Event-driven hedge funds popular in M&A revival

Hedge fund selectors are backing managers who bet on corporate events such as mergers, bankruptcy or restructuring, believing there will be more "special situations" to exploit as firms battle through the downturn.

Funds of hedge funds believe "event-driven" managers will profit as distressed companies are forced to restructure their debts to fend off creditors, and those with cleaner balance sheets look to M&A to boost sales in a low-growth environment.

"There are lots of opportunities now in distressed. Banks aren't lending, the bond market has shut down. Some companies are going to go bankrupt," said Fabrizio Ladi Bucciolini, head of alternative investment at Swiss-based Reyl Asset Management.

"Companies that went bankrupt in '08 and '09 are coming out of it now. It's just a perfect environment," said Bucciolini, who has 40% of his multi-strategy fund in liquid distressed funds.

Hedge funds can profit from such events by buying the firm's bonds at deep discounts to par and hoping they rise in value, and often by holding them until debt is restructured and their bond is converted into equity. They can also short the equity or buy credit default swaps to hedge their positions.

In Europe $1.4 trillion of total corporate debt is set to mature over the next five years, of which 20% is sub-investment grade, according to S&P. Moody's estimates that more than 250 billion euros ($319 billion) of leveraged buyout bank loan refinancing is due by 2015.

"We continue to increase event-driven strategies," said Robert Marquardt, founder of fund of hedge funds firm Signet.

"There are thousands of indebted companies that must restructure their debts over the next three, four years, either through issuing new debt, through equity issuance, through asset sales or cash pay-down, or, frankly, through bankruptcy."

After 20% returns in 2009''s bull market, event-driven funds are up just 1.84% in the first six months of this year, hampered by losses in May and June's volatility.

Event-driven funds no longer dominate new launches as they did earlier this year, according to one prime broker who declined to be named, but funds of funds are still upbeat.

Jose Galeano, chief investment officer of Swiss-based fund firm 3A, has recently bought positions in Jana Offshore Partners and York European Opportunity hedge funds, lifting his event-driven exposure to 18.6% from 12.1%.

These event-driven funds focus both on mergers and also on strategies such as capital structure arbitrage, where managers can profit from anomalies in a firm's capital structure, for instance by buying a high-yield bond and shorting the equity, thereby hedging out equity risk.

"(Companies) will be issuing ... debt with lower costs. Balance sheet restructuring is an opportunity for people doing capital structure arbitrage," said Galeano, whose firm runs fund of hedge funds ALTIN.

However, funds that bet on M&A events, often by buying shares in the target company and shorting the acquirer, are also popular with funds of funds.

While recent deal making has been stymied by government debt worries -- European M&A is up less than 2% in the first half of this year from the crisis-ravaged first half of 2009 -- optimists point to rising corporate cash balances and improving financing markets, and say many companies need to offset anaemic growth prospects with smart acquisitions.

This week has seen a flurry of announced or possible deals including Reckitt Benckiser Group's $3.8 billion buy of condom-maker SSL International and revived tie-up talks between GDF Suez and Britain's International Power.

Fund of hedge funds firm Oakley has invested 10% of a newly launched fund in a merger arbitrage fund.

Meanwhile, Magnetar is planning to launch an event-driven fund for its founder Alec Litowitz, to bet on M&A and other corporate events.

"Corporates have been very good at cleaning their balance sheets and some have quite a lot of cash ... We think some will use some of the cash to acquire other companies," said 3A's Galeano.