing opportunities unexploited. Corporate leverage can also provide benefits to shareholders by disciplining a firm's management to deploy the capital wisely and oversee the firm more closely. The managers of a highly leveraged firm may become more disciplined in their investments and other decisions in order to protect their salaries and careers, since they are aware of the need to meet required debt payments. Conversely, managers of firms with limited leverage and with excess cash obtained through retained earnings may be less disciplined, may have greater conflicts of interest with shareholders, and may subject the firm to greater losses due to agency costs. Accordingly, companies that are underleveraged can be targets of shareholder activism or targets for acquisition as the market attempts to correct the inefficiency.

18.2.7 Activist Agenda 3: Mergers or Divestitures

Some mergers and related corporate activity are not driven by shareholder activism but are often related to asset-driven motivations, such as operational efficiencies, conglomeration, integration, and reduction in competition. Merger activity driven by shareholder activism is better understood through viewing such corporate reorganizations as battles for control of assets and analyzing those battles with respect to the interests of managers and shareholders.

Activists are constantly searching to understand business models and the valuations of corporations and their subsidiaries. When an activist finds a portion of a large corporation that is not maximizing shareholder wealth, the activist encourages the corporation to sell or spin off the shares of the business. This situation is especially likely in a conglomerate, in which one firm manages a wide variety of businesses, or in a large firm that has faster-growing, smaller divisions.

A spin-off occurs when a publicly traded firm splits into two publicly traded firms, with shareholders in the original firm becoming shareholders in both firms. For example, a shareholder who owns 300 shares of Company A before a spin-off may own 300 shares of Company A and 100 shares of Company B after the spin-off if each three shares of Company A spun out one share of Company B. A split-off occurs when investors have a choice to own Company A or B, as they are required to exchange their shares in the parent firm if they would like to own shares in the newly created firm.

Consider the case of McDonald's (MCD), which owned a fast-growing business named Chipotle Mexican Grill. McDonald's was encouraged by activists to split the two firms in the belief that the value of the two businesses as independent firms would be higher than the value of the two combined. McDonald's split off Chipotle Mexican Grill (eventually trading as CMG) by performing an initial public offering (IPO) of a small portion of CMG shares and distributing the remaining shares to those MCD shareholders who chose to exchange their shares. The split-off appeared highly successful for investors in both firms, as MCD shares doubled and CMG shares increased by more than 300% in the first five years after the split-off, while the U.S. stock market was relatively unchanged.

The Chipotle investment was profitable for McDonald's, which purchased 90% of the young burrito chain for $360 million in a series of transactions beginning in 1998. In 2006, the IPO and split-off of CMG earned McDonald's $1.5 billion in proceeds. By 2014, it was clear why the split-off occurred, as McDonald's is a large, slow-growing firm with a market capitalization of $92.5 billion and a forward price-to-earnings ratio of 17. Chipotle had grown quickly to a market capitalization of $21 billion and a forward price-to-earnings ratio of 50. While the share price of McDonald's increased by 300% from 2006 to 2014, Chipotle dramatically outperformed by increasing by 1,200% over the same period. It is not clear if the value of the CMG business would have increased at such a high rate if it had continued to be housed within the larger MCD holding company.

Another popular activist agenda is to separate hard assets from intellectual property. One example is the trend to separate retail firms from their real estate holdings. In the United States, Pershing Square proposed to separate Target Stores into two companies, one to hold the retail operations and another to restructure the real estate holdings into a REIT (real estate investment trust).

Several explanations can be set forth as to why such corporate reorganizations could increase shareholder wealth. For example, an agency theory–based explanation would be that agency costs are reduced. In both cases, by separating the assets, each resulting management team could manage with better focus. Other explanations are based on capital market inefficiencies or imperfections. For example, some may argue that separation of the ownership of the two units allows different clien- teles of shareholders to invest in the business they prefer rather than being allowed to invest only in the combined businesses. Similarly, some may argue that earnings are priced inefficiently in financial markets, such that higher price-to-earnings ratios are applied to the separated earnings streams than to the combined earnings stream.

18.2.8 Historical Risk and Returns of Activist Funds

Exhibit 18.1 follows the format used throughout this book, with details provided in the appendix, to analyze the historical monthly returns of an index of activist funds, along with the general category of event-driven funds, over the period 2005 to 2014. Exhibit 18.1a indicates the high average return and moderately high volatility of the cross-sectionally averaged returns of activist funds. As is expected with event-driven funds, both the returns of the activist funds and the returns of all event-driven funds were negatively skewed and leptokurtic. Exhibit 18.1b depicts the superior growth and moderately high volatility over the observation period.

