Special situation investing, also called event-driven investing, got its mass appeal with Joel Greenblatt's book "You Can Be a Stock Market Genius..." in the late '90s. He described a rather fresh and different investing approach where the core thesis around not purely on valuation, but connected it with potentially lucrative corporate-events (merger, spin-off, liquidation).
At the core special situations have a clear and often short-term catalyst (e.g. merger successfully closes), so the outcome of the trade is quite often binary - either it works out as expected or it teaches you a good lesson. Most event-driven situations revolve largely around the transactional aspects (e.g. timing, conditions, and risks) of particular corporate event, while the valuation side, while still important, acts more as a supporting argument. These aspects make special situation investing considerably more quick-paced and dynamic than a traditional value-based approach. However, a careful and well-researched process may generate considerable returns (particularly on IRR basis).
As with any other type of investing, event-driven approach requires thorough due diligence process, especially when nowadays, the specter of various special situation types is considerably wider than in the '90s. Different special situations have their own nuances, and to minimize the risk and increase profitability, investors need to be aware of these specifics.
Below we provide quick summaries for various types of special situations that are often covered on SSI (including links for 3 more elaborate deep dives). Keep in mind that this is a short overview only, intended to provide a concise description of essential points - every individual case might be different and may vary in their complexity/due diligence requirements.
In a merger, one company takes over another one by paying a certain sum in cash, stock, or a mix of both. If a target company is publicly listed, there might be an opportunity for arbitrage. Usually, in order to incentivize management and shareholders of the target to take the deal, a buyer offers a premium (sometimes even multiples) to the pre-announcement price of the target's shares. As a result, after the merger proposal is announced, the target's shares jump up. However, often due to numerous uncertainties still outstanding, they usually settle somewhat below the offer price. This spread reflects the uncertainty and riskiness of transaction as perceived by the market. Eventually, if the deal goes through and closes successfully (or the risks are resolved), the spread gets eliminated and the share price of the target company reaches the offer price. If the deal fails, however, the share price of the target company is likely to fall to pre-announcement levels. In essence, and this is crucial, opportunities to profit from merger arbitrage arise from investor's assessment that the market is overestimating/incorrectly pricing the risks of potential failure, and then betting on the successful closure of the merger (or from pure luck - by guessing correctly which mergers will close successfully).
Major risks include failure to satisfy the conditions (shareholder, regulatory approval, financing), withdrawal of the offer, and potential price amendments. Hedged positions also have to watch out for the borrow related risks - fee increase (lowers/eliminates the upside) or vanishing of the borrowing availability, which could result in a short squeeze.
Sometimes the target company may have more than one prospective buyer. The presence of other suitors (official or rumors only) shows the potential for a "standard" merger arbitrage to develop into a bidding-war. The longer and more intense the bidding-war process is, the more times buyers have to raise their bids to overcome the competitors. Sometimes, the final and winning offer ends up multifold above the initial price, thus, bidding-wars have the potential to significantly thicken the wallets of the target's shareholders as well as merger arbitrageurs. Some valuation work may help to get a picture of the potential limit the bids can go up to, however, depending on the industry and business of the target company, precise estimations are not always possible.
The situation can get particularly compelling if you can spot the acquisition target in the very early stage of the merger process (rumors, preliminary talks) or even before that - when the potential acquisition is not yet reflected in the share price. The earlier you can locate the potential target, the better as when a preliminary bid is already announced or rumors on potential offer begin spreading, share price appreciates quickly and consumes part of the potential upside. Research for early-stage merger situations includes scanning for any rumors, checking for comments from the management, analyzing the potential buyers, and industry background (maybe the industry is already in the process of consolidation?). The valuation side is important here as you have to estimate the potential limits of the offer (what is the highest possible price here).
See more in our in-depth Guide to Merger Arbitrage HERE.
This situation is similar to merger arbitrage, only that the target company is getting taken private by its management and/or major shareholders. The acquirers buy out the remaining minority and remain owners of the firm.
This is a popular special situation among US-listed Chinese companies - you can find our deep dive HERE.
