Friday 30 March 2018

GKN takeover - losing the battle, winning the war

Few things have made me as angry recently as the Melrose takeover bid for GKN. This bid was opposed by a very wide group - workers, unions, GKN customers, Labour, some Tories, the Daily Mail, most of the large long-term GKN shareholders - yet it got over the line because of the support for merger arbitrage funds (or "arbs" as they are known in the City).

I think the labour movement can learn a lot of lessons from GKN, and see this as an area where we can do some fruitful work. If we don't want hedge funds to prevail we have to figure out how to beat them. So here are some of my thoughts.

Two killer facts: the arbs won it, and most arbs were not shareholders 

It's important to be absolutely clear about two things when looking at the Brexit-shaped 52% result in favour of the bid. First, Melrose could not have won without the arbs. Second, many of the arbs were not shareholders. I say we need to be clear about these things, because a lot of the reporting of this bid has failed to grasp these important facts.

On the first point, if hedge funds accounted for 20% to 30% of the control of GKN shares, then this accounts for about 40% to 60% of the support for Melrose. In this bid, compared to other cases, they were not bit players they were absolutely central to Melrose's victory. To repeat: Melrose could not have won without them. They may not even have come close. Melrose was expecting these funds to support it, but I doubt they had an inkling of how much they would need that support (remember they initially set the acceptance level at 90%!). This from the FT today makes the point:

Incidentally, that means that GKN's FD was correct in his claim last weekend (which GKN had to retract on Monday) that the company had the support of most long-only shareholders. Assuming that the figures for hedge fund control of GKN shares are about right - GKN likely had the support of around two thirds of the remainder of the shareholder base.

The second point is just as important. Most of the arbs were not shareholders. When Elliott announced its support for Melrose last Friday this was reported far and wide as backing from GKN's "second largest shareholder". (I believe it was briefed to City journos by Melrose's PR firm in these terms, more below). But as I blogged previously Elliott isn't a shareholder, it holds contracts for difference (CFDs). The same goes for hedge funds like Och Ziff, Sand GroveDavidson Kempner, MelqartMan Group (actually a mix of shares and CFDs in the last case, but more of the latter). The disclosed CFD positions for Elliott and those other five investors alone is over 9.5%. (PS here's an example of what it looks like when an investor does hold shares - they fill in a different part of the box on the form.)

Still not convinced? Look at GKN's list of major shareholders which lists holders with 3%+. Elliot's position was 3.84%, so where is it?

No Elliott, but getting on for 16% held by two US banks. In fact, the big positions in GKN shares held by the banks was one of the things that first revealed that hedge funds were swarming in. The banks are the counter parties that facilitate what the hedge funds do, and it is they, not the hedge funds, that hold the GKN shares. There was a good Lex piece about this earlier in the week but it is paywalled. 

So it's simply not correct that many of the arbs were "shareholders". Their exposure was via derivatives. When I posted a link to Elliott's disclosure on Linkedin and highlighted the fact its interest was through CFDs it got the most traffic of anything I've ever posted on there, and prompted some interesting comments. As mentioned above, I believe that Montfort, the PR firm advising Melrose, briefed journos about Elliot's support for the bid describing them as GKN's second largest shareholder, even though they don't own shares. There is a question in my mind as to whether this counts as an unverified claim of support, though perhaps I'm splitting hairs.

Why does any of this matter? Put it together - Melrose wouldn't have won without the arbs, and many of the arbs didn't hold shares. So bid was forced through by investors who didn't even hold shares. That is pretty shocking, but the point hasn't really been made effectively in much of the bid coverage.

Outstanding questions about CFDs

The fact that most people kept describing the arbs as "shareholders" showed that little attention was being paid to the detail of the bid. A question that still hasn't been answered as far as I am aware is how the arbs actually related to the bid.

The offer that Melrose made was to GKN shareholders, but, as described above, Elliott et al are not shareholders. So does that mean that Goldmans etc tender their shares by reference to what the arbs wanted to do? I'm guessing that they do but we really need to bottom this out.

Another question that has come up is whether the CFDs enable the hedge funds to vote. Voting rights aren't an integral part of CFDs, but I have been told by a couple of people that hedge funds can and do gain these when they want to. Basically the contract with the counterparty can be written how you want it.

But in any case in this bid it didn't matter because there wasn't a vote - shareholders had to respond to the offer or not. Hence the Melrose statement talks about "acceptances" not votes. This is something I hadn't really grasped. And actually the hedge funds and their bank allies didn't want a vote as it crystallises a tax liability. Here's Lex:
These hedgies, or “merger arbs”, have converged on Goldman, BofA and Deutsche because they are not advising GKN or quoted private equity group Melrose. The theory is that these neutral “prime brokers” can tender collateral shares held on clients’ behalf with fewer conflicts of interest. 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.
When there is a look at takeover rules as a result of this bid this is an area that needs real scrutiny. Should we really allow investors without shares, who hold derivatives because it's tax efficient, to affect the outcome of bids? I need a lot convincing that the answer to this is "yes".