Exhibit 18.1c indicates consistently positive correlation of activist and event-driven fund returns to global equities, high-yield bonds, and commodities, with negative correlation to changes in credit spreads and equity volatility, substantiating the benefits of event-driven funds in strong markets and the exposures to volatile markets. Finally, Exhibit 18.1d demonstrates high correlation between the index of activist returns and the index of global equity returns.

18.3.1 Stock-for-Stock Mergers

The simplest form of merger arbitrage is a stock swap deal. Consider an acquiring firm that offers two shares of its stock, currently trading at $10, for each share of the target firm. The target firm's shares rise from $14 to $18 after the deal is announced. The traditional arbitrage for this deal would be to buy one share of the target firm for $18 and sell short two shares of the acquiring firm for proceeds of $20. The hedge ratio is determined by the merger offer. Note that if the merger is consummated, shares of the target held long can be exchanged for the exact number of shares necessary to cover the short position.

The fund receives $2 in net proceeds from the hedge and hopes to earn this $2 as a profit when the merger deal closes. Note that as long as the merger is consummated as proposed, the arbitrageur's final profit is completely protected from fluctuations in either of the share prices. Regardless of share prices, as long as the merger occurs as proposed, the arbitrageur can deliver each share in the target in exchange for two shares in the acquirer and deliver those two shares in satisfaction of the short position. Note that for simplicity, this example ignores the fact that the arbitrageur's ultimate profit or loss also depends on transaction costs, any intervening dividends, and financing proceeds or costs related to the positions. However, if the merger fails, the target share price would probably fall. The arbitrageur would lose $4 per share on the long position in the target if the target shares fell back to their previous value of $14 and would also be subject to changes in the value of the acquiring firm.

If the arbitrageur believes that current market prices imply that a merger consummation is unlikely, the arbitrageur may take the opposite position by purchasing the acquirer and shorting the target. In this side of the transaction, the arbitrageur would be negatively subjected to event risk and would not expect to earn any return as a premium for bearing event risk. Rather, the arbitrageur would be purely speculating on her ability to predict the probabilities of the outcomes of the event better than is reflected in the relative market prices. Other deal types are hedged differently. As illustrated near the start of this chapter, to participate in an all-cash deal, typically the arbitrageur simply buys the target stock. If the acquirer offers cash and stock for the target firm, the arbitrageur may hedge only the part of the deal consideration that is offered in stock.

Traditional merger arbitrage is a form of insurance underwriting. In the case of a stock-for-stock deal, if the merger goes through, the merger arbitrage hedge fund manager collects an insurance premium equal to the initial stock price spread between the target and the acquirer. If the merger fails, the merger arbitrage hedge fund manager has to pay out on the insurance policy and loses money on the failed merger.

Merger arbitrage is more deal driven than market driven. Merger arbitrage derives its return from the number of deals and the values and relative values of the companies involved in the events. Consequently, merger arbitrage returns should be driven more by the economics of the individual deals than by the levels of the general stock market. However, during periods of market downturns, merger activity dries up, and many announced mergers fall through. As a result, the merger arbitrage strategy shows some correlation with the overall stock market and tends to perform poorly during market declines.

18.3.2 Third-Party Bidders and Bidding War Risks

There is also a possibility that another company will enter into a bidding contest. A bidding contest or bidding war is when two or more firms compete to acquire the same target. A bidding contest dramatically changes the initial dynamics of the arbitrage. A traditional merger arbitrage position typically benefits from the onset of a bidding war due to its long position in the target and short position in the original bidder. The onset of a bidding war can create lucrative returns to traditional merger arbitrage transactions, but these deals can be among the riskiest situations.

Consider the bidding war that started in 2010 for control of the Dollar Thrifty Automotive Group (DTG). The market for rental cars at U.S. airports was concentrated, and whichever firm was able to control the target, DTG, would become the leader in the U.S. rental car market. In April 2010, Hertz (HTZ) made a $1.2 billion bid ($41-per-share bid in cash and stock) for the shares of DTG. DTG shares had traded below $1 in 2009 and had still traded below $25 in February 2010, but they had rallied to over $38 at the time of the bid. After shares of HTZ rallied on the day of the announcement, the combined value of the stock and cash offered in the deal rose to $42.15 per share. Yet the price of DTG shares closed at $43.07, a premium of 2.2% to the value of HTZ's bid. Apparently, the market had been anticipating that the first offer from Hertz would not be high enough to win the approval of DTG shareholders and some higher offer might be made.

