By Troy Gayeski
As the U.S. economy and capital markets continue to improve, event-driven equity has emerged as an attractive investment theme for hedge funds. There are several contributing factors that we at SkyBridge believe are improving the potential risk/reward profile for this strategy. These factors include:
Political: The fiscal cliff was handled in a relatively benign fashion and the debt ceiling was kicked down the road, which means a lower probability of disastrous news out of Washington in the near term. In addition, although the sequester has been implemented, we did not and still do not see a mild reduction in government spending growth as a sufficient cause to drive the economy into a recession. Furthermore, the tax and spending battles fought in Washington have quietly been productive, in that the near and intermediate term budget/deficit picture has improved dramatically since the second half of 2012. Still, there has been zero progress on entitlement reform, and Obamacare and other regulatory expansion continue to drag on hiring and corporate animal spirits.
Economic: Despite much Keynesian handwringing, it still appears that the real engine of economic growth, the private sector, is gaining momentum and may continue to do so. For example:
Corporations and consumers have gone through a tremendous amount of deleveraging, both at the nominal debt level, but more importantly at the debt service level (i.e. interest expenses are at all-time lows).
The housing recovery should end up having a more profound impact on consumption than a reflation in financial assets due to a more powerful wealth effect. Just as the negatives were underappreciated as housing collapsed, the positives are more than likely being underappreciated.
Liquidity: The Federal Reserve continues to pump $85 billion per month into financial markets with a commitment to not abruptly end the buying process and has anchored short-dated interest rates until 2015. Thus, we believe that an economically detrimental increase in interest rates is unlikely anytime soon. Furthermore, Japan has announced its own massive Quantitative Easing program, which began to impact non-Japanese markets in April.
Technical: Investors of all types continue to maintain portfolios that are very conservatively positioned, with heavy allocations to bonds and cash and a significant distrust of equities.
Fundamental: Equities and equity-linked strategies are starting at much more favorable valuations compared to other “vanilla” asset classes, such as bonds or cash. If the pendulum continues to swing from fear to greed, there is only one option for investors seeking the potential for returns well above the risk-free rate.
Therefore, event-driven equity looks to be a promising strategy. First, this strategy should not need capital market improvement to generate returns. If equities trade flat for the next 12 months, we are confident that managers typically will be able to generate above average returns due to the embedded optionality in existing positions, such as late stage equity restructurings, activist activity, corporate events driven by a housing market rebound, potential mergers and acquisitions, asset sales and spin-offs. This is a very important distinction to make for event-driven equity managers compared to long/short equity managers; we believe there is far less visibility into how long/short equity managers will generate returns in flat market environments. If equity markets continue on an upward trajectory, this beta will be captured more effectively by the event-driven equity strategy than by other options, and a significant escalation in M&A activity should not be needed for managers to generate returns. However, with the combination of healthy balance sheets, high cash balances, cheap financing and improved confidence of corporate America, we see these factors eventually leading to more meaningful M&A activity, and we believe event-driven equity strategies will perform even better. In essence, event driven equity has upside capture to an M&A rebound, but is not dependent on it.
Finally, the probability of a major bear market and Q3 2011 style correction, which would lead to mark to market losses in the strategy, has been low in our opinion for the previously discussed reasons. During the past 5 months, this thesis has already begun to play out better than anticipated due to the strength in equity markets. However, the above analysis and opinions continue to be valid and, if anything, more favorable market conditions may lead to an acceleration of corporate events, which could continue to provide robust support for event driven equity.
Troy Gayeski is a partner and the senior portfolio manager at SkyBridge Capital, where he oversees the firm’s two flagship discretionary portfolios (SkyBridge Multi-Advisor Hedge Fund Portfolios - Series G and SkyBridge Legion Strategies) and institutional separate accounts, comprising over $5 billion.