The short part of the bid

Lots of people, me included, have learnt a lot more about hedge funds and the merger arbitrage business as a result of this bid. This is an inherently good thing. Union staff and MPs who a few weeks ago wouldn't even of heard of merger arbitrage now know the basics of how it works, and who the main players are. The shorting aspect of it has attracted quite a bit of interest. 

It's worth stating that the arb trade around this bid was massive. If these funds had an influence over 20% to 30% of GKN shares, they would be shorting Melrose to the same extent. We could see in the FCA list (which shows shorts of 0.5% and up) that reported shorts hit 13.5% at one point. IHS Markit, which gets a lot more data, said the total level was over 20% according to City AM.

A union friend introduced me to the 'days to cover' calculation. I worked out based on average daily volume that at the low end of the possible total shorts (the total on the FCA list) the result would have been almost 12 days. At the top end - the IHS Market number - the result would have been closer to 24 days. That would have been a lot of money trying to close out short positions quickly if the bid had failed.

There's nothing illegal about shorting but to does drive home what the arbs are really about. It's an inherently short-termist business, and their interest is only in the dynamics of the bid, and how it affects the prices of the acquirer and the target's shares, not the companies themselves. Betting against the company whose bid you are actively working to assist is the sort of thing that bamboozles the public and makes them think that much of the City doesn't give a toss about anything other than money. And they're right.


To state the obvious, these funds don't care about "stewardship". Several of the funds that had big long/short positions were in the list that I compiled at the ITF of duplicate statements of non-compliance with the Stewardship Code. Again, I find incredible that funds that can determine the future of a major engineering business can get away with just putting a few sentences of copied text on their website. In our response to the FRC in addition to providing the list of duplicate statements we also recommended that the Code be expanded to capture activity around bids:

After the experience of GKN, I think we are going to need to do a lot more. I'll be following up the duplicate Code statements with regulators, but I don't see why we shouldn't ask any funds involved in merger arbitrage to make a public statement about how they do it (i.e. shares or derivatives, is it a long/short combination etc), the typical duration of their interest and so on. But really any asset manager should make clear how they approach M&A.

And what about other shareholders (actual shareholders!) in this bid? It was striking that many big investors did not get off the fence, in public. For example, the FT suggests that LGIM supported Melrose, but I haven't seen any public statement to confirm this:

We know how a few of the other shareholders went - Aviva for the bid, Columbia Threadneedle, Jupiter, Royal London etc against - but there are loads that never went public, including some of the really big ones.

Shouldn't we expect that major shareholders make their intentions known, so that clients can override them if necessary? I don't know if asset managers typically tell clients in advance how they intend to respond to takeover bids, but they ought to. I bet some clients would not want to have their shares put up in support.  

This taps into the bigger question about the extent to which investors should be public about their stewardship/engagement activity. Very big issues were raised in this bid, lots of people are concerned about it. Why should it be acceptable that the group that plays such a major role - asset managers in control of other people's money - is allowed to treat it as a private decision?


It is inevitable that there will be pressure to overhaul the takeover rules as a result of the GKN result. This is why I think Melrose winning on such a narrow margin is actually the worst outcome possible for the arbs. 

You can see some obvious technical tweaks that could be used to tighten up the system:
  • Don't let any investors that does not have shares respond to / vote on any bid.
  • Have a qualifying period to vote - you have to be on the register before the bid is announced.
  • Increase the acceptance threshold. Why not make it a supermajority of 75% like a special resolution? After all this is the most fundamental decision shareholders typically have to make.
But more generally, I think it is very likely that interest will be revived in a public interest test for takeovers. This point has already been made by Jim Moore on the Indy. The FT also anticipates it:

So let's start working on what it would look like. LFIG and Policy Network already had a go so someone has already done some thinking. This needs to be turned into practical proposals that MPs can push.

Let's clip those hedges

A final point - it's time to go on the offensive. The hedge funds won this time, but it doesn't have to be this way. Let's start to challenge them - both how they operate in the market, and the influence they have more widely. Look at the money they poured into the Brexit campaign, or that they pour into the Tories' coffers

At the very least we should seeking to stop our pension funds from giving them any money. We should also push back on their political influence. There is a model for this. In the US labour and other groups formed the excellent Hedge Clippers campaign group. There is nothing to stop us forming something similar in the UK.

I hope that the Melrose bid for GKN can be overturned, and yesterday's result was much tighter than anyone expected at the start of the bid. But still, seeing the bad guys win is a real kick in the nuts. We should be angry about it and we should use that anger to change the system. Let's turn the the GKN arbitrage trade into the most costly bit of business that hedge funds ever did.

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