At this point, arbitrageurs with traditional positions had a difficult choice, as they would lose money going forward on their long positions in DTG if the deal closed at the stated terms and existing prices. Although some of the arbitrageurs passed this deal by, others continued to hold their traditional positions in expectation of a sweetened bid at a later date. These arbitrageurs were richly rewarded in the coming months, as the anticipated bidding war materialized. The bids kept rising after Budget entered the fray with a $46.50 cash and stock deal announced at the end of July. Hertz raised its bid to $50 in September, and then Avis went to $53 per share just 10 days after the final Hertz bid. After several rounds of bidding, and even an abandonment of its bid for some period of time, Hertz completed the deal for $87.50 per share in cash in December 2012.

Because the U.S. rental car market is highly concentrated, the Federal Trade Commission performed an antitrust review designed to limit the decline in competition that can result from mergers and acquisitions. An antitrust review is a government analysis of whether a corporate merger or some other action is in violation of regulations through its potential to reduce competition. In order to complete the acquisition, Hertz was required to divest a portion of the business, selling Advantage Rent A Car and 26 locations of Dollar or Thrifty. These locations were specifically selected to limit the market share of Hertz, Thrifty, and Dollar locations at specific U.S. airports. Post-merger, the U.S. car rental business was highly concentrated, with the top three firms—Hertz/Dollar/Thrifty, Enterprise, and Avis/Budget—having an 82% market share. In some cases, antitrust authorities may deny some merger proposals if they find that market concentration is too great to have a competitive market, even after some divestitures.

Not all bidding contests turn out this well for arbitrageurs. Some deals with multiple bidders are never completed with any suitor, leaving the target stock to continue life as a stand-alone firm, often returning to the pre-deal price. Usually when merger arbitrage funds make money, they do so slowly, as the price of the target moves ever closer to that of the deal price over the 6- to 18-month life of the deal. Conversely, when a deal falls apart, the price of the target moves rapidly to lower prices, often losing as much as 30% in one day. Therefore, merger arbitrage funds tend to make money slowly and lose money quickly. This positive exposure to event risk can be seen in the negative skewness and excess kurtosis of the returns to merger arbitrage funds. The returns of these funds can be generated by risk premiums for bearing event risk or by superior returns from identifying mispriced stocks.

18.3.3 Risks of Merger Arbitrage

Merger arbitrage is subject to several sources of event risk. The primary risks affecting whether a deal will fail are regulatory risk and financing risk, which are detailed in the next two sections. There are also risks from defensive actions taken by the management of the target company, bidding war risks, and the simple risk that one or both companies will simply walk away from the deal. Merger arbitrageurs specialize in assessing these risks and maintaining a diversified portfolio across several industries to spread out the risks.

Merger arbitrageurs conduct substantial research on the companies involved in the merger. They review current and prior financial statements, SEC EDGAR filings, proxy statements, management structures, cost savings from redundant operations, strategic reasons for the merger, regulatory issues, press releases, and the competitive position of the combined company within the industry in which it competes. Merger arbitrageurs calculate the rate of return that is implicit in the current spread and compare it to the event risk associated with the deal. If the spread is sufficient to compensate for the expected event risk, they execute the traditional arbitrage. Less often, they may speculate that the deal will fail. Some merger arbitrage managers invest only in announced deals. However, other hedge fund managers will put on positions, especially in possible target firms, on the basis of rumor or speculation.

18.3.4 Regulatory Risk

Regulatory risk is the economic dispersion caused by uncertain outcomes of decisions made by regulators. Various U.S. and foreign regulatory agencies may not allow a proposed merger to take place for a variety of reasons, primarily that it could substantially reduce competition in the given market. There are three possible outcomes to an antitrust ruling: yes, no, and conditional. Governing bodies typically allow most proposed mergers, especially in fragmented industries in which market share is so widely spread that antitrust issues are not a concern. Conditional approval of mergers may require divestiture of some assets before the merger is completed, bringing more balance to the market share across firms. A key skill of merger arbitrage managers is the ability to determine the likely outcome of antitrust concerns before the governing bodies rule. In deals for which antitrust issues are a concern, the spread between the price of the target and the price of the acquiring firm may start out wide and then narrow substantially when and if the deal is cleared by regulators, as moving beyond this potential roadblock makes the deal more likely to close and the timing of such a deal more certain.

