Hedge funds have had an increasing influence on M&A activity
over the past year, and although hedge funds' returns may not have
been as impressive in the second half of 2004, they remain
extremely popular with investors and can be expected to continue to
grow in influence.
Transaction arbitrage
Transaction arbitrage - where hedge funds effectively take
positions in either the target company and/or the bidder depending
on whether they believe a proposed transaction will succeed - is
the main strategy of many hedge funds. In deciding how to invest,
hedge funds will consider competition and regulatory issues,
expected shareholder reaction and the likelihood of a competitive
situation developing. If they think the transaction will succeed,
they would normally invest in the target in anticipation of its
share price rising to the bid price and, if the bidder is issuing
its own shares as consideration, take a short position (described
below) in the bidder in anticipation of its share price falling.
Hedge funds are becoming more scientific in their approach to
transaction arbitrage. For instance, they are increasingly seeking
specific legal advice on the likelihood of a proposed transaction
obtaining regulatory clearance.
Whereas institutional shareholders are sometimes unwilling to
sell their shares to private equity bidders (in the belief that
their company is being sold to those private equity firms on the
cheap), it is quite common to see large volumes of shares being
sold by institutional shareholders to hedge funds after rumours of
M&A activity. The advantage for the institutional shareholders
is they can be certain of an exit at a premium, even though they
won't receive the full premium being offered under the rumoured or
announced bid. For example, it is reported that hedge funds
acquired about 50% of the free-float in DFS between the date of
Lord Kirkham's management buyout of DFS being announced and the
date of its approval by shareholders. Some commentators believe
that this is the first time that hedge funds have (collectively)
been able to determine the success of a UK bid, potentially making
their transaction arbitrage strategy a self-fulfilling
prophecy.
The speed and volume of trades involving hedge funds in the
course of a bid timetable is making life much more difficult for a
target trying to defend itself against a hostile bid. For instance,
it can be difficult for a target to track the identity of hedge
funds that hold virtual positions in it (described further below).
Further, a target will normally seek to rebut a hostile bid by
showing that the bid price undervalues the company in the medium to
long term. Such arguments might be persuasive to institutional
shareholders, but they are unlikely to have much influence on hedge
funds focusing on short-term returns generated as a result of the
transaction succeeding. An unsuccessful transaction would be a bad
result for a hedge fund that has taken a long position in the
target, because it would normally have paid more for the shares
than they would be worth immediately after the transaction
fails.
Conversely, if a hedge fund decides to take a short position in
the target (that is, where it gambles on the transaction failing
and the target share price subsequently drops), it could become a
useful ally to a target seeking to defend against a hostile
approach. A hedge fund will often take a short position in a target
by borrowing stock from institutional investors. Legally the hedge
fund would acquire, rather than borrow, the stock, and as part of
the arrangement it would agree to return the same amount of stock
to that institutional shareholder at a future date. The hedge fund
might hope to make a profit by selling the borrowed stock in
anticipation that the price will fall, and it can buy the same
amount of stock at a cheaper price when it needs to fulfil its
obligation to return that stock to the lender. The Financial
Services Authority regards stock borrowing as an important element
of market activity, because it increases the liquidity of
stocks.
Given the investment power now available to hedge funds, they
often have a big, and sometimes decisive, influence on even the
largest transactions. Some hedge funds have even successfully
influenced the type of consideration being offered by potential
bidders.
Virtual positions
Hedge funds often acquire their economic interests in the target
and/or bidding companies by acquiring derivatives that mirror the
economic performance and returns of that company, rather than its
actual shares. The most frequently used type of derivative is known
as a CFD (a contract for differences). The broker selling the CFDs
will almost always seek to hedge its position by acquiring shares
in the company - often by acquiring the company's stock if the CFD
holder is taking a long position or by borrowing stock if the CFD
holder is taking a short position. It is estimated that CFD trading
now lies behind one in three London Stock Exchange trades. Because
hedge funds holding CFDs or other similar derivative products do
not directly own shares in the company, they are often known as
virtual owners of the company's stock.
Despite being virtual owners, hedge funds have recently been
behaving as if they were actual shareholders of the company. For
instance, in June 2004, hedge funds holding a virtual position in
Alvis persuaded BAe Systems to announce a competing takeover for
Alvis because they were unhappy with the terms being offered by
General Dynamics. Despite not owning the underlying shares in
Alvis, those hedge funds gave Alvis irrevocable commitments to
request physical settlement of the CFDs. The hedge funds knew that
the broker who sold the CFDs to them would tender the underlying
Alvis shares (acquired by the brokers to hedge their position) in
accordance with their clients' wishes as the hedge funds, rather
than the broker, had the economic exposure in the outcome of that
bid. In addition, a number of hedge funds that had entered into
CFDs referenced to Marks & Spencer shares sought to put
pressure on the M&S board to allow Philip Green to carry out
due diligence in an attempt to enable him to turn his virtual bid
into a real bid. Because purchasers of CFDs (or equivalent
products) pay a margin to the broker, hedge funds acquiring their
economic interest in a company in this manner can have much greater
potential voting influence than if they were to pay the full price
for the actual underlying shares. As such, their already
substantial influence can be increased.
