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Overview: Event Driven & Special Situations
The HFN active and inactive databases contain nearly 400 unique fund products with a primary investment strategy focused on event driven and special situations. The commercial database contains 225 products, 67% of which are unique with 4 of the unique products structured as UCITS.
•The HFN Event Driven Index was -1.09% in June and +1.42% YTD 2011. This compares to +0.65% YTD for equity hedge fund strategies, +4.06% for fixed income, -2.50% for commodity strategies and +0.39% for the broad hedge fund industry.
•HFN estimates total hedge fund assets invested in event driven and special situations (ED/SS) strategies were $515.41 billion at the end of Q2 2011.
•HFN estimates there were 80 ED/SS funds launched in 2010 against 24 liquidations. There had been a net decline in ED/SS funds the prior two years.
ED/SS strategies focus on a variety of objectives and typically utilize a combination of equity and debt related securities. The majority of special situations funds refer to the same catalysts that event driven strategies exploit which is why the groups have been combined in this report for asset flow and performance measures. In addition to shared catalysts including M&A, spin-offs, regulatory changes, share buybacks, changes in capital structure, etc., the group often also has distressed situations as targets. The remainder of this report breaks down ED/SS classifications to elucidate performance differentials.
Event Driven & Special Situations Fund Characteristics
The aggregated qualitative details of event driven and special situations strategies in the HFN database give an indication of the collective characteristics of the group in the entire industry:
•New York is the most common city in which ED/SS strategies base their operations exceeding the popularity of other cities by a wide margin. This is paralleled by the U.S. being the most common country for operations.
•ED/SS fund launches peaked in 2007, but the group also had the second largest % decline in fund counts during the financial crisis behind fixed income arbitrage.
•The average ED/SS entity has $440.5 million in strategy assets, compared to the average equity strategy size of $203.7 million and average industry aggregate size of $314.4 million.
•While the majority of the current crop of ED/SS funds invest in the entire capital structure, a slightly smaller group focuses primarily on equity investments.
Total Asset Levels and Flows Estimates
Event driven and special situation fund AUM increased rapidly in 2010 following above average performance in 2009. More recently, volatile equity markets appear to have led investors to reduce exposure to the group.
•HFN estimates total assets invested in ED/SS strategies at the end of Q2 2011 were $537.1 billion. Early estimates for July show continued, but muted, performance losses and an uptick in redemptions.
•Total AUM has increased 4.1% in the first six months of 2011, or $21.1 billion. AUM increased 26% in 2010 and 49% in 2009.
•Performance accounted for a $6.9 billion increase and investors added net $14.1 billion in the first half of 2011.
•Despite the influx of assets, the recent trend is negative. In Q2, performance reduced AUM $6.3 billion and investors redeemed a net $4.2 billion.
•The rate of AUM change due to performance has led the ED/SS benchmark through July which is an indication that larger funds (which have a smaller representation) have outperformed smaller funds during the year.
It is not surprising to see rising net redemptions from the group in the last three months. ED/SS funds were one of the earliest to return to net inflows following the financial crisis and had one of the three highest core growth rates in 2010 behind only fixed income and merger arbitrage. Increased volatility in equity markets has negatively influenced allocations to directional equity related strategies and ED/SS funds have been affected. The bulk of net inflows to the group resulting in its rapid post-crisis growth were from June 2009 through May 2010.
Performance by Product Size
Figures 6-8 show returns for ED/SS funds by fund size over the last 24 months (Figure 6) and over the last 5 years (Figures 7-8). Asset groups are defined by fund $AUM at the beginning of the period to best quantify returns by actual fund size at the time of initial interest.
Returns by strategy assets differ slightly. ED/SS entities appear to have a higher concentration of managed accounts and so actual fund size may not be the best indication of the size of an ED/SS operation.
•Mid-sized ($100-$500 million) ED/SS funds outperformed all other asset groups at every percentile ranking. This varies from the industry where smaller funds exhibit the highest upside and the largest funds show the most controlled downside.
