Wednesday, October 29, 2008

Shortenfreude

(FT Editorial) Schadenfreude more than sympathy is likely to greet the plight of short sellers caught on the wrong end of a bet about the direction of Volks­wagen’s share price. Their scramble to cover losses sent the European carmaker’s price so high that on Tuesday morning it was – briefly but still ridiculously – the largest company in the world by market capitalisation. Some hedge funds may fail because they have incurred such big losses, but not many people will be weeping at that. The real cause for concern is the opacity of the German stock market.

The immediate cause of the problem was Sunday’s revelation that Porsche, which has been engaged in a creeping takeover of VW for the past three years, controlled not just 35 per cent of the group as had been known, but 74.1 per cent, through an equity stake of 42.6 per cent and 31.5 per cent in cash-settled options, which it did not have to disclose. Taken with the 20.1 per cent owned by the state of Lower Saxony, that left a free float of just 5.8 per cent, barely above the 5 per cent required for the company to remain in Germany’s blue-chip Dax index.

Porsche said it had revealed the extent of its control both directly and through derivatives so that hedge funds could unwind their positions “in an orderly manner”. But there can be no orderliness in a system of financial regulation that allows investors in general to operate on the basis of such misleading information for so long. The volatility of the VW share price shows that clearly enough: from Friday’s close of about €210, it touched €1,005 on Tuesday morning before finishing the day at about €800.

The episode has exposed a woeful lack of transparency in the German market. For Bafin, the financial regulator, to talk about looking at VW share price movements is to miss the point. The broader question is the ability of any investor to build up a significant stake in a publicly quoted company without having to inform the market. In July, the privately owned car parts company Schaeffler mounted a hostile take­over of its bigger rival Continental, on the back of a derivative-based stake of 36 per cent acquired while no one noticed.

Several European markets are reviewing their rules about the use of covert stake-building in take­overs. Disclosure of derivative positions above 1 per cent in a company that is subject to a bid is the route the UK has adopted. Different takeover regimes will require different answers. But they must all be based on the principle that investors deserve transparency – and the knowledge that if they think it is lacking they will trade elsewhere.

Porsche offers to settle VW hedging trades (FT)

Porsche continued the extraordinary rollercoaster ride in Volkswagen’s shares when it said on Wednesday it would sell 5 per cent of VW to try to avoid “further market distortions” that had threatened the survival of some hedge funds.

Porsche, which sparked panic-buying among hedge funds by revealing at the weekend that it held up to 74.1 per cent in VW directly or indirectly, said it would settle hedging transactions up to 5 per cent in an attempt to nearly double the free float in Europe’s largest carmaker.

VW’s shares, which had quadrupled on Monday and Tuesday alone to make it the second-largest company in the world by value, immediately fell 37 per cent to €597. But that would still leave Porsche booking a handsome profit on any sale as it has said in the past that the average buying price for its VW stake was €70-€100.

Max Warburton, analyst at Sanford Bernstein, said: “Porsche are set to shock the financial community yet again by making money – lots of money – out of this situation.”

The surge in the German carmaker’s share price was triggered by Porsche’s revelation on Sunday it had a much larger interest in the carmaker than many traders had realised, sparking panic among hedge funds which had bet on VW’s share price falling. Porsche’s enlarged holding meant that there was a free float of only 5.8 per cent — the state of Lower Saxony has a 20.1 per cent stake — which sent traders rushing to cover short positions by buying stock from a shrinking pool of available shares.

The squeeze on short-sellers is thought by many market participants to be the biggest in history and is likely to lead to large losses at many traders and perhaps even the failure of some hedge funds.

Some leading investors – led by DWS, Germany’s largest fund manager – have said that Porsche has manipulated the market. But Porsche said on Wednesday that it “denies all responsibility for these market distortions and for the resulting risks to which the short sellers have exposed themselves.” In a statement headlined: “Short sellers responsible for extreme price movements in Volkswagen”, Porsche said it wished to point out that the applicable capital markets law provisions had been “complied with at all times”.

Porsche said on Sunday that it held a 42.6 per cent equity stake, up from a previously-disclosed 35 per cent. In addition, it holds options over 31.5 per cent of VW shares but these settle into cash rather than convert into shares. Under German law, cash-settled options do not need to be disclosed.

Regulators worldwide, including the Financial Services Authority in the UK, are grappling with how and whether to regulate cash-settled options.

Bafin, Germany’s financial regulator, has said it is monitoring VW’s share price movements but has not launched a formal investigation. It has underlined that Porsche’s non-disclosure of its cash-settled options was legal.

VW’s share price closed at €210 on Friday before soaring as high as €1,005 on Tuesday.

Its fall on Wednesday meant the Dax 30 index of leading shares fell 2 per cent even though all other 29 members apart from VW rose, most of them by more than 10 per cent.

As a result of the distortion, Deutsche Börse, which operates the Frankfurt stock exchange, said late on Tuesday it would limit VW’s weight in the index, currently at 27 per cent, to 10 per cent.

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