Corporate control on the cheap?

A couple of years ago, I got into the guts of the Melrose Industries hostile takeover of GKN. This deal squeaked through, despite it being opposed by GKN employees.

The bit of it that particularly interested me was the role of hedge funds doing the merger arbitrage trade, which ended up influencing a major part of GKN's shares (and simultaneously shorting Melrose). I say 'influencing' as the overwhelming majority of the funds' exposure to GKN was through derivatives, rather than ownership of its shares. 

My understanding of how this corner world works is that hedge funds utilise equity derivatives primarily because they are cheap. It costs a lot of money to buy 1% of a PLC, and if a hedge fund with a few billion under management went out and bought the shares it would represent both a big expenditure and a very significant position. So using CFDs or swaps enables them to gain exposure to movement in the target's shares without having to pay to own the underlying asset. They obviously pay for the derivative itself, but that's a fraction of the cost of the underlying equity.

As I blogged previously about GKN, my understanding is that, as the counter parties to the derivatives, investment banks end up holding shares. Again, no problem in principle, and everyone is clear that it is the hedge funds which have the economic interest in the shares even if they don't own them. If the hedge funds have long derivatives they make money if the shares go up and lose it if they go down. That in turn means that if the bid fails they lose money, so holders of long derivatives obviously want the bid to succeed (or look to be set to do so - if they got in early they could take profits before the outcome is decided I suppose).

In a hostile bid the bidder essentially makes an offer over the heads of the incumbent management of the target to the company's shareholders. Those shareholders in turn have to decide by a set deadline whether or not to accept that offer. If you're a shareholder you can accept that offer or not (and the management of the target will be telling you to ignore it) and if you're not a shareholder you can't. And by extension, if you hold derivatives, not shares, you're not a shareholder. So you can't respond to the bid. 

So far so simple. But what if you're an investment bank that holds the shares as a counterparty to a derivative holder? You do hold the shares, but only because of the derivatives. How do you decide how to respond? Pure survival instinct is surely going to tip you to support the bid because you know that your valuable hedge fund client is going to lose money if the bid looks like it might fail. It is possible, even, that the derivative is written in a way that stipulates this, though I simply do not know if this is the case or not.

My issue is that this may mean that de facto those holding derivatives are able to exercise influence on the outcome of bid equivalent to that of an investor holding equity. If so this is influencing what we used to call the market for corporate control on the cheap. It doesn't feel right to me that investors whose only interest is in an instrument that mirrors the share price, and its appreciation during the limited timeframe of the process a bid, should be able to influence the ownership of major employers.

I could be off-target on some of this so would welcome any corrections etc from anyone who knows this area better than I do. I will keep private just email if you don't want to comment on here. (I'd also be interested to find out how much gaining an exposure of say 1% via derivatives actually costs vs buying the shares.) But I think I do have the outlines broadly right. If so, I think this ought to attract more attention than it does currently. 

PS. Given that a change in ownership is absolutely fundamental to a company's future this is very obviously a significant stewardship issue. Yet, as I've blogged before, a number of the funds active in the merger arbitrage market do not adhere to the Stewardship Code.

Shire takeover & derivatives

So the takeover of Shire PLC by Takeda Pharma has been completed. I thought I'd have a quick look for merger arbitrage plays in the filings.

A few familiar names in the list below. Most of these investors are listed as having an interest (presumably short) in Takeda too and I've found a couple of examples:

Millennium - 0.68% in shares, 2.28% in derivatives
York Capital - 1.51% in derivatives
Marshall Wace - 0.3% in shares, 0.7% in derivatives
DE Shaw - 0.54% in shares, 1.07% in derivatives (Takeda short here)
Davidson Kempner - 1.39% in shares
UBS O Connor - 1.03% in derivatives
HBK Investments - 0.17% in shares, 3.08% in derivatives
Elliott - 0.0002% [chuckle] in shares, 1.28% in derivatives (Takeda short here)

This is just from a quick Google. Final positions may have been high/lower. But doesn't take long to get to 10%+ interest through derivatives.

Hedge funds and Sky

I thought I'd have another quick look at hedge fund activity around the bidding war for Sky PLC. This looks like it could be quite a profitable trade (especially after several got burnt on Qualcomm / NXP).

