Hedge fund arbs face a $3.2 bn crunch day

It's crunch day for hedge funds trying to make a turn on the 2.3 billion-pound ($3.2 billion) buyout bid for UK power group Aggreko Plc. A few weeks ago, the funds were betting that a higher offer would turn up for the supplier of generators to events such as the Glastonbury music festival. Now they're worried the show could be cancelled altogether. The situation has become a test of solidarity for the merger arbitrage community.

Aggreko agreed to be bought for 880 pence per share by I Squared Capital and TDR Capital in March (less any subsequent dividends). The shares traded slightly above that level in anticipation of a counterbid that hasn't materialised. Such disappointments appear manageable when there's a binding offer on the table that seemingly underwrites the shares at the bid price. But last week it became doubtful whether the deal would go through. Aggreko's lead shareholder, Liontrust Asset Management Plc, is inclined to oppose it, Sky News reported. The possibility has always been lurking in the background given the buyout firms failed to secure irrevocable commitments to their bid from major investors when it was announced.

If the deal dies, the stock price would probably fall, hurting late-arriving arbs who bought in around the offer level. How far is unclear. Shares in United Rentals Inc. and Ashtead Group Plc, two rival power equipment suppliers, are up roughly 20 per cent since bid interest for Aggreko emerged. Had Aggreko tracked these peers in the absence of takeover interest, its shares would be about 750 pence. When a formal offer fails, UK takeover rules bar the bidder from coming back for 12 months without the target's consent.

Liontrust is a long-term investor, so it would presumably be comfortable with the shares wobbling in the short term if the deal fails. But the average merger arb would prefer to take profit on the deal and move on to the next situation.

The shareholder poll formally takes place on Monday. Approval of the deal requires 75 per cent backing from those who vote. Liontrust has 12 per cent, putting it in a strong, but not decisive, position to kill the transaction. Suppose the vote turnout is 80 per cent. That means investors with 60 per cent of the total shares outstanding could force the deal through by clearing the three-quarters hurdle.

But there's a wrinkle. Merger arb support doesn't automatically translate into votes for the deal. These holdings are usually in vote-less derivative positions. They're backed by voting shares held by prime brokers, the investment banking divisions that cater to hedge funds. The prime brokers can theoretically vote on their clients behalf. But that's usually tricky if they're also advising on the transaction in question. As it happens, this deal has an army of prime broking firms advising the various parties — including Goldman Sachs Group Inc., Morgan Stanley and JP Morgan Chase & Co.

To vote, the arbs can shift their positions to an unconflicted prime broker, or stump up the cash to convert them into Aggreko stock. That requires time and hassle. The risk is that at an individual level, each arb assumes its fellow arbs do the legwork here. If they all think that way, their votes won't be enough. They need to act in each other's interest, not their own. And time is short. Had I Squared and TDR bumped the price slightly last week, it would at least have provided a pretext to delay the shareholder vote, allowing time for arbs to make arrangements.

Merger arbs are a useful force for holding bidders' feet to the fire to pay a full price. But they take huge risks in doing so. The potential for a counterbid may be a valid reason for buying a company's shares above the price where a deal has been agreed. But that upside also has to be balanced by the risk the deal could fail. That seems to have been forgotten lately. Even if Aggreko's deal gets over the line, the eleventh-hour nerves have been a nasty reminder. (Bloomberg)