investing in Europe

7 minutes, 19 April 2024, Paddy Dear

Welcome to Alternative Insights

This is the first of our Alternative Insights series, in which we explore key aspects of generating alpha through alternative investments.

Our focus in this thought leadership series is on asset classes and investment strategies that offer what we call ‘intrinsic alpha’, where investors, or in our case Tetragon, may earn excess returns when compared with the investment risk involved. Readers should also be aware that many investors will also want and accept some correlation with the market – known as beta. These terms will crop up on a regular basis through the series.

In this piece, we consider event-driven investment in European companies and how investors may seek to successfully capture the alpha we believe these investments offer.

Finding alpha in event-driven investing

Event-driven investing in Europe offers a multitude of opportunities, challenges and risks. It is a niche that we believe has historically been a source of alpha for Tetragon. Here we explain why we find it such an interesting area, why the region
is particularly geared towards it and the skills that are important.

Events drive change, feeding alpha.

‘Event-driven’ investing means different things to different people. Some think of it as revolving around ‘special situations’ or ‘merger arbitrage’, but for us it encompasses more than that. Corporate events can take various forms and change as markets shift and evolve.

What broad categories of events do we generally focus on?

  • 1.

    Changes to the company’s structure, mergers and acquisitions, demergers or spin-offs, corporate restructurings and returns of capital such as special dividends.

  • 2.

    Legal or regulatory issues, especially litigation.

  • 3.

    Capital market issues, including the company moving to a different stock market or sector, lack of research, or problems with shareholders – anything that leads to a gap between business reality and market perception.

Whatever the background to an event, one thing is clear: the event often becomes a key driver of a company’s share price for a period of time. In our experience, these events are often a catalyst for change which may create market dislocations. Understanding and anticipating the dynamics of how these situations will unfold, in our opinion can only be developed through longevity in the market. This creates high barriers to entry, as investment and analysis of these situations requires a wealth of prior knowledge. It is not that event-driven investors have information that fundamental investors do not, it is that they may have developed an expertise into the probable impact of that information.

For most companies, events do not happen that often and so traditional fundamental investors do not necessarily need to be event-driven experts. And some types of events, for example merger arbitrage, may lead to such a massive gap in risk-reward dynamics that any potential gain is outweighed by a large potential loss. Not surprisingly, many investors try and avoid that kind of dynamic.

The European opportunity

Although corporate events happen every day across the world, we believe that the breadth of opportunities is especially interesting in Europe.

Why? It is a much more commercially, legally and regulatory dislocated environment than the United States. In our experience, this creates a level of complexity that can allow anomalies to develop. Europe is not a single country and that leads to an intricate mixture of regulatory and legal processes. While the European Union brings some of that together, the underlying regulatory environment remains divergent and nationalistic in nature. There are, for example, no uniform takeover codes or corporate law.

What are the key investment skills?

  • 1.

    Experience of precedent events – the convoluted mix of regulatory and legal processes may be problematic to analyse for those that are unfamiliar with the landscape, but it also creates opportunities for those who have experienced a multitude of precedent “events”. You need to be able to navigate amongst the diversity of languages, cultures, approaches and business models. Furthermore you need the infrastructure to simultaneously execute complex trades in multiple currencies and markets.

  • 2.

    A good network of advisors in each country – we believe your network across the various markets is essential. These are the people that may alert you to new potential situations, to changing regulatory landscapes, to the kinds of events that have the ability to create mispricing and where an experienced event driven investor may find value. This network comprises the likes of lawyers, bankers, accountants, consultants, PR specialists and more. Advisors that you know that you can rely on to give you high quality and local insights at speed.

  • 3.

    Ability to balance ‘hard’ and ‘soft’ processes – and what that means for different situations. The former revolves around aspects like law, regulations and politics; the latter on areas such as valuation norms, precedent and institutional expectations. The ‘soft’ element also involves understanding who works with whom; it is not just about numbers.

Typically, we believe the stocks with the greatest opportunity will have a bias towards Europe’s mid and small caps, a very broad and deep asset class. Any events are likely to be much more material in these businesses and therefore have a greater opportunity to drive share prices. These types of businesses may also benefit hugely from the ‘soft activist’ role that those with deep and broad experience of events can bring to a senior management team.

Capturing alpha while mitigating risk

In our view, most corporate events create long-side alpha – where investors benefit from owning the stock rather than taking a short position. Capturing that alpha can be difficult and complicated. Each event is different and the dynamic may change as a new aspect enters a situation. That change can be as wide-ranging as, say, an adverse political reaction to another bidder entering a fray, or to a union calling for a strike. Events can play out over anything from a few days to a few years so you need to be able to stay the course, understanding and adapting to ongoing and evolving events.

In addition to the risk reward dynamics of each individual investment, a portfolio of investments needs to be risk managed as a whole. An ideal portfolio has its individual investments subject to idiosyncratic risks that are uncorrelated to each other. But in reality there are correlations between positions, both overt and more subtle. Managing the individual idiosyncratic risks of each investment plus their collective correlations of risk factors, durations, liquidity etc. is down to the skill of the portfolio manager.

While an event driven portfolio strives to be focused on diverse and relatively idiosyncratic risks, one obvious correlation is likely to be market risk. It is possible to hedge away some of the market risk, “the beta”, but this requires complex hedging, using single stocks, baskets, indices and options. Also, this hedging comes at a cost to the portfolio as the expenditure reduces the total alpha available. However, the reward should be a alpha-generating strategy that has a low correlation to other asset classes and the broader equities market.

We believe the optimum exposure is to accept some market risk (i.e., beta) and thus appreciate the alpha as an addition to the beta. For investors who want a long position in European equities – which many do – they may enhance this exposure by allocating a portion of their capital to alpha-generating strategies, such as an event-driven fund.

In our decades of allocating capital, we have found event-driven investing in the European mid-market to be complex yet rewarding. In our view, imperfect markets fractured by borders create mis-pricings, and opportunities generated by change and by events are one of the few features, along with risk, that financial markets guarantee.

At Tetragon we have built a firm that gives us the flexibility to explore investment opportunities that many others simply can’t. We have a proven ability to compound investment growth and return value to our shareholders.

Paddy Dear

Tetragon Co-Founder

Meet Paddy Dear

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