Friday, 13 April 2018

IEA report on GKN/Melrose / old Takeover Panel comments

The Institute of Economic Affairs has stuck a report out today on the Melrose bid for GKN. Very broadly it says that there is nothing to get worked up about. Most importantly, a headline message is "leave it to the shareholders"

Interestingly, the report doesn't really look at how the bid got over the line as a technical process. I think this is important, because when you get into the detail it reveals quite a lot that suggesting that this is just about "shareholders" deciding doesn't really clarify.

For example, the report talks about a "vote" on the deal. Yet there was only a vote by Melrose shareholders to authorise the bid, GKN shareholders did not vote. If they had voted that would have raised its own questions, but because GKN shareholders had to accept the Melrose offer or not the dynamics were different.

Also the report does not distinguish between shareholders and other investors, and in particular does not look at how the hedge funds operate. For example:
This brings us to the third type of objection that the takeover has been decided by shareholders – including ‘rapacious hedge funds’ – who just want to make a quick profit regardless of the long-term implications for the business, let alone for the wider economy. This argument doesn’t stack up either. ....It seems odd to complain about ‘rapacious hedge funds’ making a quick profit if they do so by selling back to ‘long-term investors’, especially as they had presumably bought from ‘long-term investors’ who had lost faith in GKN’s management. 

To reiterate, the merger arb funds were largely not shareholders, they held derivatives (primarily CFDs as far as I can see) linked to shares. Hence I do not think they could "accept" the deal themselves, rather the counterparty (a bank) would have done this. Again, if you look at Elliott's carefully-worded statement about the bid it talks about having an "economic interest" in GKN shares, not holding shares, and says it will "support" rather rather "accept" the bid.

The hedge funds by and large don't seem to have bought shares from long-term holders, and so won't be selling back to them either. They built up derivative exposure with the help of banks (who did presumably buy the shares off institutions).

If the IEA does not think the hedge funds were out for a quick buck, let's keep an eye on hedge fund exposure to both companies once the deal is done. What we can see, even since the result was announced, is a further surge in the short position in Melrose on the part of some who are/were also long GKN through derivatives. The publicly disclosed short positions (0.5% and up in the FCA list) are now nearly at 17%. IHS Markit reckons one third of Melrose shares are on loan.

That does not look like a bet on the long-term success of Melrose to me. Rather it looks like an inherently short-term trade intended to take advantage of an expected drop in the share price when it has to cough up for GKN. Exactly what greater purpose this serves I am unclear, but then Adam Smith's hand is invisible.

As to the actual mechanics of how bids work when there is a lot of derivative action, I found this old Takeover Panel paper which sought to deal with these sorts of issues. I've dug out a couple of bits of commentary on what actually happens (some of this was in response to claims that derivative holders don't really have an influence.
First, the Code Committee believes that, notwithstanding the contractual arrangements between them, a counterparty will usually know the derivative investor’s likely wishes and therefore it would be na├»ve to assume that the counterparty (who has no economic interest in any hedge securities it holds but who does have an ongoing client relationship with the investor) will act without having some regard to those wishes. In addition, as indicated in paragraph 3.3 of PCP 2005/1, the Code Committee understands that it is frequently the expectation of a long derivative investor, notwithstanding the terms of the documentation, that his counterparty will ensure that the securities to which the derivative is referenced are available to be voted by the counterparty and/or sold to the investor on closing out the contract. If the counterparty does not hold any such securities (because, for example, its book is balanced by an offsetting short derivative), the investor would normally expect the counterparty to acquire the necessary securities, even if that resulted in a cost to the counterparty.…..the Panel continues to encounter situations where holders of long derivative positions behave as if they were shareholders and, more importantly, situations where investment bank counterparties enquire of investors with long derivative positions as to their preferences in terms of bid outcomes in order that the counterparties may take those preferences into account;
This is pretty much how I thought things work (NB it's an old paper, so perhaps practice has changed a bit). Essentially the huge funds act like shareholders even when they are not, and expect counter parties to help them, perhaps even when this isn't actually in the contract. Now again, you can argue that none of this really matters, and many "free market" types would. But it certainly makes the argument about "leaving it to the shareholders" more complicated. Do we mean "leave it to the counterparties"?

Equally folks on the Left could argue that to the extent that we do leave it shareholders to determine bid outcomes, those "shareholders" should be people who both hold shares and have an economic interest in them (i.e. only having one or the other means you don't qualify).  

No comments: