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Alternative investments and special situation investing is good for portfolio diversification

Arun Malhotra October 28 | Updated on October 28, 2021

They differ slightly from direct equities and other conventional investment avenues

Alternative investments and special situation investments have become the new asset class for diversification. They differ slightly from direct equities and other conventional investment avenues. Special situation investing offers a niche and differentiated approach to a specific event that arises from corporate actions like spin-offs, mergers, demergers, buybacks, delistings.

For example, delisting is an event where the shareholders can get a much higher value than the prevailing market price as the promoters are eager to take the company private. These corporate events help unwind value. This approach is combined with fundamental research or “buffetology” to make sure the investment ticks on the basics of the traditional approach to investing.

Special situation investing has gained prominence across markets because it provides the flexibility to invest across the firm’s capital structure, either in secondary market debt or direct equity. It may also help gain control of companies in distress scenarios by investing in hybrid convertible structures.

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The investing framework requires a “situational event,” be it either merger, a demerger, or situational distress that may or may not be correlated to the macro environment and can happen at various points across the business cycles. All these situations have a catalyst that will help the investors realise the actual value of the company.

The research process involves identifying a company announcement that will bring a fundamental transition in the company’s fortunes and Indian equity markets to offer a plethora of such event-driven opportunities. It is worth mentioning here that a Special situation is a one-time event that will impact the company’s stock price.

I want to provide a few examples for investors to comprehend this better; let us take the example of an already announced demerger, where separate businesses that may be uncorrelated and may have different capital requirements get demerged and listed separately.

There is a high probability that a particular segment/business can get a higher multiple, in-line with other listed peers, leading to higher valuations of the combined entity after completing the merger process. The value unlocking happens because post the demerger capital allocation becomes clear from the company’s perspective. The sum of individual entities is much higher (not always, though) than the earlier consolidated entity. Best in case example is Piramal Enterprises, where the two businesses – financial services and pharmaceuticals are entirely unrelated and have different capital requirements.

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NBFC requires capital and funding for growth, while pharmaceuticals has a positive cash flow, and expansion is funded primarily through internal accruals. The same is the case with the conglomerate Reliance Industries that consists of three unrelated businesses (businesses that lack synergies) of oil & petrochemicals, telecom, and retail. A demerger of these businesses may lead to better focus and better capital allocation, while the three entities will also allow investors to choose their preferred businesses.

The reverse of the demerger is a reverse merger, where two companies are merged to extract synergies or reduce the holding company discount existing between two related entities. The undervaluation typically ranges from 20-70 per cent. A recent ongoing reverse merger is in the case of Equitas where the operational entity Equitas Small finance bank is getting reverse merged with the parent holding company Equitas Holdings Ltd, and this will remove the holding company discount (~30-40 per cent existing before this announcement) as well as remove the possibility of equity dilution on account of the mandated reduction in promoter holding for SFBs.

Another set of interesting situations have arisen from the redressal of NCLT cases. The NCLT resolution mechanism has thrown open many investible opportunities for Alternative funds and Special situation investors. NCLT resolution involves reducing debt and significant management changes that could transform the company’s business and earnings capability.

Also, ‘distress valuations’ is one common theme where both debt and equity investors are keen to participate across the firm’s capital structure as the business moves in the recovery phase of businesses & economic cycles.

The more significant advantage of these strategies is their low correlation to the general market movement. These scenarios and investible opportunities in the special situation space may not be correlated to the market returns in the medium to long term, hence providing the necessary diversification for the portfolios and higher returns.

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These events are available across all market caps, across economic cycles, and the beauty is that there is a low correlation to the market movements. The reduction in market risk happens because the pre-announced event more or less fixes the exit valuation and price while the stock-specific risk is taken care of by the underlying fundamental research.

In the US markets, the special situations or alternative investments are a big chunk of the whole asset management industry (roughly 28 per cent and upwards of $20 trillion). Many funds are dedicated to this segment to provide a diversified bet in the overall portfolio.

As explained above, the Special situation strategy performance will not depend entirely on the market beta but the progress of the events and regulatory approvals. In many such cases, the overall market valuation is at a significant discount to the realisable value. As the events progress, the valuations catch up with the increase in stock price, resulting in massive outperformance Vs the benchmark.

The main risk is the delay in regulatory approvals due to some unforeseen events or technical glitches that cause modifications in the original theme, reducing the IRR earned by the investors. Our experience tells us that Special situation investing helps attain superior returns with reduced risk and is a must for portfolio diversification for all investors.

(The author is Co Founder & CIO of CapGrow Capital Advisors)

Published on October 28, 2021

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