Regulators can also disallow deals for nationalistic or tax-related reasons. Cross-border mergers of commodity-producing firms or national-defense-related firms tend to be especially politically sensitive. In 2005, the China National Offshore Oil Corporation withdrew its bid for the U.S.-based oil company Unocal after the U.S. House of Representatives criticized the $18.5 billion merger on concerns of national security. The U.S. firm Chevron later acquired Unocal. In August 2010, the Australian firm BHP Billiton made a $130-per-share bid for the Canadian firm Potash Corporation of Saskatchewan. BHP Billiton, the world's largest mining firm, sought control of Potash, which controls between 25% and 50% of the world's potash supplies, a key ingredient in fertilizer. On the day of the bid, the stock price of Potash rose from $112 to over $143, showing the market's clear expectation that BHP would need to offer more than $130 per share to complete the merger. But in November 2010, the Canadian national government, at the urging of the Saskatchewan provincial government, rejected the proposed merger deal. Canadian law requires that foreign takeovers of Canadian firms offer continued benefits to the nation, a promise that BHP was either unable or unwilling to make.

18.3.5 Financing Risk

Financing risk is the economic dispersion caused by failure or potential failure of an entity, such as an acquiring firm, to secure the funding necessary to consummate a plan. Whenever a merger is announced, arbitrageurs need to analyze the probability that a deal will be completed on the proposed terms. For stock swap deals, investors focus on the regulatory issues and the fit between the two firms. Whenever there is a cash component to the merger offer, there also needs to be an evaluation of the financing risk, which is the ability of the acquiring firm to acquire the cash necessary to fund the purchase of the target firm. Financing risk should be seen as minimal when a large firm with a strong balance sheet acquires a smaller firm. But a firm with $4 billion in market capitalization and $1 billion in cash may find it challenging to fund a $3 billion cash merger if its balance sheet already shows $3 billion in debt. In this case, the arbitrage spread may be wide, showing that the market is not confident in the ability of the acquiring firm to fund the purchase of the target firm. The merger spread is likely to tighten substantially when the financing is arranged, perhaps through a bank loan, a bond issue, or asset sales.

A commonly cited example of financing risk is the proposed 1989 management and employee buyout of United Airlines. After the potential acquirers failed to secure financing for the $6.7 billion transaction, the deal collapsed, and the U.S. stock market declined nearly 7% in one day on fears that the time of easily financing mergers through the issuance of junk bonds was coming to an end. On that day, merger arbitrage managers experienced both deal risk and systematic risk, as the falling market and the difficulty of financing future deals simultaneously hit returns.

More recently, John Paulson of Paulson & Co. invested in a number of merger arbitrage transactions in his event-driven fund. Leveraged buyouts are particularly sensitive to financing risk and were a key source of merger activity between 2005 and 2007. Near the start of the recent financial crisis, Paulson correctly predicted that difficulties in obtaining financing for leveraged buyouts would be a driver of failed deals. Paulson sought to hedge this financing risk in the financing market. He concluded that the subprime mortgage market was particularly vulnerable to financing risk and selected that market to hedge the financial risk of the fund's merger arbitrage activity. Paulson bought credit default swap (CDS) protection (credit default swaps are discussed in Part 5). His conviction of the financing risk in the subprime mortgage market also led him to start two credit funds that generated legendary levels of profitability (300% and nearly 600%, respectively). Although questions were raised as to the conformity of the fund's strategy to its original goals, the hedging strategy illustrates financing risk as extending beyond being merely a deal-by-deal phenomenon.

18.3.6 Historical Risk and Returns of Merger Arbitrage Funds

Exhibit 18.2 follows the format used throughout this book, with details provided in the appendix, to analyze the historical monthly returns of an index of merger arbitrage funds, along with the general category of event-driven funds, over the period 2000 to 2014. Exhibit 18.2a indicates the moderately strong average and exceptionally low volatility of the cross-sectionally averaged returns of merger arbitrage funds that led to an excellent Sharpe ratio. As is expected with event-driven funds, the returns were negatively skewed and leptokurtic. Exhibit 18.2b depicts the steady returns of merger arbitrage funds with very low volatility over the observation period. Note from Exhibit 18.2a that the maximum drawdown was only –8.1%, consistent with Exhibit 18.2b's steady rise for merger arbitrage.

