Special situation opportunities are investments generally predicated on some type of event. The event could be a change in a company’s ownership profile, capital structure, or operations. In other words, a set of circumstances has disconnected the company’s valuation from its fundamentals and the future is likely to be different than the past (i.e. there is a reason why price and value should converge).
Common special situation opportunities include:
- Merger Arbitrage
- Operational Restructuring
- Spin-Offs / Carve-Outs / Split-Offs
- Companies Pursuing “Strategic Alternatives”
One of the main advantages of special situations is the opportunity for positive total returns irrespective of the general stock market’s performance. This could come from several different circumstances, including:
- Price gap closing in a merger arbitrage situation
- Distressed asset getting recapitalized
- Company getting acquired
- A company’s stock getting punished due to forced selling from large shareholders
While all these situations can be profitable in the short-term for investors, the main attraction of special situations for long-term investors is the opportunity to purchase good assets at prices well below fair value.
Of the different special situations listed above, there are a few that represent excellent opportunities for long-term investors to find mispriced securities.
Spin-Offs / Carve-Outs / Split-Offs
A stock spin-off is the formation of a new, independent company via the distribution of shares from the Parent Company. Historically, spin-offs have generated excess returns relative to the general market and industry peers. These types of situations have characteristics which can lead to excellent opportunities for investors to find unique businesses that are not initially recognized as being such:
- The potential for forced selling by legacy shareholders for noneconomic reasons (index funds, large institutional investors, etc.)
- Reduces complexity and improves focus
- New management incentives
- Close a conglomerate discount
- Opportunity for improved capital allocation and revenue growth
Activist investing is when an investment firm takes a stake in a company and attempts to influence the management and/or the Board of Directors. Investors can find companies with activist investors by searching through 13D filings or by looking at the Form 13F for well-known activist funds. When an activist investor targets a company, they usually push for one or more changes, including:
- Focusing the business on a core segment and spinning/divesting the remaining business
- Improving underperforming operations
- Changing capital allocation policies / corporate governance
- “Strategic Alternatives”
In each of these cases, the company’s operations and governance going forward could be much different than in the past. As a result, long-term investors can benefit from positive changes in the company.
Pursuing “Strategic Alternatives”
Pursuing ‘strategic alternatives’ is a phrase commonly used by a company when they put the business up for sale and hire an investment bank to find a buyer. Investors can make money if the market misprices either the probability of a sale or the value of the company to an acquirer.
Distressed investing refers to companies that are either in bankruptcy or have a high likelihood of going into bankruptcy. For long-term investors, there is an opportunity to invest as either part of this process or when the company emerges from bankruptcy. Typically, these types of investors look for situations where there is a “good business, but a bad balance sheet”. Recapitalizing the balance sheet can help reduce debt (or other liabilities such as pension, legal, environmental, etc.) to more manageable levels and allow the company’s equity/debt to be valued on fundamentals rather than bankruptcy risk.
Companies that undergo large restructurings usually have some problems with the business. This could include a bloated cost structure, inefficient distribution, low asset utilization, misaligned sales force, excess working capital, poor free cash flow conversion, or a number of other issues.
The catalyst for change in these situations could be a new management team or stakeholder in the company (a large minority shareholder such as an activist investor, private equity firm, industry peer, etc.). In these situations, there will be significant restructuring costs such as legal, consulting, severance, environmental, asset write-downs, etc. As a result, the company’s financial statements will not reflect the ‘steady-state’ operating profile of the company. Investors who do the fundamental work to understand the future economics of the business and ‘look through’ the current financials could have the opportunity to invest in the business at an attractive valuation.
Simply put, these types of special situations have characteristics that take significant time, effort, and skill to find and understand. Historical financials either don’t exist or are not indicative of the business’ value going forward. As a result, these types of investment opportunities can be overlooked because the companies don’t screen well and look unattractive on the surface.
Many investors may never find these companies until the ‘special situation event’ has passed or years later when the company has enough trading and financial history (balance sheet data, revenue, operating income, earnings, cash flow, etc.) that it begins to show up in stock screens.
The main downside of investing in some types of special situations is the tax implications from short-term capital gains and the constant need to find new opportunities as investments ‘play out’ (merger closes, company gets acquired, etc.). For instance, after a successful merger arbitrage trade, you must find another similar situation and do all the necessary due diligence that’s required to put on a trade all over again. Furthermore, this new situation may have very little overlap with the previous situation. As a result, you can’t continually utilize all your previous research for the next investment.
This means that investors don’t build up a knowledge base on a single company and management team that can be monetized over many years.
In these shorter-term types of special situations, the most valuable information (e.g. is the merger going to close or not?) only has a short timeframe for which it is relevant. Once the event “plays out”, the value of that information expires. On the other hand, the most valuable information in some special situations (quality of the business model, potential growth opportunities, industry structure, management team incentives/skill, etc.) can have a long timeframe for which it is relevant.
While not the case in every type of special situation, having to constantly generate new ideas by finding and analyzing a lot of new information each time is a huge downside.
Special situations represent attractive opportunities for fundamental investors. One of the main benefits is the prospect for positive total returns irrespective of the general stock market’s gyrations. This return can come from investing in an idiosyncratic, short-term situation, such as merger arbitrage or a buyout. Conversely, it can come from being a long-term investor in a business that happens to trade at an attractive valuation – which was created by the special situation. These longer-term opportunities include:
- Spin-Offs / Carve-Outs / Split-Offs
- Operational Restructuring
The main drawback of investing in some of the short-term focused special situations is the constant need to find new opportunities as the event that created the special situation “plays out”. This style of investing can be costly not only because it is time intensive and incurs short-term capital gains, but because it comes with a huge opportunity cost. Time spent finding new buyout candidates is time not spent finding an investment that can generate attractive returns for an extended period of time.
As a result, long-term investors should focus their efforts on areas where the special situation aspect creates the opportunity to purchase a good business at a cheap price. The characteristics of special situations which have the potential for generating attractive rates of returns over the long-term include an attractive business, a misunderstanding at the time of the event, and a talented an incentivized management team.
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