As before, some old favourites are in the list. One point of interest is that alongside their derivative positions, some of these funds also have very small holdings in Sky shares. I wonder why this is - maybe to give them some legal rights, or so they can legitimately call themselves "shareholders"? If anyone has any thoughts let me know.

Anyhow, here's why I can see from section 8.3 disclosures -

Elliott Capital Advisors - 4.31% derivatives, 0.0044% shares

Davidson Kempner - 3.07% derivatives, 0.00006% shares

Farallon Capital - 2.3% derivatives, no shares

Canyon Capital - 1.9% derivatives, no shares

UBS O' Connor - 1.3% derivatives, no shares

Pentwater Capital - 0.99% derivatives, 1 (one) share

So that's 13.8% in derivatives in total across these six funds - up from 12.5% accounted for by the same group of funds at the start of the month, though Pentwater has almost cut its position in half.

NEX Group takeover & derivatives

Another takeover, another example of hedge funds piling in using derivatives. In this case its NEX Group, which is being taken over by US-listed CME Group. It's not hostile so it went to a vote and got a strong thumbs up.

I find this one interesting as it's another example of hedge funds running the merger arbitrage trade, albeit in uncontested circumstances. This is classic 'picking up pennies in front of a steamroller' behaviour. They are taking a punt on being to skim a bit off expected price movements (upwards in the target, downwards in the bidder). As far as I can see no-one claims there is any kind of market inefficiency that this behaviour is ironing out.

Anyhow, here's who is in the mix using derivatives, based on a quick trawl of rule 8.3 disclosures.

York Capital  (also active in GKN/Melrose) with 4.63%

Magnetar Capital - 1.2%

Carlson Capital - 1.95%

Omni Partners - 1.13%

TIG Partners - 1.27%

UBS O' Connor - 1.02%

PSquared - 1.9%

Sand Grove - 1.61%

Alpine Associates - 1.5%

More hedge fund shenanigans

1. I had a quick Google to see if there are any more funds that use the generic blurb I've found in dozens of cases to avoid compliance with the Stewardship Code. And... yes there are.

Curam Capital Management:

Curam Capital Management LLP (the "Firm") provides investment management services to a Fund that pursues a global equity approach with a focus on the healthcare sector. If the Firm were to invest directly in UK single equities these would represent only a small part of the Firm's business. Hence, while the Firm generally supports the objectives that underlie the Code, the Firm has chosen not to commit to the Code. The approach of the Firm in relation to engagement with issuers and their management is determined globally. The Firm takes a consistent approach to engagement with issuers and their management in all of the jurisdictions in which it invests and, consequently, does not consider it appropriate to commit to any particular voluntary code of practice relating to any individual jurisdiction. 

Cryder Capital

The Firm provides investment management services to a Fund (“the Fund”) that pursues an investment strategy that involve investing in a wide range of securities and instruments without limitation in various jurisdictions. If the Firm were to invest directly in UK single equities these would represent only a small part of the firm’s business. Hence, while the Firm generally supports the objectives that underlie the Code, the Firm has chosen not to commit to the Code. The approach of the Firm in relation to engagement with issuers and their management is determined globally. The Firm takes a consistent approach to engagement with issuers and their management in all of the jurisdictions in which it invests and, consequently, does not consider it appropriate to commit to any particular voluntary code of practice relating to any individual jurisdiction.

Tencendur Capital

When the Firm does invest directly in UK single equities these would represent only a small part of the Firm’s business. Hence, while the Firm generally supports the objectives that underlie the Code, the Firm has chosen not to commit to the Code. The approach of the Firm in relation to engagement with issuers and their management is determined globally. The Firm takes a consistent approach to engagement with issuers and their management in all of the jurisdictions in which it invests and, consequently, does not consider it appropriate to commit to any particular voluntary code of practice relating to any individual jurisdiction. 


2. In addition to Inmarsat, there is also some interesting hedge fund action around the Sky takeover. Again we can see some funds piling in using derivatives to build positions of influence.

So there's Pentwater Capital with 1.92% in derivatives.

UBS O' Connor (their hedge fund business) with 1.17%.

Our old mates Elliott with 3.73%.