Exhibit 18.2c indicates consistently positive correlation of event-driven fund returns to global equities, U.S. high-yield bonds, and commodities, and negative correlations to changes in credit spreads and changes in equity volatility. However, the merger arbitrage funds do not appear correlated to global bonds. Finally, Exhibit 18.2d indicates rather positive correlation between the index of merger arbitrage returns and the index of global equity returns, although it should be noted that the horizontal axis covers a relatively narrow range, since the merger arbitrage index experienced a narrow range of returns.

18.4.1 The Bankruptcy Process

When the face value of the liabilities of a firm exceeds the market value of its assets, the bankruptcy process allocates the assets across various security holders and stakeholders of the firm. The bankruptcy process is the series of actions taken from the filing for bankruptcy through its resolution. Those who are paid after the most senior claims such as wages are paid are the holders of senior, secured, and collateralized debt. Once these senior claims have been satisfied, junior, subordinated, and convertible bondholders are next in line. In many cases, these junior debt holders do not receive a full recovery during the bankruptcy proceedings but may receive equity in the firm if it is reorganized. Last in line come preferred stock and equity holders in the firm, who often receive little or no value during the bankruptcy reorganization process.

In the United States, firms declaring bankruptcy may either liquidate or reorganize operations, but European firms typically face liquidation when they are deemed unable to meet their debt obligations. In a liquidation process (chapter 7 in U.S. bankruptcy laws), all of the assets of the firm are sold, and the cash proceeds are distributed to creditors. A firm is liquidated when it is viewed as not viable as an ongoing entity. Firms with liquidity problems but with reasonable chances of being viable are reorganized. In a reorganization process (chapter 11 in U.S. bankruptcy laws), the firm's activities are preserved. The goal of a reorganization process is to stabilize the operations and finances of the company in a way that allows the firm to continue operations after the bankruptcy process has been completed. To strengthen the firm, contracts such as labor union contracts, pension programs, and real estate leases can be substantially revised during the process. Debt holders may agree to lengthen maturities, reduce coupon rates, or accept equity in the reorganized firm as a way of reducing the emerging company's cash outflows and debt burdens. During the reorganization process, the equity in the pre-bankrupt firm is typically canceled and becomes worthless as shares in the newly reorganized firm are either offered to subordinated debt holders or sold to new investors.

Distressed securities investments can be inefficiently priced and require active management. Positions in investment-grade equities require almost no ongoing involvement other than periodic voting. However, management of positions in distressed securities may require frequent participation in the bankruptcy process to negotiate and litigate better outcomes. Most distressed securities investments are one-off transactions. A one-off transaction has one or more unique characteristics that cause the transaction to require specialized skill, knowledge, or effort. Investors in traditional equity positions may rely to some extent on the availability of public information and the high level of competition in financial markets to drive market prices toward reflecting available information, meaning that the prices are informationally efficient. As securities involving unique situations, rapidly changing situations, information asymmetries, and limited numbers of institutional owners, distressed securities are less likely to trade at informationally efficient prices. Information asymmetries occur when individual economic actors possess different knowledge.

Thus, investing in distressed securities requires specialized, skillful, and ongoing analysis and involvement. Therein lies the potential of the strategy both to generate alpha and to contribute risk to the investor. However, seeking alpha through distressed investing does not necessarily mean involvement in an asset type that is a zero-sum game, wherein each investor with a positive alpha must be balanced by an investor with a negative alpha. Most institutions either do not want to directly invest in distressed securities or are unable to invest in distressed securities. Many institutions, such as insurance companies and pension companies, are prevented through regulation from purchasing or even holding substantial quantities of non-investment-grade securities. Other institutions may divest speculative holdings prior to bankruptcy for the following reasons: (1) to avoid the increased monitoring needs; (2) to avoid ending up with inappropriate securities (e.g., bond funds that might receive equity in the reorganization process); or (3) to avoid revelation of embarrassing investment holdings in future portfolio disclosures, meaning to window-dress the public view of the portfolio. It is argued that the dumping of securities by institutions as they spiral downward in quality causes low price levels that permit generous alphas to those providing liquidity to the market by purchasing the unwanted securities. Overall positive average alphas to distressed securities investing may therefore be generated by institutional factors and offered to distressed investors as a reward for the provision of liquidity.

18.4.2 Short Sales of Equity as Writing Naked Call Options

There are many variations on how a hedge fund plays a distressed situation. The declaration of bankruptcy by a firm can vary from being made by viable firms seeking temporary protection from cash flow problems to highly distressed firms with virtually no chance of survival. When a firm known to be in financial trouble seeks bankruptcy protection and reorganization (chapter 11 in the United States), the stock price often rises in recognition of the firm's decision to use the technique to solve its financial problems. However, surprise bankruptcy filings and chapter 7 (liquidation) bankruptcy filings usually cause share price declines. Most of the following discussion focuses on firms for which bankruptcy is perceived to be likely to end in liquidation.

