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.