Farallon Capital - 1.87%

Canyon Capital - 1.8%

And another old fave Davidson Kempner with 2.16%

That's about 12.5% just on a quick trawl. Worth keeping an eye on.

Inmarsat: in come the hedge funds

At the back end of last week the UK-listed telecoms business Inmarsat revealed that it has been approached by US-listed Echostar Corporation about a potential takeover, which it knocked back.

As a result of the offer, a different regulatory disclosure regime kicks in, which means that we can see all sorts of detail on which investors are doing what. And, as you might expect, we can already see some hedge funds piling in with fairly sizeable positions.

For example, Marshall Wace:

And Pelham:

As you can see from the disclosures, the long positions these funds have taken have been built up using derivatives rather than by buying shares. This shouldn't be any surprise to anyone who followed the detail of the GKN/Melrose bid. And obviously this will be a bloc of investors that will want Inmarsat to be taken over.

It also means that we should expect to see banks emerge as major shareholders on the Inmarsat shareholder register as they build up holdings as counterparts to these derivative positions. Plus we will probably see a notable short position in Echostar emerge.

Finally, here is a quick look at who the major shareholders (1%+) at the moment, data from Capital IQ.

UPDATE: for completeness it's worth noting that a few investors are actually short Inmarsat. So worth keeping an eye on this too. Latest from FCA disclosure below.

Derivatives, influence, tax, policy etc

One of the things that was left hanging after the Melrose/GKN bid was the nature of the relationship between hedge funds and similar investors and their counter parties, and how this plays out during bid situations.

When I watched Greg Clark defending his own inaction in relation to the bid in parliament last week, and some of the questions / comments he received in response, it was clear that a lot of the technical detail was still confused. For example, Clark talked about hedge fund acquiring shares from long-term holders, where as in reality most never held shares. And there was talk too of a "vote" of GKN shareholders to accept the deal, which did not happen.

This stuff is important, because it also affects how much tax is paid. There was a good piece in Lex at the end of March. The key bit is below:

The broader advantage of prime brokers is that they are exempt from stamp duty. This means clients can generally buy and sell shares tax-free at arm’s length. If they vote the shares, they could crystallise a liability. Experts say the danger of that is less in a hostile bid, where investors show support by tendering shares to the bidder. However, critics of the Melrose bid are likely to resent tax breaks for hedge funds. 

So, if you're a hedge fund holding CFDs in a target that is the subject of hostile bid resulting in an offer to shareholders (but not a vote) it doesn't look like you get hit with tax if things go to plan.

The interesting question for me is whether the counterparty responds to the bid, and in a way that aligns with the interests of its client? I think that is likely - and as as reminder here is what the Takeover Panel said on this point a few years back:

a counterparty will usually know the derivative investor’s likely wishes and therefore it would be naïve 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

This points to an interesting policy question. As I understand it, CFD holders incur tax when they have voting rights to tackle the problem of them acting like shareholders, but on the cheap (on this point there's a good FT piece, a bit old, on Elliott's tilt at BHP here). But surely the decision to sell a company (despite the wishes of its management) is even more important than the right to vote? Why on earth would we let this happen, and in a tax-advantaged way?

If counter parties are tendering shares by reference to the clients' wishes I would suggest that this is an easy target for Labour. It should be the case that only those who both hold shares and have the economic interest in them should be able to respond to a bid. In addition, we could increase the tax paid on CFDs and other instruments that allow access to voting rights in order that they are less attractive than holding shares.

This in turn suggests other policy interventions. A lot of this stuff couldn't happen without a load of stock lending going on. So why doesn't Labour commit to introduce a stock-lending register, hosted by the FCA? This would provide the names of lenders in a given stock above a certain ownership threshold (say 0.1%). This would enable us to see if, for example, asset managers are lending stock belonging to the sponsor of a corporate pension scheme that is being used to short the same company.

In addition there should be transparency around who gets what when stock is lent. After all, it is the property of the client (pension fund or whatever else) so let's have a look at how much the client and manager take respectively from the lending fee. This info must be captured already, so let's get it into the public domain.