Prior to a bankruptcy, if an analyst views a situation as likely to deteriorate financially, the simplest trade is to sell short the stock of the distressed firm. This requires the hedge fund manager to borrow stock from its prime broker and sell the stock with the expectation that it will be able to purchase the stock back at a lower price in the future after the fundamentals of the firm have deteriorated. This is an unhedged speculation and nothing more than an attempt to sell high and buy low.

Short selling of a distressed company exposes the hedge fund manager to substantial risk if the company's fortunes suddenly improve. Perhaps the riskiest trade in the equity market is to be short the stock of a firm that is rumored to be descending into bankruptcy but recovers vigorously. Consider the stock of American Airlines, which traded below $2 in March 2003, shortly after both United Airlines and US Airways declared bankruptcy. Similarly, shares of Ford traded below $2 in November 2008 as General Motors approached bankruptcy. Unfortunately for short sellers, the shares of each firm traded above $11 one year later, when it became clear that neither American Airlines nor Ford would declare bankruptcy any- time soon.

As is detailed in Part 5 on structured products, shares in highly leveraged firms resemble call options. Short selling distressed equities is therefore analogous to writing naked call options on the firm's assets and generates a negatively skewed return distribution. An investor has a naked option position when the investor is short an option position for which the investor does not also have a hedged position, such as owning the underlying asset when short a call and being short the underlying asset when short a put. The negative skew is seen in the previous examples in the potential gain of $2 and potential loss of $9 or more in the shares of American Airlines and Ford. Conversely, an analyst who views share prices as reflecting overestimated probabilities of further deterioration in the firm's financial condition may establish long positions in the firm's equity and typically receive a positively skewed return distribution.

After most bankruptcy filings, the stocks are delisted. In some cases, there is almost no probability that the firm will distribute any cash to equity holders, and therefore the stocks are virtually worthless. Nevertheless, it is sometimes the case that the shares trade at values that reflect unrealistic probabilities of survival. So some investors are comfortable selling short shares in companies after bankruptcy is declared, even at prices of $0.50 per share or less. However, a caveat must be provided regarding the potential danger. Shares of USG Corporation (USG) and General Growth Properties (GGP) rallied sharply while in bankruptcy. USG shares, which traded below $3 in 2002, rallied to over $110 per share early in 2006 before exiting bankruptcy. Similarly, GGP shares, which traded below $0.20 in late 2008, increased in value to over $15 by the end of 2010, as it became clear that the value of the firm's real estate holdings exceeded the outstanding value of the debt.

18.4.3 Buying Undervalued Securities and Estimating Recovery Value

The prices of debt in distressed firms can trade substantially below face value before and during the bankruptcy process. Senior debt typically has higher prices than subordinated debt of the same firm due to the higher priority of claims on the assets of the firm. At the time of the bankruptcy filing, many debt holders sell their bonds due to restrictions on the credit quality of holdings that may be imposed by insurance or pension plan regulators or simply because of investors' unwillingness to stomach the risk or tolerate the time-intensive nature of holding and evaluating distressed securities. In cases of poor market liquidity, debt securities of these firms may be undervalued and therefore offer return from alpha in addition to a systematic risk premium for their market risks.

The job of a distressed investor sounds simple: Estimate the recovery value. The recovery value of the firm and its securities is the value of each security in the firm and is based on the time it will take the firm to emerge from the bankruptcy process and the condition in which it will emerge. Unfortunately, analyzing probabilities and outcomes and making both of these estimations can be difficult and firm-specific processes. The estimated liquidation or reorganized value of assets is analyzed with the priority of claims to arrive at the estimated recovery rates for each bond issue. The recovery rate of a bond is the portion of face value that is ultimately received by an investor in a bond issue at the end of the bankruptcy proceedings. Securities with higher seniority in bankruptcy generally experience higher recovery rates and are therefore worth more than junior securities. Thus, a firm may have senior debt issues trading at 60% of par value and subordinated debt issues trading at 30% of par value, even though they share the same underlying assets.