The concept of hedge funds using virtual positions to behave as
real shareholders is not restricted to the UK. In December 2004,
the New York Times referred to certain commentators and
shareholders being dismayed by Perry Corporation using similar
techniques to obtain voting power in Mylan (in the midst of its
takeover battle for King Pharmaceuticals) without having bought
actual shares in Mylan.
Regulators are becoming increasingly alert to this issue. The UK
Takeover Panel has noted that holders of derivative products, such
as CFDs, are not caught by disclosure obligations under the City
Code and the Rules Governing Substantial Acquisitions of Shares
(SARs), which would otherwise apply if they had actually acquired
shares. It reasons that the lack of disclosure obligations can
prejudice targets and bidders and has recently published a
consultation paper recommending that the City Code be amended to
require disclosure of such positions. Lack of transparency and
disclosure over hedge fund activity was also a cause of some
concern to the staff of the SEC when it prepared a lengthy report
analyzing the implications of the growth of hedge funds towards the
end of 2003. That report prompted a recently announced change to US
law broadly requiring that hedge fund advisers with 15 or more US
investors will have to register with the SEC, and become subject to
certain SEC supervision. Given their broad investor base, these
changes will also catch many European hedge funds.
Taking on private equity houses
If the increasing influence of hedge funds through the use of
virtual ownership and transaction arbitrage techniques was not
enough, there have been a number of reports of hedge funds going
head-to-head against private equity funds in respect of primary
M&A activity. Historically, private equity firms believed that
they had little to fear from hedge funds as the investment criteria
of hedge funds is skewed towards short-term positions in liquid
investments, whereas private equity firms undertake medium- to
long-term positions in illiquid investments. However, 2004
increasingly saw several reports of hedge funds competing with
private equity firms to acquire businesses (such as Macquarie's
consortium bid with various hedge funds to acquire NTL).
This trend is worrying to private equity houses, as hedge funds
typically seek lower returns and can afford to make higher offers
than their private equity counterparts. It has previously been
argued that hedge funds don't have the expertise to run and develop
businesses, but even private equity luminaries such as Henry Kravis
and Guy Hands have been quoted recently about being concerned by
the competitive tension created by hedge funds.
Some private equity houses (such as Carlyle and Blackstone) seem
to be adopting the "if you can't beat them, join them" attitude and
have created their own hedge fund divisions. Recently there have
also been examples of private equity houses teaming up with hedge
funds as another source of capital.
Food for thought
Hedge funds' impact on M&A in 2004 was dramatic, and has
given M&A practitioners and private equity houses food for
thought. Some of the strategies used - such as transaction
arbitrage - were not new, but had an unprecedented impact due to
the substantial investment power that hedge funds now have. Hedge
funds will also continue to be creative in their investment
strategies. As such, their impact on M&A is only likely to
increase. Regulatory change will surely follow.
Author biographies
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| Edward Braham, partner |
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David Higgins, partner |
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Stephen Hewes, partner |
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Bruce Embley,
senior associate |
Edward Braham, David Higgins, Stephen Hewes and Bruce Embley
work in Freshfields Bruckhaus Deringer's corporate practice in
London, offering specialist advice on domestic and cross-border
public and private M&A, shares issues, privatizations,
international capital markets and joint ventures.
They have worked on some of the largest and most prestigious
M&A deals in recent years, including acting for Novar on its
defence against Melrose and the white knight bid by Honeywell
International; Bain Capital Partners and Thomas H Lee Partners, as
members of the Warren Acquisition consortium, on the acquisition of
Warner-Chilcott; Brascan and its consortium in relation to the
contested takeover offer by CWG Acquisition (the consortium bid
vehicle) for Canary Wharf Group; TPG/CVC/Merrill Lynch Private
Equity's successful contested consortium for Debenhams and
Debenhams' subsequent refinancings; Cinven on the buyout of
Amadeus, the world's largest travel bookings company; the London
Stock Exchange on its various proposed takeovers; the Oppenheimer
family on the take-private of De Beers; and the Valentia Consortium
on its successful contested bid for eircom of Ireland.
Freshfields Bruckhaus Deringer
65 Fleet Street
London EC4Y 1HS
Tel: +44 20 7936 4000
Fax: +44 20 7832 7001
www.freshfields.com