More or less the same aspects apply with the going-private transactions as with the merger arbitrage (see above). One particular difference that should be noted here is that with US-listed Chinese transactions, it is very important to check what type of proposal is on the table - definitive agreements usually indicate a very high chance of success, while non-binding/preliminary offers include a much higher risk (termination, prolonged timeline, etc.).
To put it simply, a split-off transaction usually comes in two types:
- Parent company is divesting its business unit by merging it into another listed company.
- Parent company is distributing its ownership in another listed company to parent's shareholders.
In both cases the parent company allows its shareholders to exchange parent shares for the ones of another listed company (subsidiary company). To incentivize participation the exchange ratio is usually set at a premium (e.g. $110 of new shares in exchange for $100 of old shares) with an upper limit in place to fix the max number of new shares to be received for each old share. Only a small portion of parent company shares are accepted in the tender (around 3%-10%), therefore these split-off transactions tend to be heavily oversubscribed. As a result, only about 5%-10% of the tendered shares end up being accepted and exchanged (see proration factor graph below - proration has decreased with the increasing popularity of these arbitrage trades).
However, all the listed split-off transactions so far have always included an odd-lot provision, meaning that holders of 99 shares or less are being accepted on a priority basis. This allows to effectively escape the proration and have a guarantee that your shares will be accepted in the tender.
When researching a split-off make sure to check the timeline (especially the valuation date), borrow availability for a hedged trade, and decide on your trading strategy. There are two main choices you have to make - whether you will go with a hedged trade or unhedged trade, and when will you initiate the position (right after the announcement or post valuation date when the final ratio is known). All strategies have their own pros and cons, however, our analysis shows that the most profitable strategy seems to be opening an unhedged position right after the initial splif-off announcement is made.
See our Analysis Of Split-Off Trading Strategies HERE.
Spin-offs are kind of similar to the above mentioned split-off transactions, only that here the company is divesting part of its business into a second public company. Consequently, the parent company also distributes its shares in the spin-off on a pro-rata basis to its current shareholders. Often a spin-off is done to separate potentially undervalued business, which should help to increase the market's awareness. Thus, if the market starts recognizing the previously undervalued business, it could increase the combined value of both companies and result in a profitable trade. Spin-offs include a considerable amount of valuation work as you have to estimate the potential value of the remaining parent and separated entity.
Aside from these basic mechanics, one other interesting potential opportunity may arise when the spin-off is done into an OTC stock. Most institutional investors are not allowed to hold OTC stocks, thus, creating significant selling pressure right before/after the transaction. This might offer a chance to play on the eventual rebound.
Additional research may include the shareholder structure - particularly if besides the institutional investors, there are any other large shareholders, which are likely holding the parent for its core business and won't be interested in owning the spun company shares post-transaction. It is also necessary to look into management's background - track record, share ownership, and spin-off related role transfers.
A tender offer is announced when a company intends to buy a part of its own outstanding shares. This can be done for various reasons, such as capital return to shareholders or maybe management simply thinks that shares are very cheap at the moment. Usually, the consideration comes in cash, and to incentivize the participation, the offer is done at a premium to the share market price. Because of the premium, the offer might end up oversubscribed, and leave some of the tendered shares not accepted (prorated). This creates a certain risk, as quite often after the tender offer is closed, shares drop to around pre-announcement levels,. which may result in a significantly lowered profit or even loss for the whole trade.
There are two types of tender offers - a normal tender, with a fixed size and consideration per share, and a dutch tender offer. Dutch tender offer is a bit different and functions more like an auction - the company announces a total consideration amount and states a price range in which it will accept the shares. Shareholders then choose the lowest price in which they will tender. The company starts accepting the tendered shares from the bottom of the range and continues until the total consideration amount is filled up. Higher participation in the offer indicates a higher likelihood that upper limit prices won't even be reached.
