Hooray for exchange offers
14 May 2019
IHS Markit’s Sam Pierson discusses how exchange offers reflect the key role that securities lending plays in the plumbing of global financial markets
Image: Shutterstock
When Eli Lilly (NYSE:LLY) announced it would spin off the remainder of its stake in Elanco Animal Health (NYSE:ELAN), ears perked up on securities lending desks. Exchange offers reflect the key role that securities lending plays in the plumbing of global financial markets, which we’ll discuss in some detail here. This corporate action type is also boon to the securities lending industry itself, driving significant loan balances and fees. One industry veteran recently quipped that an advocacy group ought to be formed to raise awareness of exchange offers in corporate boardrooms.
Elanco Animal Health was spun off from Eli Lilly in September of last year, at which time $1.5 billion of ELAN shares were floated. On 8 February, seeking to complete the divestiture, Eli Lilly offered their shareholders an opportunity to tender LLY shares in exchange for ELAN shares, the latter offered at a 7 percent discount to incentivise participation. This type of incentive also attracts arbitrageurs who will buy shares with the intention of tendering them. In theory, this position could be hedged by shorting ELAN shares, which would lock in the 7 percent discount. There’s a catch. Not all tendered shares will be accepted, so arbs need to estimate the percentage of their tendered shares which will be accepted and hedge those shares with a short position in ELAN. That leaves their position in LLY shares which aren’t accepted, so they need to hedge that as well by shorting LLY shares, or “boxing” their position. The hedging could also be affected by put options.
The hedging activity on the part of arbitrageurs causes borrow demand for both securities to increase. The real driver of lending revenue comes from the LLY shares; in forgoing the opportunity to tender shares, lenders can charge a premium to lend their holdings. These shares are referred to as “take no action” or TNA shares and are typically auctioned off to borrowers.
The scale is massive. Fully 44 percent of the outstanding shares of LLY were tendered, reflecting a market value greater than $57 billion. The corresponding borrow in LLY shares to hedge that position reached $33 billion, while the ELAN borrow balances reached $2.7 billion.
In the press release announcing the exchange offer, Eli Lilly noted that the maximum exchange ratio would be 4.5262 ELAN shares per tendered LLY share, with the aim of exchanging all 293 million shares of ELAN. That ratio suggested that there would be approximately 65 million shares of LLY accepted, or 6 percent of all outstanding shares. For an arbitrageur, that 6 percent reflects the minimum proration or percentage of tendered shares which they can be sure will be accepted.
An estimate of minimum proration could be further refined through analysis of shareholder filings. For example, one could reasonably assume that the Eli Lilly Foundation would not tender their 118 million shares. Similarly, index holders would most likely be precluded from tendering by investment mandate, which accounted for 170 million shares. Removing that 288 million shares would suggest a proration factor closer to 8.5 pecent. Further refinement could have been achieved by estimating the portion of shares which would be tendered out of the 220 milion shares not accounted for in public filings, along with consideration of non-index 13F holders. In the event, the actual proration factor was 14 percent. For this analysis, we’ve used public filings aggregated by IPREO.
To simplify the profit and loss associated with the arbitrage transaction, consider a shareholder who tendered 100 shares. Fourteen shares would have been accepted, for which the shareholder would receive Elan shares at a 7 percent discount. At a price of $127 per share of LLY that would imply a $124.5 profit ($127 x 0.07 x 14), less $2.5 to borrow the ELAN shares to hedge, so net $122. For the 86 tendered shares which weren’t accepted the borrow cost of 72 cents per share would be paid for the TNA shares, for a total cost of $62. The difference of $60 would be the arbitrage profit or $0.6 for each share of the original LLY holding. That’s an idealised version, as it would mean that the proration was perfectly estimated, and both sides of the trade were fully hedged. This example also belies the opportunity for trading the spread between LLY and ELAN in the days ahead of the final exchange ratio being set—calculated using the volume-weighted average prices for the three days ending 6 March.
The preceding example, $0.72 was used for the LLY per share cost for take no action (TNA) shares. A thorough accounting of the lending revenues associated with TNA shares is challenging, owing to differing mechanics across the industry for recording these transactions.
