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Adverse conditions unlock opportunities for special situations

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Markets have relapsed since early May due to the unexpected return of policy uncertainty in most areas.

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Performance Risk Management 21

Markets have relapsed since early May due to the unexpected return of policy uncertainty in most areas. This has been particularly challenging for asset managers, leading the majority of them to move further onto the sidelines and lock year-to-date profits. In contrast, Special Situations have remained active buyers. All in all, US activists launched no less than 40 new campaigns since the start of Mr. Trump’s tweets. Details reveal interesting investing patterns.

First, they mostly targeted the more isolated mid and small caps segments. While the credit and governance quality of these companies appear weaker than in large caps, we find that the majority boast a favorable revenue and profit growth mix. Managers typically avoided riskier deep turnaround or distressed situations.

Second, managers concentrated on a selective set of industries —energy, industrials and consumer discretionary— while also focusing on companies with hard catalysts. In the energy industry, for example, the concentration of insufficiently profitable E&Ps remained dominant. One key theme in the consumer segment was the reshuffling of the media content industry, where the concentration in large caps is expected to extend to smaller players. In contrast, they were few additions in healthcare and technology, sectors which both face heavy political uncertainties.

Third, managers tended to focus on companies attractively priced relative to their large or small mainstream peers. While returns from these new positions have proved mixed so far, weak market conditions have unlocked more opportunities.

Fourth, the objective of each new campaign was increasingly related to a merger event. About half of these positions aimed at either blocking or improving the terms of a deal considered suboptimal, or accelerating a concentration move. The Anadarko deal in energy and the WellCare operation both fall into that category. Restructuring, changes to the board, or cost-cutting were secondary objectives.

Risk-off episodes usually take a toll on Special Situations performance, due to the strategy’s long structural market beta exposures (which are currently low to long-term averages). However, they historically tend to be more active in these periods as they look for appealing value opportunities. This time has been no exception.