Overall, for a tender offer, it is crucial to estimate the likelihood of proration and, for a dutch auction, at which side of the range the final price is going to settle. The size of the offer can be a good hint as larger tenders have higher chances of low/no proration, while smaller transactions (e.g. 5%-10%) often end up significantly oversubscribed. Sometimes the offer documents state information regarding the participation of major shareholders. If large shareholders or management that owns a considerable stake has agreed to abstain from participating, this indicates the odds of lower proration (higher price for a dutch tender). However, if the company is buying only 8% of the outstanding shares, while 5% of shareholders have already confirmed to tender, it might be not the best idea to put your money in such a transaction. Furthermore, if the company has done any other similar tenders in the recent past - their results might provide some hints regarding shareholder activity and potential participation of the current offer.
Don't forget to look into taxation matters. This is an important aspect in certain markets (e.g. Canada), where withholding taxes can consume a sizeable part of the upside.
ODD-LOT TENDER OFFER
When launching a tender offer the company also can opt to reduce its further administrative burden and cash out various minor shareholders. In this case, the tender offer may include an odd-lot provision. This provision means that holders of 99 shares will get accepted in the tender offer on a priority basis and won't get prorated. Such situations provide a rather low-risk upside (yet capped) for odd-lot holders as it is very rare for an-odd lot provision to get canceled later on. However, with the odd-lot tender offer situations becoming more and more popular recently, the amount of odd-lot arbitrageurs has also increased dramatically. Elevated participation of arbitrageurs, who "exploit" the provision may incentivize companies to re-think the inclusion of the provision. In fact, in the last two years, we've already had some cases where an odd-lot provision got canceled or amended in the process (for the above-mentioned reason).
A reverse split is announced when a company intends to reduce the number of its outstanding shares. This can be done for various reasons, for example, to nominally raise the share price and keep it above $1.00/share, which is the level required to stay listed on NYSE and NASDAQ. Reverse splits include a split ratio (e.g. 1 for 100, so if you previously owed 1000 shares, only 10 will remain post-split), while the odd-lot or fractional shares usually get cashed out at a premium to the market value.
Sometimes, the goal is not to reduce the number of shares but rather to decrease the number of total shareholders. For example, a company wants to dark and stop reporting to the SEC (stock exchange commission), for which it has to lower the number of its shareholders below 300. To do this, a reverse split (which cashes out the odd-lot shareholders) is immediately followed by a forward split that restores the original number of outstanding shares.
The main point to check here is whether the transaction makes sense for the company from a financial standpoint and what is the real incentive here. For example, if a company expects to delist after the reverse/forward split, the important factor here will be whether the transaction costs are going to pay-off. However, if a pile up of odd-lot arbitrageurs elevates transaction costs to the extent that savings from cancellation of the public listing are no longer worth it, the chances are high that the splits might get canceled or amended.
Major risks are termination of the transaction, terms amendment (e.g. split ratio is lowered), or various delays.
As a special situation liquidation can come in many different forms and stages - sometimes it's a company that is selling all of its assets and intends to distribute the proceeds ex liquidation costs to shareholders, sometimes the company only intends to sell the assets and a lot of uncertainty regarding the sale still remains. The other times, it can be a company that simply has its assets in run-off and needs to wait a certain amount of time before winding-up. Thus, usually, a liquidation involves a lot of moving parts (value of remaining assets and operations, cash burn, management's incentive, etc.). The tricky aspect here is estimating the eventual distributions and the likelihood that all other parts of the play will work out as expected. This involves valuation mechanics and quite often some guesswork as well. Usually, liquidations include a few partial distributions and a final one (sometimes the last one takes significantly longer due to certain outstanding conditions).
When stumbling upon a liquidation case, it is important to figure out at which stage it is currently in. The more assets, operating businesses there are left to sell, the more uncertainty regarding the potential upside and timeline. Checking the background of the company and the asset sale can help to understand whether the remaining assets will be sold easily (assets have demand in the market) or maybe it is something that management has been trying to get rid of for a long time already, but wasn't able to yet. Timing plays an important role when deciding on the attractiveness of the situation, as liquidations usually take longer than expected and it's likely you don't want to get stuck in a (potentially) illiquid stock for 3-4 years with limited updates from the management.
