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Oct 10, 2010

Holding off the hedge funds

How arbitrage funds are influencing the outcome of hostile deals

‘I operate under the premise that shareholders ultimately make the decision,’ said Marius Kloppers, CEO of BHP Billiton, a week after his company went hostile in its approach for Potash Corporation of Saskatchewan (PotashCorp). But which kind of shareholders did he mean?

The truth – as Kloppers well knew – is that hostile takeover attempts are not always decided by the long-term shareholders of the target. ‘Clearly there are a lot of arbitragers in there,’ Kloppers continued in the interview with US television channel CNBC. ‘Normally, how a typical M&A transaction proceeds is that ultimately the quick money makes the decisions.’

Arbitrage investors move into a stock in anticipation of, or following the announcement of, a takeover attempt, and wait for the price to rise before exiting with a tidy profit. In this situation, it is against the interests of the arbitragers for the deal to fall through so once a certain amount of stock is owned by this group of opportunists, the deal is almost certain to be approved.

What’s more, the presence of arbitrage funds makes it harder for boards and their IR teams to maximize shareholder value. Institutional investors with a long-term value outlook will require a higher premium to sell up than short-term traders looking for a quick return on their investment.

Roger Carr, the former chairman of UK confectioner Cadbury, saw this happen all too clearly as he attempted to hold off the advances of Kraft, the US food group, in the final months of 2009. ‘If they could buy enough shares, the deal would become a self-fulfilling prophecy,’ he later said in a speech at Oxford University’s Saïd Business School. ‘And I can tell you, eight of the largest buyers over the period were, surprise, surprise, short-term traders or hedge funds.’

By the end of the deal period, short-term investors made up a ‘critical holding’ of 31 percent of Cadbury’s stock, up from 5 percent at the outset, which is around the average level for companies across the FTSE 100, added Carr. ‘Individuals controlling shares they had owned for only a few days or weeks determined the destiny of a company that had been built over almost 200 years,’ he concluded.

Normal service
Right now arbitrage traders are in the spotlight, following the return of hostile M&A on a large scale. But the number and size of arbitrage funds has stayed pretty consistent over the last decade, says Erin O’Reilly, a director at Strategic Stock Surveillance, a firm that specializes in hedge fund surveillance. ‘It has been like this for some time now,’ she states.

Of course, event-driven funds don’t just get involved during hostile takeovers; they are also attracted by friendly acquisitions. But it is in hostile situations when dangers exist for the target. And these situations are set to crop up more and more, given the recent uptick in hostile activity. In the year to the end of August, there has been almost $54 bn in value of hostile deals announced, according to data from Thomson Reuters.

This is well up on last year – even if you discount BHP Billiton’s $40 bn offer for PotashCorp, it is still an increase of around 40 percent. Hostile deal numbers are also up on last year. By the end of August, there had been 13 deals announced, compared with seven over the same period during 2009. There are also a few more in the works that have yet to be made public, notes O’Reilly.

British debate
In a large part thanks to Carr, there has been plenty of debate about the role of hedge funds during takeovers in the UK. The Takeover Panel – which regulates and adjudicates on takeovers in the country – is reexamining its takeover code following the Cadbury/Kraft deal. As part of this process, it launched a consultation that closed in July.

Carr has suggested a number of ideas for tweaking the system. In his speech to the Saïd Business School, he pondered whether the proportion of votes needed to approve a takeover in the UK should be lifted from the current level of 50.1 percent to 60 percent, and also questioned whether traders should get voting rights if they move into a stock at short notice.

IR professionals are cautious about the proposed changes, however. In its submission to the consultation, the UK’s IR Society argued against raising the voting threshold or altering voting rights. In any case, some market participants play down the influence of arbitrage funds.

‘We think the majority of these situations are influenced by top 10 shareholders,’ says Don Duffy, president of ICR, a financial communications consulting firm. ‘Every situation is different, and there are certainly situations where new shareholders, such as arbs and/or special situation funds, can swing a vote, but those tend to be in the minority.'

Be prepared
The IR Society argued against Carr’s proposals, in part, because it was keen to preserve the competitive nature of the UK market, which it felt could be undermined by arduous new takeover rules. And this view may well prevail among regulators. But if IR teams are not going to get any new support from the authorities, what can target companies do to help themselves when the hedge funds start buying up stock?

‘You can’t prevent the arbitrage players moving in,’ says O’Reilly. ‘But if the target works with its surveillance firm, proxy solicitation firm and PR firm – as well as its advisers to see what strategies people are taking in the derivatives market – it can get its message out to the market. That’s when all the pieces come into place.’

It’s important to take into account the size of your company when considering how much influence hedge funds could have, she adds. While smaller companies may see a large portion of their share register taken up by the arbitragers, it is harder for them to have a similar influence over issuers with much larger market caps.

There is also an argument that fostering a domestic shareholder base can help you out when an aggressor comes calling. During the Cadbury/Kraft deal, the percentage of Cadbury’s shares held by North American institutional shareholders fell from 49 percent to 27 percent, while UK institutional holdings remained steady at 28 percent. Over the period, nine of the biggest sellers were from North America.

It is sometimes the case that domestic shareholders hold out for more, or are more optimistic about the appearance of a white knight or some other kind of intervention, according to an analyst at one major market intelligence company. Overall, the better your relationships with your big shareholders, and the more convinced they are of the long-term value of the business, the better chance you have that they’ll hold on to their shares when faced with the opportunity of a quick profit.

Friendly deals
Arbitrage funds are not just interested in hostile deals. ‘Judging from the stock price movement and the phone calls I got, I am very sure there are many short-term investors (arbitragers) that came in during the bidding process,’ says Ben Liao, treasury and investor relations manager at 3PAR.

3PAR was acquired in early September by Hewlett-Packard, after a fierce bid battle with technology rival Dell. ‘A prolonged bidding war such as our situation certainly attracted a lot of attention from these types of investors,’ Liao says.

Erin O’Reilly of Strategic Stock Surveillance argues that, in these circumstances, arbitrage funds perform a valuable function by providing liquidity to investors who want to get out of the stock before a deal is concluded.