The choices of an event-driven strategy are many. An investor’s interests, expertise, and risk tolerance will dictate which investment path is chosen. But which is an example of an event-driven strategy? Read on to learn about a stratagem that capitalizes on a company’s misfortune.
Which Is An Example Of An Event-driven Strategy?
Distressed debt investing is an example of an event-driven strategy. Special situations investors invest in, purchase, the debt of companies experiencing disappearing revenues, melting net profits, bankruptcy, or desperation restructuring.
The strategy is event-driven because the investment opportunity and potential gains are borne out of corporate action and not created based on market momentum. Let’s answer the question; which is an example of an event-driven strategy? by examining the structure, pros, and cons of distressed debt investing.
The Mechanics
Opportunity Identification – Distressed debt hunters analyze a firm’s capital structure, sector and industry comparables, restructuring prospects, and overall fiscal health. In these special situations, investors seek to identify distressed loans or bonds trading at a sizable discount to face value.
Recovery Potential – Company assets, liabilities, accounts receivable and payable contra-accounts, and net and levered cash flows are evaluated to assess the liquidation, restructuring, or turnaround value of the firm’s distressed securities.
Event-Driven Strategy Execution – Distressed debt strategy can be implemented in different ways, including one or a combination of the following:
- Purchase the discounted distressed debt and hold the investment until maturity or until the firm’s fortunes improve.
- Participate in the restructuring process by exchanging debt for equity ownership, known as debt-for-equity swaps, or swaps.
- For companies undergoing bankruptcy, a special situations investor can provide debt-in-possession (DIP) financing. DIP financing are funds extended to the debtor firm to maintain control of their assets and continue operations while under bankruptcy court receivership.
- Litigation proceedings participation to exercise shareholder or creditor rights to maximize potential recovery value.
Which is an example of an event-driven strategy? Distressed debt investing offers high returns on discounted debt securities. What are the advantages of this event-driven strategy?
1. High Returns
As mentioned, an investor’s accurate assessment of an undervalued distressed opportunity and the company’s subsequent emergence from financial distress can generate substantial returns on invested capital.
2. Diversification
Due to the low correlation of distressed debt to stocks and bonds, diversification becomes an advantageous externality.
3. Capital Structure Priority
Distressed securities investors can hold proceeds distribution seniority. During a restructuring or liquidation and based on a hierarchy of claims, an investor holding distressed company bonds will receive payment before preferred and common shareholders.
No investment is perfect and distressed debt investing is no exception. Here are a few drawbacks.
- High Risk
Troubled companies are risky, and their debt securities are an identical risk twin. Distressed debt investing’s inherent risk stems from the probability that the firm’s court sanctioned restructuring plan fails to produce a satisfactory recovery.
- Illiquidity
Investors may not be able to exit their distressed debt position due to the illiquidity of the securities in the secondary market. This risk magnifies during economic downturns.
- Regulatory and Legal Landmines
Regulatory and bankruptcy changes, creditor disputes, coupled with creditor and shareholder litigations are some of the risks that can derail a successful distressed debt investment.
Which is an example of an event-driven strategy? Distressed debt investing is a potentially lucrative pursuit. Though the high returns are alluring, they are accompanied by significant transaction complexities and risks. Investor due diligence and expertise are mandatory.
Read next: What Are the Components of Event-Driven Investment Strategies?