For some lenders, these trades are booked as traditional securities lending transactions where the fee or rebate fully captures the payment for borrowed shares. Other lenders run these transactions through a separate system, in some cases a legacy process from a time when securities lending software was unable to process fees of such magnitude. Bearing in mind some reporting inconsistencies, there is enough data to meaningfully estimate the total revenue and how that relates to per-share payments, which is how these special situations are typically priced.
Breaking the LLY transactions into bands by fee and date suggests a weighted average fee to borrow for 12 March at $0.72 per share, which was paid either just for the 12 or split between the 12 and 13. There was a small block of transactions done at $1 per share, but that equates to just 13 percent of balances with fees which could reasonably be expected to fully reflect the payment for borrow. It’s worth bearing in mind that many shareholders are precluded from lending 100 percent of their holdings of a given stock, so returns across actual portfolios were likely lower. The observation of near parity between arbitrage profits, $0.6, and returns to lending LLY TNA shares, $0.72, suggests that both sides of the trade effectively handicapped the proration and resulting profit opportunity.
Exchange offers reflect one of the critical roles securities lending plays in capital markets, facilitating a smooth execution for corporate actions. This process also allows shareholders who do not tender to benefit by lending their shares. Eli Lilly paid a Q1 dividend of $0.65 per share, so revenue from lending TNA shares could have roughly doubled Q1 income. If all 245 million shares on loan for 12 March achieved the observable $0.72 per share average, that would imply $177 million in Q1 revenue for LLY (based on the fees reported, LLY Q1 revenues were $48 million).
In recent years, there has been roughly one exchange offer per year which delivered outsized lending returns.
Most recently Fortive’s exchange offer for Altra in September of 2018, preceded by CBS exchanging shares for CBS Outdoor in November 2017 and duelling P&G and Lockheed Martin exchange offers in the fall of 2016. P&G was divesting part of it’s holding of COTY, shares of which are currently subject to a tender offer from investor JAB Holding prompting an increase in borrowing ahead of the 15 April deadline and may also result in short-term demand for TNA shares.
The broad market rally year-to-date has created a challenging environment for equity short sellers, which has, in turn, kept a lid on borrow demand, particularly for hard to borrow shares. Against that backdrop corporate action related securities loans have received significant diligence by traders seeking to maximise returns.
Our view is that having the most complete and up to date securities lending dataset is a key component to that process.
Elanco Animal Health was spun off from Eli Lilly in September of last year, at which time $1.5 billion of ELAN shares were floated. On 8 February, seeking to complete the divestiture, Eli Lilly offered their shareholders an opportunity to tender LLY shares in exchange for ELAN shares, the latter offered at a 7 percent discount to incentivise participation. This type of incentive also attracts arbitrageurs who will buy shares with the intention of tendering them. In theory, this position could be hedged by shorting ELAN shares, which would lock in the 7 percent discount. There’s a catch. Not all tendered shares will be accepted, so arbs need to estimate the percentage of their tendered shares which will be accepted and hedge those shares with a short position in ELAN. That leaves their position in LLY shares which aren’t accepted, so they need to hedge that as well by shorting LLY shares, or “boxing” their position. The hedging could also be affected by put options.
The hedging activity on the part of arbitrageurs causes borrow demand for both securities to increase. The real driver of lending revenue comes from the LLY shares; in forgoing the opportunity to tender shares, lenders can charge a premium to lend their holdings. These shares are referred to as “take no action” or TNA shares and are typically auctioned off to borrowers.
The scale is massive. Fully 44 percent of the outstanding shares of LLY were tendered, reflecting a market value greater than $57 billion. The corresponding borrow in LLY shares to hedge that position reached $33 billion, while the ELAN borrow balances reached $2.7 billion.
In the press release announcing the exchange offer, Eli Lilly noted that the maximum exchange ratio would be 4.5262 ELAN shares per tendered LLY share, with the aim of exchanging all 293 million shares of ELAN. That ratio suggested that there would be approximately 65 million shares of LLY accepted, or 6 percent of all outstanding shares. For an arbitrageur, that 6 percent reflects the minimum proration or percentage of tendered shares which they can be sure will be accepted.
