October 27, 2005
Hedge Fund Paranoia: Fretting Over the Mylan/King Deal Hedge
The Mylan Laboratories covered short by Perry Corporation, a hedge fund, has captured the attention the the anti-hedge fund crowd. See David Skeel. Here is the background. Mylan made a bid for King Pharmaceuticals of $16.00, King shares traded after the bid at about $12.00 because several Mylan shareholders (Carl Icahn, no shrinking violet, was one of them) thought the price was too high and wanted to block the closing of the deal. Perry bought the target shares, King shares, at $12 and hoped the deal would close at $16 so he could make $26 M or so. Nothing novel about this.
What infuriated Icahn, got the attention of the SEC and is the subject of comment by the anti-hedge fund crowd was what Perry did next. He bought 9% of the outstanding shares in Mylan, the bidder, and shorted 9% of the shares at the same time; he entered into a covered short. In other words, he bought 9% of the shares in the markets, borrowed another 9% of the shares (for 30 days or so), and sold the borrowed 9% of the shares back to the markets. In the end, Perry holds 9% long and owes 9% to the share lenders in 30 days, the short. [The details were not revealed.] In a covered short, the owner takes no risk on the price of the stock -- price increases, the gain on the long position offsets the loss on the short -- price decreases the short gain offsets the loss on the long position. The only cost is the transaction cost of buying and clearing the two positions. Why do the covered short? Perry could vote the shares held long in the bidder in favor of the deal to make money on the close in the target. It looked like Perry was vote buying in the bidder to make a gain in the target. In voting to close the deal he would be voting against the best interests of the bidder without suffering the economic consequences, a drop in the price of the bidder's stock due to its overpaying in the deal.
This strategy is not as dangerous as Skeel and others make it out to be. Perry could vote the 9% he held long in Mylan to vote in favor of the deal, but someone else votes the 9% he sold short against the deal if indeed the deal was a bad one for Mylan. The votes wash but now there is a 9% yes vote on the deal that did not exist before the covered short. The yes votes do not come free. Perry will pay for it in the costs of borrowing the stock from a knowledgeable lender, who knows about the covered position and will discount the risk of losing share value in the rental fee (especially before a vote).
It is as if Perry borrows the stock, votes it and returns to the lender after the vote (also a common hedge fund ploy). The lender will charge in the rental fee for potential damage to the stock value generated by the unfettered voting, particularly if the stock is borrowed before a vote. [One arrangement would charge Perry a fee plus hold the lender harmless for any loss in the stock during the period of the lease.] Perry's cost of a vote to against the company's interest would be close to what he would lose if he owned the 9% block of shares outright.
If Perry buys a straight 9% of Mylan to vote against Mylan's best interest, he has a right to, but is not likely do so; he understands that he is unlikely to influence the outcome if the deal is truly bad for Mylan -- he will be outvoted. [If he owns enough to be a controlling shareholder of Mylan, a traditional duty of loyalty case law applies to remedy, if need be, his conflict of interest; nothing novel.] It is more likely that he has assessed that the deal is good (or at least neutral) for Mylan and he wants to help it close over what he believes to be ill-considered objections (Icahn's).
Suppose Perry did the minimum and just bought the right to vote 9% of the shares (probably an illegal arrangement under existing law). A knowledgeable seller would make Perry pay full value for the potential damage to the underlying stock when the seller sells the votes (perhaps more to account for the unknown risk of what Perry could do); Perry's costs will be the same value (or more) as if he owned the shares outright. Again a sensible fee would include a hold harmless payment against loss in the value of the stock around the time of the vote.
Note that in the Mylan deal, Icahn, the complainer, was shorting the shares of King while he was trying to block Mylan deal. He also was on both sides of the deal! I would argue, however, that he similarly did not pose a threat -- this is another post, however.
Why these deals panic smart people is beyond me. Hedge funds look sinister to these folks somehow, yet they operate within the rules and take financial risks. When they are wrong the lose money and when right they make money. Moreover, they provide a real service -- they move prices faster to reflect available information and they are an outside influence on the operation of companies, many of which should restructure but are slow to because of manager's vested interests. See Wendy's post. [Oesterle]
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