Event Hedge Funds Positions Determine Risk and Reward
The size of the long arbitrage position, measured in days to liquidate, among other factors, determines the downside risk.
When discussing event-driven (risk arbitrage) hedge funds, they often mention a rotation that occurs during a deal, where traditional holders sell the stock once it surpasses their price target. Future returns are highly dependent on deal analytics, an area where many managers lack expertise.
There is a rotation from 'real money' investors to event-driven funds from traditional accounts. If the deal closes, the stock appreciates, but shares convert without needing to be unwound. In cases of stock consideration, the short parent shares are covered without a trade.
Event-driven funds metaphorically refer to 'arbs owning the company.' Although this is somewhat exaggerated, they can hold a significant portion, as indicated by various metrics.
The risk to the stock arises if the deal fails, leaving event-driven hedge funds holding the stock at lower levels, prompting them to sell to fundamental buyers who no longer own it.
This reflects how much stock is supported by the deal and how much will need to be unwound if the deal fails. This downside level is crucial for assessing the risk and return of the deal.
Greater hedge fund ownership of the target, particularly concentrated ownership, tends to lower the stock price in the event of a deal failure.
Traditional managers may choose to go long or short these stocks based on these metrics.
On average, S&P stocks are held by hedge funds 1.69% and by event-driven funds at 0.1%.
For deal-related names, these averages rise significantly to 14% and 5.5%, respectively, highlighting a different dynamic. Hedge funds holding the stock due to the deal can own a substantial part of the company.
Long and Short Analytics for Large Targets in Deals
Broken deals with wide spreads, such as X and others, are disproportionately held by hedge and event funds, with traditional accounts staying away due to the complexity. Hedge fund ownership is approximately 32%, and event fund ownership is about 15% in these cases.
One metric to assess risk in these long positions is the Average Days to Liquidate. For deal-related names, this average almost doubles from before to after the announcement, whereas for control stocks in the S&P, no such trend is observed. The downside is a function of the Days to Liquidate and other factors.
Analysis of the Size of Long Positions in Announced Deals
When hedge funds own a higher percentage, event funds do as well, and vice versa.
Larger companies have a longer Days to Liquidate than smaller companies.
Stocks that are more heavily shorted are owned by more hedge funds and show a higher increase in Days to Liquidate.
An anomaly in deal analysis is the Nippon Steel deal for U.S. Steel (X). Another branch of the government can veto this cross-border deal. While a normal deal spread is 5-10%, this one is 50%, leading many to believe the deal will not happen. The short interest as a percentage of float is 9%, significantly higher than for other deals and the average stock. This indicates that there is substantial smart money betting against the stock, not just large positions betting in favor.
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