October 28, 2005
Takeover Plays by Hedge Funds: Should We Care?
In the Mylan takeover of King, Carl Ichan was long in Mylan and short in King. He thought Mylan was paying too much and wanted to stop the deal. If he was successful stopping the deal, he believed Mylan shares would go up and King shares would go down. To get a play on both sides he sold King shares short while voting his Mylan shares against the deal (in a contested proxy contest). A hedge fund could also take the opposite side, selling Mylan short and going long in King shares, hoping the deal would close. In most deals, on the announcement the target shares appreciate in valve and the bidder shares depreciate (or are neutral). The difference between the bid and the target share price after announcement but before closing is a discount reflecting the liklihood that the deal may not close; the difference between the lower bidder share price after announcement and before closing and the even lower bidder share price on close is similarly a discount on the liklihood the deal may not close.
Should we care about such hedges?
No. I have heard the argument that the latter hedge, long in the target and short in the bidder, encourages the holder of the hedge to vote (or otherwise encourage) the target to close no matter what, even if it could negotiate successfully a higher price from the bidder or a third party, new bidder. The hedge fund would not be neutral to any changes in price between the two parties; a higher price would produce gains in both positions, the long in the target and the short in the bidder. Similiarly a lower price would decrease both positions. A new bidder with a higher price would, however, increase the gain in the long position in the target but generate losses in the short position in the bidder; the gain may not be large enough to maximize the position given the loss. So a hedge fund may have a stake in closing the deal and acting to block new bidders. The problem with the argument is that the two events are interrelated. A new bidder might cause the existing bidder to raise its price in response; if the existig bidder prevails the hedge fund maximizes gains. In sum, there is no pure, fixed incentive to stop outside bidders and we should not create legal rules to stop the practice...
If a hedge fund is long on both sides, the bidder and the target, to lock in an arbitrage gain from different disounts on whether the deal will close (the bidder's stock reflects a higher probablity of closing that the target's), then the hedge fund has a stake in the deal closing, but a new bidder at a higher price maximizes gains. Only when a fund is shorting both sides (the target stock is reflect a much higher probablity of the deal closing than the bidder's stock) will the fund encourage a broken deal with no higher bids from new bidders.. Both positions are very hard to calculate, however, (the bidder's discount is tough to figure out accurately) and the latter, short/short position is too risky.
TrackBack URL for this entry:
Listed below are links to weblogs that reference Takeover Plays by Hedge Funds: Should We Care?: