Sunday, 18 February 2018

Melrose / GKN bid arbitrage: like flies round...

The Melrose bid for GKN is currently subject to a lot of scrutiny, and is actively being campaigned against by Unite.

What hasn't attracted much scrutiny so far (as far as I am aware) is the extent of speculative activity that is occurring, and as such is affecting the share ownership of both companies involved in the bid. As many people are probably aware, M&A has become quite fertile territory for "event driven" hedge funds, who look to skim off value based on their expectations of how deals usually play out.

Very simply, when there is a bid it is typical for shares in the acquirer to under perform (this could reflect the cost of the acquisition, but perhaps also expectations about how it will play out). On the other side, obviously shares in the target are pushed up when the likely offer is known, but may not totally capture the premium to the pre-bid price because of uncertainty as to whether the bid will be successful. So you will often find some investors are on both sides of the bid - short the acquirer, long the target.

This is happening with Melrose / GKN. The disclosed short interest in Melrose is now over 10%.

To be honest, I've never really followed these trades closely, so I don't know if having 10% of your shares shorted is particularly out of the ordinary. But it does represent a substantial chunk of money that has an interest in the bid going ahead, and being value destructive for Melrose.

Of those that are shorting Melrose, I can already see two investors - AQR and Blackrock - that are also long in GKN (for completeness, Blackrock will also be long Melrose via index funds etc).

Meanwhile, we can also see the impact on the GKN share register. Just in the past few days both Merrill Lynch (Bank of America) and HSBC have disclosed holdings in the company of over 5% (HSBC now has over 6%). When you dig into the detail you can see two things. First, the large majority of this does not NOT relate to traditional asset management (in HSBCs case, it is very clear it is primarily the bank). Secondly, much of the holding in both cases is accounted for by equity swaps.

That means that there are other counter parties out there with an economic interest in the performance of GKN shares, but who have chosen not to (or were not able to) acquire shares. Quite possibly there are counter parties to those swaps that are shorting Melrose. And again we are talking quite a big proportion of GKN's ownership - over 11% - being tied up in these two positions alone.

There are a couple of things that interest me here. First, how do Merrill Lynch and HSBC decide how to respond to the bid? Have they ceded that decision to the counter parties? If so the future of GKN would in part be decided by investors that we can't even see. If not what is the basis of their own decision, and in whose interests is it taken?

Second, it does seem to demonstrate just how far modern capital market activities are away from any notion of "ownership" or "stewardship". A large proportion of the share ownership of both companies is accounted for by investors whose primary interest is in the event of the bid, rather than the future of the companies concerned.

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