•The group, assessed over the last 12 months using assets in strategy, maintained the aforementioned trend. ED/SS entities with over $500 million in strategy assets averaged 9.55% over the LTM while those with assets between $100 and $500 million averaged 14.91%.
•Looking back 5 years, the largest ED/SS funds outperformed smaller funds pre-crisis, but under-performed post-crisis. Contrary to the rest of the hedge fund industry, it was not the smallest ED/SS funds which rebounded fastest post-crisis, rather the mid-size $100-$500mm funds.
Performance by Regional Focus
Figures 9-12 break down the performance of ED/SS funds by their primary regional exposure, or the region in which their event driven strategies are focused.
•Event driven strategies with targeted regional exposures have outperformed each corresponding regional benchmark in 2011.
•In the last twelve months, only event driven strategies with exposures to Australia trailed their regional benchmarks. In the last two years, only Aussie and EM funds have trailed their regional hedge fund benchmarks.
•In the last twelve months, U.S. focused ED/SS funds had the most impressive spread between top 10th percentile and 75th percentile. A/P focused funds had the highest bottom 90th percentile, but failed to produce high top percentile rankings.
•ED/SS emerging markets performance appears to be more beneficial than broad EM exposure in volatile markets (comparing 2011 to the last 2 years which includes the broadly positive second half of 2009), but in no specified time frame has ED/SS emerging markets exposure produced meaningfully better results than ED/SS U.S. exposures.
Performance by Market Sector Focus
Figures 13-14 break down the performance of ED/SS funds by primary industry exposure. For the most part, ED/SS funds do not specify a focus on a particular industrial sector, but those that do tend to focus on the resources/energy, healthcare, finance and technology sectors, in that order.
•In both the last twelve months and YTD 2011 time frames, sector specific exposure appears to have benefited healthcare and natural resource focused ED/SS funds compared to non-sector focused ED/SS strategies. However, only natural resource ED/SS strategies outperformed the average corresponding sector specific EQ fund.
•The average finance sector ED/SS fund has underperformed all relevant comparisons. Looking within the sample, there is one product which has outperformed the average finance sector equity funds in 2011, but performance is still below the average of all ED/SS funds.
With the exception of resources strategies, sector specific ED/SS funds appear to have been unable to outperform their EQ sector specific counterparts. Additionally, outperformance over non-sector specific ED/SS funds seems to be due to sector specific exposures and may not necessarily come from sector specific ED/SS expertise.
Going Forward
There are several factors influencing the outlook for the ED/SS space. Corporations, at least in the U.S., have an increasing amount of cash on their balance sheets. A recent publication of corporate cash balance indicators from the Association of Financial Professionals (AFP)1 showed that more firms had increased the levels of cash on corporate balance sheets both from Q1 to Q2 in 2011 and year-over-year from Q2 2010 to 2011. Additionally, corporate borrowing costs are near the lowest levels in 10 years (but slightly off these lows through August) as seen by Aaa rated corporate rates and the spread between Aaa and Baa rates.
Despite the large amount of cash on hand and low borrowing costs, the current volatile global economic and political climates have likely reduced the attractiveness of deploying cash. Alternatively, sharp declines in equity markets can make share repurchases and takeover targets more attractive. However, neither is likely to be accelerated until volatility declines. This confluence of factors, combined with the rapid increase of AUM in the ED/SS space throughout the end of 2009 and 2010 indicate investors believed an active event driven environment would persist.
For equity oriented investors, outside of market neutral strategies, and despite being in negative territory on average, event driven funds are holding up relatively well. Both equal and asset weighted performance estimates for the last three months through July show that event driven strategies have outperformed equity market indices, the average long/short equity strategy and the aggregate average of all hedge funds. This is a firm indication that amid recent volatility there is still some level of support in the event driven markets.
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