An estimate of minimum proration could be further refined through analysis of shareholder filings. For example, one could reasonably assume that the Eli Lilly Foundation would not tender their 118 million shares. Similarly, index holders would most likely be precluded from tendering by investment mandate, which accounted for 170 million shares. Removing that 288 million shares would suggest a proration factor closer to 8.5 pecent. Further refinement could have been achieved by estimating the portion of shares which would be tendered out of the 220 milion shares not accounted for in public filings, along with consideration of non-index 13F holders. In the event, the actual proration factor was 14 percent. For this analysis, we’ve used public filings aggregated by IPREO.
To simplify the profit and loss associated with the arbitrage transaction, consider a shareholder who tendered 100 shares. Fourteen shares would have been accepted, for which the shareholder would receive Elan shares at a 7 percent discount. At a price of $127 per share of LLY that would imply a $124.5 profit ($127 x 0.07 x 14), less $2.5 to borrow the ELAN shares to hedge, so net $122. For the 86 tendered shares which weren’t accepted the borrow cost of 72 cents per share would be paid for the TNA shares, for a total cost of $62. The difference of $60 would be the arbitrage profit or $0.6 for each share of the original LLY holding. That’s an idealised version, as it would mean that the proration was perfectly estimated, and both sides of the trade were fully hedged. This example also belies the opportunity for trading the spread between LLY and ELAN in the days ahead of the final exchange ratio being set—calculated using the volume-weighted average prices for the three days ending 6 March.
The preceding example, $0.72 was used for the LLY per share cost for take no action (TNA) shares. A thorough accounting of the lending revenues associated with TNA shares is challenging, owing to differing mechanics across the industry for recording these transactions.
For some lenders, these trades are booked as traditional securities lending transactions where the fee or rebate fully captures the payment for borrowed shares. Other lenders run these transactions through a separate system, in some cases a legacy process from a time when securities lending software was unable to process fees of such magnitude. Bearing in mind some reporting inconsistencies, there is enough data to meaningfully estimate the total revenue and how that relates to per-share payments, which is how these special situations are typically priced.
Breaking the LLY transactions into bands by fee and date suggests a weighted average fee to borrow for 12 March at $0.72 per share, which was paid either just for the 12 or split between the 12 and 13. There was a small block of transactions done at $1 per share, but that equates to just 13 percent of balances with fees which could reasonably be expected to fully reflect the payment for borrow. It’s worth bearing in mind that many shareholders are precluded from lending 100 percent of their holdings of a given stock, so returns across actual portfolios were likely lower. The observation of near parity between arbitrage profits, $0.6, and returns to lending LLY TNA shares, $0.72, suggests that both sides of the trade effectively handicapped the proration and resulting profit opportunity.
Exchange offers reflect one of the critical roles securities lending plays in capital markets, facilitating a smooth execution for corporate actions. This process also allows shareholders who do not tender to benefit by lending their shares. Eli Lilly paid a Q1 dividend of $0.65 per share, so revenue from lending TNA shares could have roughly doubled Q1 income. If all 245 million shares on loan for 12 March achieved the observable $0.72 per share average, that would imply $177 million in Q1 revenue for LLY (based on the fees reported, LLY Q1 revenues were $48 million).
In recent years, there has been roughly one exchange offer per year which delivered outsized lending returns.
Most recently Fortive’s exchange offer for Altra in September of 2018, preceded by CBS exchanging shares for CBS Outdoor in November 2017 and duelling P&G and Lockheed Martin exchange offers in the fall of 2016. P&G was divesting part of it’s holding of COTY, shares of which are currently subject to a tender offer from investor JAB Holding prompting an increase in borrowing ahead of the 15 April deadline and may also result in short-term demand for TNA shares.
The broad market rally year-to-date has created a challenging environment for equity short sellers, which has, in turn, kept a lid on borrow demand, particularly for hard to borrow shares. Against that backdrop corporate action related securities loans have received significant diligence by traders seeking to maximise returns.
Our view is that having the most complete and up to date securities lending dataset is a key component to that process.
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