How to Invest in Special Situations?

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 turned 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 a particular corporate event, while the valuation side 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 a quick list (click the headlines for more information) of various specal situation types that are often covered on SSI. Keep in mind that this is a short summary 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…

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. Similar aspects apply with the going-private transactions as with the merger arbitrage…

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)…

Spin-offs take place when 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…

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…

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…

A SPAC is a shell company with no operations, created in order to buy another company. SPAC raises cash through its IPO, identifies a target and then merges with it. In this way the previously private company (i.e. the target) gets a public listing without having to go through the burdensome IPO procedures. SPAC companies usually have 3 types of securities – shares, warrants and units, which provides multiple different investment strategies…

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…

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…

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…

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…

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…

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…

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…

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…

Here you can find our recommended sources to expand your knowledge on special situation investing (will be constantly updated).