It is necessary to calculate the potential liquidation value of the company including the to-be-sold assets, potential cash burn, and liquidation expenses. This will help to get a better picture of the existing margin of safety - how much can the whole process get prolonged and how high can the expenses go until the upside is gone. Sometimes distribution estimates are provided by the company, in which case it is necessary to double-check if the management is not painting in the brightest colors.
Make sure to research the largest shareholders and, especially, what stake belongs to the management. A higher stake could indicate that they will be incentivized not to destroy value in the liquidation process. However, it is important to keep in mind that most liquidations include a conflict of interest as the longer time the whole process takes, the more compensation the management can pump out from the company until it winds up.
Finally, check if there are any special conditions related to the asset sale or distributions.
This special situation is closely related to the sum of the parts valuation of the company. There are many companies that trade at a significant discount to its SOTP and have their assets undervalued by the market. In such cases, an asset sale could become a catalyst for the share price increase as when the assets eventually get exchanged into cash, the market is much more likely to start recognizing that value.
Asset sale situations require a sum of the parts valuation of the company in order to see its financial position and potential valuation post-sale. It is also important to check the transactional details of the sale, estimate the chances of failure (buyer's credibility, conditions), and whether there were any other buyers present.
NAV DISCOUNT ELIMINATION
This type of special situation revolves around holding companies or funds (e.g. closed-end) that trade at a discount to its NAV, have their assets listed on an exchange (straightforward valuation), and are easy to hedge. In essence, the idea is that a certain corporate event may eliminate the company's discount to net asset value, however, all cases are different from each other so there are no ultimate rules here. For example, for a holding company, the discount elimination could be induced by a split-off of its major asset, while for an exchange-traded equity fund it can be triggered by the conversion into ETMF (actively managed ETF). The main point here is to spot the catalyst and research the potential risks/consequences of it failing.
CAPITAL STRUCTURE ARBITRAGE
When a company has more than one tradeable share class (e.g. additional nonvoting common share class or preferred shares) it is usual for a certain discount to exist among the classes. There might be various reasons for that - a voting benefit of voting shares, liquidation preference of the preferred stock, or the difference in free-float/liquidity/inclusion in major indices. Over the years this discount settles into a certain average and sometimes due to unexpected events (e.g. market crisis) or some untraceable reasons, the discount widens significantly. Such situations offer a play on the capital structure arbitrage.
Sometimes this opportunity may also be induced by a clear corporate event. For example:
- The share price of a recently SPAC listed, controversial company skyrockets, and substantial uncertainty remains regarding the future performance of its stock (high risk of bubble burst). These dynamics may create a price discrepancy between its stock price and warrants. Hyped up stocks usually have a very limited and expensive borrow, however, there might be a possibility for a synthetic short (options play). Due to high volatility, unhedged trade is extremely risky and speculative.
- For certain reasons (e.g. to simplify capital structure) a company intends to eliminate all of its outstanding warrants and offers to exchange them into stock or cash. This provides a rather straightforward arbitrage opportunity for a hedged trade. Unhedged position is also possible (longing warrants only), however, it offers much greater risk due to common stock volatility. Dilution plays a big role here - the more common shares are expected to be issued, the higher the risk of post-transaction sell-off. It is important to get a picture of the company's background and financial condition to understand why is the offer being done and how likely is further dilution.
Overall, hedged trade involves borrow related risks - fee increases/potential short squeeze/early option exercise (for synthetic short) and also higher potential loss in case the transaction is terminated (can get burned from both sides). Unhedged position is exposed to the common share price changes - the upside can get eliminated even before the transaction is closed, while post-closing sell-off is also a risk here.
In certain jurisdictions (e.g. Honk Kong, Sweden), when a buyer acquires a certain level of ownership in the company (30% in both HK and Sweden), it must make a mandatory offer for all of the remaining shares of the company. The consideration also depends on the jurisdiction, but usually is either the last price or the highest price paid by the buyer in the last 6 months.
