Corporate restructuring, corporate transactions, and other catalyst-based events in markets are often referred to as special situations.
There are many traders, investors, and other market participants who base a portion or all of their strategy on special situations.
We’ll cover the various types of special situations, which popularly include spin-offs and divestitures, share repurchases, security issuance or repurchase, asset sales, mergers and acquisitions (M&A), and other catalyst-oriented situations.
Special situations also exist outside of corporate finance and impact macro events.
On the securities side, in his popular book Security Analysis, Ben Graham divided special situations into six categories:
- Class A: Standard arbitrages, based on a reorganization, recapitalization, or merger plan
- Class B: Cash payout, in recapitalization or mergers
- Class C: Cash payments on sale or liquidation
- Class D: Litigated matters
- Class E: Public utility breakups
- Class F: Miscellaneous special situations
Special situations in financial markets
The following are the most common types of special situations.
Spin-offs and divestitures
Spin-offs are when a company separates a division or subsidiary into an independent company.
This is often done to unlock value that may be hidden within the larger company due to disparate businesses being lumped together.
For example, an oil and gas company might have a renewables division.
The oil and gas company might fetch a lower valuation multiple because of investor concerns about its long-term growth and viability and may have constraints to investing their capital in the entire company as a result.
By the same token, an investor might want the oil and gas business because they know the economics of the business and believe it’ll have a healthy profit margin, reliable dividend, and so on.
But they might not want the renewables business because it loses money and makes the overall investment less attractive.
On the other hand, the renewables division might get a good valuation in the markets as its own separate entity because of ESG flows and other benefits.
Whatever synergy an oil and gas business and renewables business have may be minimal and not worth keeping together to help them realize their own value.
So, as their own separate entities, the oil and gas investors can get what they want and the renewables investors can get what they want, getting more value separately than they can while combined.
Divestitures are when a company sells off all or part of a business unit.
A company might see its stock and credit get rewarded because it can use the cash on other things (dividends, R&D, capex, debt servicing, etc.), which may be better used than keeping it in a business that isn’t performing as well as the rest of the company, making it lighter and leaner with better margins and better return on invested capital.
Both of these special situations can offer investors an opportunity to buy shares at a discount to intrinsic value as the market may underappreciate the true worth of the spun-off or divested business.
When a company repurchases its own shares, it is reducing the number of outstanding shares, thereby increasing the ownership stake of each individual shareholder. It’s typically a tailwind for the stock.
This can be done via open market purchases, tender offers, or other methods.
Security issuance is when a company sells new shares or bonds to the public.
The proceeds from the sale are used to finance operations, expand the business, or pay down debt.
An asset sale is when a company sells off non-core assets in order to focus on its core businesses.
This special situation can offer investors an opportunity to buy shares at a discount as the market may undervalue the intrinsic worth of the company’s remaining assets.
Mergers and acquisitions
A merger is when two companies combine to form a single entity.
An acquisition is when one company buys another company.
When companies merge, the goal is that they’ll unlock value either through synergy on the revenue side (cross-selling products, becoming better integrated) or by helping to cut costs (i.e., they only need one sales team or HR team rather than two).
During an acquisition, the acquiring company often goes down in value because a lot of the time the market believes they’re overpaying or taking a temporary hit.
It takes a “control premium” to take over a company, which means overpaying for it relative to what the market thinks it is worth now.
Whereas the company being purchased (the so-called target company) typically sees a rise in value because of this control premium and the other acquirer paying more than its believed to be currently worth.
Other catalyst-oriented situations
There are many other special situations that can offer investors an opportunity to buy shares at a discount, including bankruptcies, restructurings, equity rights offerings, and more.
These situations often involve some kind of catalyst that will trigger a revaluation of the company’s shares or credit.
Special situations in macro
These are special situations that don’t necessarily involve a company, but rather an event. Special situations also exist in the macro market.
For example, some traders might believe the chances of a geopolitical conflict are priced too low into a market and go long oil (if it were to have implications for the commodity).
Or they might believe a country is about to get sanctioned by major powers and short its currency.
To trade special situations successfully, you need to have an edge.
How do traders and investors profit from special situations?
There are many ways to profit from special situations.
The easiest way is for traders and investors to take a position in the shares of the company that is undergoing the special situation.
For example, in an M&A deal, a company that is being acquired will typically see its shares go up and trade close – but not at – the buyout price.
For example, a company might trade at $40 before the buyout and see a proposed buyout offer for it at $50 per share, a 25 percent premium.
If the market finds the offer credible, it will trade at close to $50, but not quite.
This is because market participants will take into consideration that the deal could fall apart and because $50 is probably the ceiling for the shares given that’s what shareholders will be paid if the deal closes.
The stock might trade at $49.25, or cover 92.5 percent of the range of the pre-proposal and after-proposal price, leaving a remaining premium of ($50/$49.25 = 1.5 percent).
If the deal is expected to close in three months, then that 1.5 percent premium is 6.2 percent annualized, which is a fairly typical figure for deals that have a high probability of going through.
If the deal falls apart, traders and investors long the shares can lose a decent amount. Those long the shares will profit if the deal closes.
Moreover, sometimes a better offer may come along and beat the current offer, which means those long the stock can profit even more if the new offer is also credible and ultimately closes.
Other traders use special situations as an opportunity to arbitrage the market.
By and large, traders need a deep understanding of how a special situation or catalyst can impact prices by having knowledge of the investment and special event(s) related to it.
Merger arbitrage is a popular type of special situations strategy.
In merger arb, you commonly take:
- a long position in the shares of the company that is being acquired (because they’re being acquired at a premium) and
- a short position in the shares of the company that is acquiring (because the market typically believes they’re overpaying and they’ll have advisory fees, extra debt, interest on the debt, shares issuance, and so on)
For all the talk about synergies, they can be difficult to achieve in practice.
If the merger goes through as planned and you’re short the acquirer and long the target, you will make money on your positions.
If the merger falls apart, the opposite will happen.
Trading special situations is like other forms of trading where an edge is needed in one way or another.
This could be access to information, analytical skills, or some other kind of advantage that allows you to make better-than-average predictions about how the market will react to a special situation.
It’s also important to have a clear exit strategy before entering into a special situation trade.
You should know when you’re going to take profits and cut losses.
With proper risk management, special situations can be a great way to generate alpha in a portfolio.