How Do Special Situations Funds Work?

Waiting for a haircut, you leaf through a tattered magazine’s worn pages and come across an article about an event-driven hedge fund. The author states these types of investments can be lucrative, but how do special situations funds work?  Dive in and learn the answer.

How Do Special Situations Funds Work?

Special situations funds work by capitalizing on the price anomalies created by event-driven corporate actions. These events include but are not limited to, spin-offs, liquidations, restructurings, mergers, acquisitions, and distressed debt and securities investing. To answer, how do special situations funds work? We look at the fund’s structure:

Opportunity Prospecting – Special situations funds prospect for the mispricing or asset undervaluation offered by a company or companies undergoing a corporate event.

Analyses – The fund’s research and analysis team comb through financial statements, regulatory filings, legal documents, market and sector data, and peer fiscal comparisons. This comprehensive investigative effort is conducted to determine the risk/reward profile of the identified opportunities.

Investment Decision – Fund managers make an investment decision based on their qualitative and quantitative analyses. They may elect to take a short position in a firm deemed to be overvalued or go long (buy) the securities of an undervalued company.

Risk Mitigation – How do special situations funds work? Risk assessment and management are essential workings of the fund. Special situations transactions are complex and risk inherent. Funds employ hedging, derivative investing, diversification, varied position sizing, and long-short (straddle) strategies to mitigate the loss of permanent capital.

Monitoring and Active Management – Fund managers monitor the fund’s performance and actively manage their positions. Investments are evaluated based on analytically determined benchmarks and position adjustments are made to realize these objectives.

Exit Strategy – Special situation funds map out a beginning, middle, and end to their investment involvement. Their ending participation is the exit strategy. This phase may encompass liquidating the position once the investment’s capital appreciation target has been reached or exceeded its intrinsic value, or the underlying investment fundamentals have adversely changed, or the corporate event has concluded.

Is Special Situations Distressed Debt?

Yes, special situations are distressed debt. However, special situations are not limited to just distressed debt. Distressed debt investing is the buying and selling of a troubled firm’s debt and equity securities. Distress debt is a component of special situations investing and the broader range includes:

Merger Arbitrage – Profiting from the securities pricing spread created by the blending of two independent companies.

Bankruptcies and Restructurings – Investing in the discounted debt and equity securities of an ailing firm embroiled in bankruptcy proceedings or fiscal restructuring.

Spinoffs – Investing in a parent company’s divested subsidiary seeking to exploit the market’s unrecognized value discrepancy of the newly formed entity.

Liquidations – Investing the winding-down assets and debt securities of a failed ongoing concern.

Stubs – Stubs or stub equity investing is the purchasing of shares created from a corporate event such as a bankruptcy or restructuring. Special situations investors look to profit from the market appreciation of the discounted stock. Spinoff shares are also stub equity,

Event Driven Investing – Capitalizing on the event-driven profit potential of share buybacks, tender offers, stock splits, expected special dividend distributions, and favorable and adverse regulatory changes.

How do special situations funds work? Special situations funds work by taking advantage of corporate event-created opportunities exposing market pricing discrepancies.

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