Hedge funds are betting commodities trader Glencore will raise its bid for Xstrata and win over disgruntled shareholder Qatar, hoping to turn a tidy profit from the belief chief Ivan Glasenberg won't flinch in his efforts to buy the mining group.
Funds are staying long in shares of miner Xstrata in spite of the fact Qatar, which owns around 11 percent of the miner, shocked markets this week with a late demand for better terms, forcing both firms to push back the timing of the deal.
The proposed $26 billion merger, welcomed by a hedge fund community starved of the complex, all-share deals they thrive on, has often frustrated funds unwilling to try and outsmart Glencore chief exexutive Glasenberg. Others have been put off because the cost of hedging out their positions is prohibitively expensive.
But the surprise move by Qatar Holding has thrown the deal into disarray, leaving everyone guessing about Glencore's next move and handing hedge funds a window of opportunity.
“Apart from this latest twist it's all been playing out according to the script ... Now it's got a lot more interesting. In terms of what you can make versus what you can lose, it's a great relationship,” one London-based hedge fund manager betting on a fresh offer said, asking not to be named.
Several hedge funds and analysts reckon a ratio of around 3 new Glencore shares for every Xstrata share, a rise from the current offer of 2.8 but below Qatar's demand for 3.25, will be enough to win over the Middle East investor.
If Glencore successfully buys Xstrata at a ratio of 3.1, this would hand hedge funds an annualised gain of around 20 percent - a big payout for these so-called merger arbitrage funds, which make money by betting on the outcome of M&A deals.
Glencore and Xstrata stock has traded at a ratio of around 2.6 this week, implying markets were not expecting better terms.
Typically, “merger arbs” hedge out a long position in the target firm by short-selling shares in the acquirer.
Short-selling means betting on a lower price by borrowing shares you don't own and then selling them in the market, with the aim of buying them back later at a cheaper price.
“It's good news,” said Catherine Berjal, CEO and CIO of Paris-based hedge fund firm CIAM, which had already been betting on the deal. “We took the position because we expected a bump (up). We are pretty sure Glencore needs Xstrata for financial reasons.
“When Glasenberg said that if Qatar doesn't change its mind then he will leave, I don't think he will. I don't think you can have 3.25 but I think you can have 3.1. I think he's playing hardball.”
NO RAW MATERIAL
A slump in European merger and acquisition dealflow this year has frustrated merger arbitrage hedge funds. The average event-driven fund is up 2.53 percent to mid-June this year, according to data from Hedge Fund Research.
While this is more than the average hedge fund's 1.86 percent gain, many European-focused managers have fared worse.
The possible Glencore Xstrata tie-up has proved tough for many funds to trade, however.
In order to protect their downside if Glencore walks away - which could send their Xstrata shares hurtling lower - funds short the shares of the commodities trading giant.
This is because Glencore shares could also fall if the deal collapses, protecting them from losses on their Xstrata stock.
But this hedge has proved difficult because of the high cost of borrowing Glencore shares - which managers said varies from 7 to 10 percent per annum, much more than the 2 to 8 percent typically charged - eating into their returns.
The limited availability of shares also poses a challenge, although Glencore's free float rose to over 50 percent in May after lock-ups on a big chunk of employees' shares expired.
“I would love to get tons more borrow but it's just not there. So you have to wait until some trickles into the market. It's really hard to play because the raw material you need to put on the spread is just not available,” the London-based fund manager said.
Amit Shabi, partner at Paris-based Bernheim, Dreyfus & Co, told Reuters his fund had reversed the typical merger arbitrage bet by shorting Xstrata and buying Glencore shares, but had sold the position a few weeks ago when the deal spread widened.
He said he is considering buying Xstrata and shorting Glencore, but has not put on the bet because finding Glencore shares to borrow is “almost impossible”, while the cost makes the trade unattractive.
“We're checking the cost of borrowing every day,” he said. If it falls to around 4 percent then he would make the trade.
According to figures from Markit, while less than 6.5 percent of Glencore shares are out on loan, this is more than 70 percent of the total number of shares that can be borrowed.
One special situations adviser estimated hedge funds own less than 5 percent of the Xstrata stock, showing that the size of hedge fund bets remains limited despite potential returns.
Even those who concede that the potential for a higher offer now makes the bet more appealing warn that speculating on whether a revised remuneration package for Xstrata bosses will now be enough to win over shareholders is a risky strategy.
“Unless you believe there's a bump you're not making a lot of money ... But I'm not getting involved because I don't think the risk-return stacks up and because I can't have a view on this management package,” said one manager. - Reuters