Hedge funds can be broadly classified into three categories:
1) Relative Value
In event-driven hedge funds, managers look for stocks trading at discounts due to unusual circumstances. Such circumstances can include merger arbitrage, distressed securities, and private placements.
Here's an example of merger arbitrage. Let's say Blockbuster and Circuit City agree on a buyout whereby each share of Circuit City would receive 1 Blockbuster share. But Circuit City's price only jumps to $9, while Blockbuster's shares trade for $10. A merger arbitrageur might buy Circuit City shares, and short Blockbuster shares, hoping to profit from the eventual convergence of these values.
We've discussed action on distressed securities here.
Private placements are allow securities to be sold through private buyers rather than public offerings. In this way, companies can receive funding or help their owners get paid out, while avoiding the costs and rigour of having to go public. As such, these companies are sold at a discount to what they would sell on the public market.