Friday 1 July 2022

Takeovers versus turnout

At the back end of 2020 I wrote something about the impact of the merger arbitrage trade and some of the stewardship issues related to it. Looking back, one rather fundamental stewardship issue that I hadn't considered was the impact on voting turnout. Subsequently I have spent quite a lot of time looking at this and I now think merger arbitrage is having a major impact.

To recap, funds doing the merger arbitrage trade typically utilise equity derivatives like CfDs and swaps to get long exposure to the target. This trade also sees the investment banks which write the derivatives acquire significant equity holdings in the target (sometimes with mirroring short positions). The banks do not have an economic interest in the shares, they hold them as counterparties to those that do (through derivatives).

As I understand it, derivatives can be written pretty much how the client wants, including with the ability to exercise voting rights and/or convert to the underlying equity. But it seems that most of the time this does not happen, and therefore a large proportion of shares do not get voted when there is a correspondingly large derivative interest. This can result in a sharp drop in turnout.

How large? Below is a table of companies that are takeover targets which have held their AGMs *this month* showing turnout at the 2021 AGM (pre-bid), the 2022 AGM (post-bid) and the % reduction in turnout between 2021 and 2022. In all cases there has been significant hedge fund interest in the target using derivatives.

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In all cases the drop in turnout is significant, but the top three!

The risk (or opportunity, perhaps) with low turnout is that those who do vote have relatively more power. If turnout drops by two-thirds but your position (in terms of *number* of shares) remains the same, that's quite a power-up. From a company perspective, an issue that seemed to be a minority concern can get you into the 20%+ oppose range that requires you to publicly respond. I can already see a couple of examples where this has probably happened.

Two initial and related thoughts - first, it would not be surprising to see a company lose a vote at a GM or AGM because of low turnout resulting from merger arbitrage, second, an investor motivated to do so might try and take advantage of this trend at some point. I flag this latter point as I'm pretty confident now that I could identify some way in advance which companies will see sharp drops in turnout.

More generally, I am curious if corpgov people think this is a problem. Generally we worry about low voting turnout, as it's difficult to take talk of stewardship seriously if investors aren't using their control rights. But when it looks likely that a company is going to be acquired it seems stewardship goes out the window. I personally feel there is a significant issue here that deserves some discussion.