The recovery value of distressed securities at liquidation can be especially sensitive to market conditions in the industry. Consider the bankruptcy of an electric utility such as Enron. When the firm is liquidated, hard assets, such as power plants, need to be sold in a relatively short time frame. When the entire industry is in distress and overleveraged, it may be necessary to sell these assets at depressed prices. Some distressed investors—especially when the firm will need to sell substantial industry-specific assets—hedge the recovery rate risk by selling short shares in firms that have similar assets.

The time that firms spend in bankruptcy can vary widely, even when the firms are of relatively similar size and from the same industry. For example, US Airways spent just seven months in bankruptcy court, from August 2002 to March 2003, but United Airlines spent over three years, from December 2002 to February 2006, finally reemerging as a reorganized firm.

The annualized returns of deals involving distressed investing are highly influenced by the time the company spends under the supervision of the bankruptcy court. For example, consider an investor that buys a senior debt issue at 60% of face value and a subordinated debt issue at 30% of face value that yield eventual recovery values of 80% and 50%, respectively. These recovery values would generate non-annualized returns of 33.3% on the senior debt and 66.7% on the subordinated debt, assuming no coupon income. These returns are computed as the difference in the percentage of face value invested relative to the percentage of face value recovered, expressed as a percentage of the invested quantity. In the example of a six-month bankruptcy process, these returns represent annualized returns of 67% (33.33% × 2) on the senior debt and 133% (66.7% × 2) on the subordinated debt, ignoring compounding. But for a deal that takes 3.33 years to work out, the same deal generates annualized returns of 10% on the senior debt and 20% on the subordinated debt, ignoring compounding.

Investors may also profit from determining if and when the company will declare bankruptcy. An understanding of the financial condition of the firm based on financial statements and other information is key, as the investor needs to estimate how cash flows, including interest expense and debt maturities, can affect the timing of the bankruptcy. An investor who predicts that a bankruptcy filing will not occur for two years, perhaps a longer view than the market's, can profit if correct by buying debt issues with less than two years till maturity while selling short debt issues with more than two years till maturity. If the first debt issue is repaid at its full face value before the company files for bankruptcy and before the maturity of the later debt issue, the distressed investor has probably earned alpha.

18.4.4 Distressed Activists

Many distressed investors do not take an activist approach; rather, they simply buy distressed securities and wait for the events related to reorganization to unfold. Activist investors in distressed securities seek to influence both the recovery value and the timing of the exit from the bankruptcy process. The activist approach is an intense process that requires a substantial amount of legal work as the manager negotiates with the court and other investors.

The activist investor may simply choose to expedite the bankruptcy process by cooperating with other parties, which may lower ultimate recovery rates but increase annualized returns. Alternatively, the activist may attempt to improve its position relative to other parties in the priority of claims with a less cooperative approach that may generate higher recovery values as well as delays in distributions.

18.4.5 Capital Structure Arbitrage

Unhedged positions in distressed firms, such as simple long positions or short positions in equity or other securities, involve relatively high risk. Unhedged positions in distressed securities are plays on absolute value and are subject to substantial idiosyncratic and systematic risks. Most hedge fund managers typically use a hedging strategy known as capital structure arbitrage. Capital structure arbitrage involves offsetting positions within a company's capital structure with the goal of being long relatively underpriced securities, being short overpriced securities, and being hedged against risk. These hedged positions have reduced exposure to the general risks of the economy or the firm and are plays on relative values within the firm's capital structure.

For a traditional capital structure arbitrage trade, investors typically buy the more senior claim and sell short the more junior claim. Consider a company that has four levels of outstanding capital: senior secured debt, junior subordinated debt, preferred stock, and common stock. Two standard distressed security investment strategies are (1) to buy the senior secured debt and short the junior subordinated debt, or (2) to buy the preferred stock and short the common stock.

In a bankruptcy, the senior secured debt stands in line in front of the junior subordinated debt for any bankruptcy-determined payouts. The same is true for the preferred stock compared to the common stock. In both of the common capital structure arbitrage strategies just detailed, there is a long position in the more senior security and a short position in the more junior security for each pair. Therefore, in both cases, the strategy is long the security with the higher standing in the bankruptcy process.

Consider the case of buying the senior secured debt and shorting the junior subordinated debt. Assume that equal dollar positions of $10,000 (of opposite sign) are established in both bonds at discounts to face value, with the senior debt trading at a smaller discount than the junior debt. The gains and losses on this hedged position depend on the relative movements of the constituent positions. There are four cases that provide insight into the risks of this traditional hedge:

1. At the bearish extreme for the firm's assets, no recovery is ever received on either bond, and the hedge breaks even by gaining $10,000 on the short position and losing $10,000 on the long position.
2. On the bullish extreme for the underlying assets, full recovery is made on both bonds, and the loss on the short exceeds the gain on the long, causing the hedge to lose money.
3. If the senior debt is fully recovered and the junior debt has no recovery, the hedged position gains on both legs of the trade and generates a large profit.
4. If recovery rates of the bonds are equal, the junior bond gains more and the hedge generates a net loss.