Mandatory offer situations might differ depending on the way the ownership threshold was breached (was it a small purchase in the open market or a large, still ongoing tender offer). In any case, the key here is to understand the incentives of the buyer (will it be willing to proceed with a further offer or will it try to evade it) and the possible risk of the mandatory offer getting waived. For example, in HK it is possible to escape the mandatory offer only if 75% of the total and 50% of independent shareholders approve the whitewash waiver. Therefore, sometimes, the buyers take precautions and include such a condition in the original tender offer beforehand.
When the company becomes insolvent and is no longer able to repay its debt, it can file for Chapter 11 protection and proceed with a bankruptcy process. Depending on a particular case, the outcome of the bankruptcy might vary, but the most important question remains - is there any value to be left for equity holders? The answer to this question might provide two types of play:
- Most of the time, when the bankruptcy is truly a result of a terrible financial position of the company you may find out that the equity is undoubtedly worth 0. However, for one reason or another, shares might be trading way above that. If borrow is available and the fees are adequate, such cases may provide an opportunity to short.
- However, sometimes companies file for bankruptcy not because of straight-up insolvency, but, for example, to get rid of certain legacy liabilities (e.g. post-spin) or to run a smoother asset sale process (in fact, there are cases when the company enters into bankruptcy with an already received offer for most its assets). Such situations are very interesting and often indicate high recovery potential for equity holders. If the recovery is high enough, it could provide an interesting entry point for a play on bankruptcy recovery.
However, it is very important to note that investing in any bankruptcy is highly risky and involves plenty of legal nuances and other potential caveats (bankruptcy filings, intricate conditions, uncertain timeline, unexpected appearance of claimants, etc.).
Rights offering is another way of raising equity while giving the priority to current shareholders. Each shareholder is given an opportunity to acquire a certain amount of shares (e.g. 0.2 new shares for each currently held share) and to incentivize the participation, new shares are offered at a discount to the market price. Sometimes an oversubscription clause can be included as well, meaning that you can buy more new shares if someone else chose to abstain from exercising their rights. Moreover, it is particularly positive if the offer is backstopped by the management or another major shareholder (this indicates that the stock is worth considerably more in their eyes).
Overall, rights offerings increase the capitalization of the company and sometimes even has a positive effect on price per share, while allowing you to buy shares at a discount. However, it is also important to take into account the size of the offering - what number of new shares will be issued and how much dilution it will cause to existing shareholders. Very large offerings (even at a great discount) are highly dilutive and often result in significant pressure on the share price of the company (participation doesn't pay off). Therefore, it is useful to check the background and financial position of the issuer as well as run some quick calculations modeling the post-transaction situation of the company.
Here you can find our recommended sources to expand your knowledge on special situation investing.
Above all, we've found that a very efficient way to learn is by analyzing past/already closed cases. SSI offers several hundreds of different special situations, where you can see the clear and concise picture of the whole set up, thought process behind the thesis, further developments, and additional valuable feedback from the members. This sums up to an experience that can be hardly compared to any book or newsletter. Moreover, following the currently active cases allows you to participate and live-track the development of an idea, while also asking questions from our experienced team and members. In parallel, there are other sources that can back up the learning process, and provide, strengthen the necessary background sophistication.
- Joel Greenblatt's book "You Can Be a Stock Market Genius. Uncover the Secret Hiding Places of Stock Market Profits". This is basically a special situation investment bible, which offers insights into the most popular event-driven opportunities like - merger arbitrage, spin-off, liquidation, etc. Definitely worth checking out if you want to learn the basics and see the reasoning of the pioneer himself.
- Aswath Damodaran's "Valuation" course at NYU Stern School of Business. The valuation side is an important, and sometimes quite a crucial part of investing in special situations. Mr. Damodaran is a worldwide acclaimed "valuation guru" and (in our opinion a brilliant professor with an engaging and entertaining teaching approach). His courses are available online for free.
- Guy Wiser-Pratte "Risk Arbitrage". A great and detailed overview of merger arbitrage with some historical background as well.
- Alexander Tübke "Success Factors of Corporate Spin-Offs". In-depth analysis of spin-offs and their success factors.
- Brian J Stark "Special Situation Investing: Hedging, Arbitrage, and Liquidation". A good read from an experienced fund manager.