Finally Labour could also ensure that the Stewardship Code is rewritten to require section on M&A and related activity. It's seems odd in retrospect that it doesn't feature when this has a major impact on the companies concerned. The guidance could include that asset managers must actively consult clients on bids (again there could be a threshold). For example, I suspect there will be one or two out there who were surprised that their manager backed Melrose in the GKN bid. So the onus should be on the manager to consult.

So there are quite a few potential policy angles on this one. And this is before we start talking about a public interest test...

PS. Judging from the feedback I've had over the past couple of months, it is striking how much companies and some key groups within them hate the behaviour of many hedge funds and activists. Even where they accept the nature the takeover regime in general, there is clearly a view that some of these funds bend the rules. I think a proper overhaul of this stuff would actually be seen as a good thing by some players that are not natural Labour supporters.

Merger arbitrage in practice: Sand Grove Capital

Given the renewed interest in financial market activity around mergers and acquisitions, I thought it might be interesting to have a look at the regulatory disclosures for one of the funds that has caught my eye lately.

I hadn't heard of Sand Grove Capital until recently, but it ended up taking a sizeable (almost 3% at one point) short position in Melrose Industries in the run-up to the acceptance of its bid for GKN.

Here it is at play in the bid - long GKN 1.27% using CFDs on 12th March and short Melrose 2.09% also using CFDs on 14th March.

There's a similar story in the GVC/Ladbrokes takeover. Here is Sand Grove long Ladbrokes 2.1% on 19th March using CFDs and short GVC 1.87% also using CFDs on the same day. 

And we see the same thing with Tesco/Booker. Here is Sand Grove long Booker 1.17% using CFDs on 7 Feb and short Tesco 0.22% using CFDs on 8 Feb.

And here are a few more examples of Sand Grove's position in UK PLC that are/were potential or actual takeover targets - Fenner (long 3.63% using CFDs, 5 April), Fidessa (long 1.39% using CFDs, 18 April), Sportech (long 8.91% using CFDs, 8 January), Sevelec (long 3.17% using CFDs, Nov 2017) and Brammer (long 4.67% using CFDs, Dec 2016).

Obviously, their main approach is to gain exposure through derivatives. On a quick search I could only find one disclosure - in respect of Revolution Bars - where there was an actual shareholding. This was reduced later, according to reports, when a takeover was rebuffed.

Stewardship

What I couldn't see on the Sand Grove Capital website was a a Stewardship Code statement. Just as a reminder, the FCA Conduct of Business rules say:

A firm, other than a venture capital firm, which is managing investments for a professional client that is not a natural person must disclose clearly on its website, or if it does not have a website in another accessible form:

1. (1) 
   the nature of its commitment to the Financial Reporting Council’s Stewardship Code; or

1. (2) 
   where it does not commit to the Code, its alternative investment strategy.

I can't see a statement on the website, but, weirdly, you can access a statement via this site which does third party hosting for regulatory disclosures. The Sand Grove statement is here. If you can't be bothered read it, here's the key bit:

The Firm manages event-driven strategies involving a variety of asset classes, global jurisdictions and timeframes, and approaches companies and their managements on a case-by-case basis. Therefore, while the Firm supports the principles of the Code, it does not consider it appropriate to conform to the Code at this time. 

If you stick the second sentence into Google you get a few other hits for hedge funds that coincidentally came up with the same set of words. Spooky.

No, Elliott is not Whitbread's largest shareholder

With the Melrose bid for GKN almost complete, our old friends Elliott are back in the news again, this time targeting Whitbread, where it looks like they will be pushing for Costa to be spun off. Cue lots of headlines, many of them identifying Elliott's stake making it Whitbread's "largest shareholder".

Well, now, you see, actually, err.... no.

If you read Elliott's statement carefully, that's not quite what they say. What they actually say is that they have "an economic interest in excess of 6% of the Company". They do not say they hold 6% of Whitbread shares.

There's a very good reason for this - they actually hold 0.01% of Whitbread shares. Here is the RNS statement that shows that they hold just 18,707 shares, but they also have a load of CFDs. Notably Elliott has secured voting rights, so in practice they are going to have real power.

But they are not Whitbread's largest shareholder or anything close to it. And we are doing Elliott's PR work for them if we erroneously describe them as such.

PS - Jim Moore has a good piece on the way that passive institutions allow firms like Elliott to do their thing.