Thus, capital structure arbitrage is not a simple bullish or bearish bet on the eventual value of the firm's assets that can be distributed to security holders. The key to traditional capital structure arbitrage profitability is when the more senior security improves more, or deteriorates less, than the junior security. Note that the analysis assumed equal sizes for the long and short positions. Other hedge ratios are common, and they can generate substantially different profits and losses for various outcomes.

Senior claims in distressed debt securities tend to offer higher loss potential and lower profit potential than do junior claims. For example, the equity can resemble a call option or a lottery ticket, with a small investment required and a small chance of a large payout. If less sophisticated investors prefer the return distributions of the junior claims, it is possible that more sophisticated investors can consistently profit from the traditional capital structure arbitrage strategies to the extent that the market overprices the more junior claims and underprices the more senior claims.

Derivative securities can expand the opportunities available for capital structure arbitrage and make strategies more versatile and riskier. In some cases, especially pre-bankruptcy, it is argued that financial market segmentation occurs such that the stock market and the bond market may be valuing securities based on very different appraisals of the firm's prospects. Financial market segmentation occurs when two or more markets use different valuations for similar assets due to the lack of participants who trade in both markets or who perform arbitrage between the markets. The idea is that each market attracts its own clientele, and the different clienteles generate different values.

For example, the bonds of General Motors (GM) were rated as CCC at a time when GM stock was trading at over $20 per share. Assuming that these observations indicated sharply divergent valuation standards in the debt and equity markets, investors could have chosen to perform capital structure arbitrage with the legs of the trade in different markets. A hedge fund manager could have bought put options on the GM stock to hedge a long position in GM bonds. Derivatives expand the set of markets pricing a deal by adding derivative markets. Thus, a capital structure arbitrage opportunity may be designed to exploit perceived mispricing due to financial market segmentation. The CDS market is also a key component of capital structure arbitrage strategies, providing cost-effective vehicles for hedging credit risk in long or short positions in corporate debt. CDS protection is bought and sold in the over-the-counter market, further increasing opportunities to exploit financial market segmentation.

18.4.6 Buying the Firm Using Distressed Securities

A distressed securities hedge fund can become involved in the bankruptcy process as a strategy for establishing a controlling position in firms that the fund perceives as substantially undervalued. This is where an overlap with the strategies of private equity firms can occur. To the extent that a distressed securities hedge fund is willing to learn the arcane workings of the bankruptcy process and participate in its steps, including sitting on creditor committees, substantial value can be realized if the distressed company can be successfully restructured and is able to regain its profitability. This strategy, with its intention of gaining a controlling interest, differs from that of hedge fund managers who purchase the securities of a distressed company shortly before it announces its reorganization plan to the bankruptcy court. The latter case is based on the expectation of a positive resolution with the company's creditors, whereas the former case includes a desire to obtain control.

18.4.7 Historical Risk and Returns of Distressed Restructuring Funds

Exhibit 18.3 follows the format used throughout this book, with details provided in the appendix, to analyze the historical monthly returns of an index of distressed funds, along with the general category of event-driven funds, over the period 2000 to 2014. Exhibit 18.3a indicates the stellar average and relatively low volatility of the cross-sectionally averaged returns of distressed funds that led to an outstanding Sharpe ratio over the observation period. As observed in activist funds and merger arbitrage funds, the returns were negatively skewed and leptokurtic. The range of monthly returns was from –7.9% to 5.5%. Exhibit 18.3b depicts the strong growth of distressed funds, the large decline during the financial crisis that began in 2007, and the high correlation of distressed funds with global equity returns. The –27.4% drawdown to the distressed fund index can be seen in Exhibit 18.3b, along with a recovery that appears to have recouped all of its losses by the end of 2010. Exhibit 18.3c indicates consistently positive correlation of distressed restructuring fund returns to global equities, U.S. high-yield bonds, and commodities, with a negative correlation to changes in credit spreads and changes in equity volatility. The correlation coefficient of 0.66 between distressed funds and global equities is confirmed visually in Exhibit 18.3d.