The Wharton Blog Network recently posted a great piece by Maurice Lefkort on Appraisal Arbitrage, an esoteric area of finance in which legal rules that shape governance in the M&A process can be exploited by sophisticated professionals. A number of specialist appraisal arbitrage hedge funds have increasingly been targeting a quirk in the custody system.
What is Appraisal Arbitrage?
In order to understand appraisal arbitrage, it’s helpful to understand a few aspects of Wall Street’s plumbing, and how these have evolved over time.
A hundred years ago, if you owned stock, your ownership was represented by a physical certificate, representing legal title to the shares. People sometimes kept their certificates in a safe deposit box. Companies maintained lists of all such owners, who were “shareholders of record.”
If you sold shares through a brokerage, the broker would send your certificates to the purchaser. Over time, this became impractical. As trading volumes increase, this transfer process became a paperwork nightmare.
The solution was the creation of a central depository (now known as the Depository Trust Company (DTC), and its nominee, Cede & Co. (Cede)) for electronic storage of certificate records, with clearing and settlement taking place electronically.
One wrinkle of the new system was that securities registered to Cede, who were now the shareholder of record (rather than the individual, as previously under the old system), were held in “fungible bulk.” That is, today when you buy stock, you don’t have a claim on a specific certificate, but instead your ownership is an accounting journal entry representing a pro-rata share of Cede’s total position. This has implications for “appraisal rights” in M&A transactions.
So what are appraisal rights?
In a merger, minority stockholders who don't like a deal have some remedies. Lefkort explains:
Those stockholders that did not vote in favor of the deal were given the right to go to court to have the value of their stock judicially determined and to have that judicially determined value paid to them in cash. Those rights are referred to as “appraisal rights.”
This way, if the initial purchase price is too low, these shareholders can get a (hopefully) higher appraised value.
The circumstances surrounding an early appraisal rights case, involving a biopharmaceutical company called Transkaryotic Therapies, illustrates how this can play out.
In the Transkaryotic case, on the record date of its proposed merger, Cede was the record holder for 30mm shares. 13mm voted in favor, 10mm voted against, and 7mm abstained/didn’t vote.
The merger was approved.
Also on the record date, a group of hedge funds owned 3mm shares. Next, after the record date, but prior to the effective date a few months later, this group went into the market and bought another 8mm shares. Subsequently, this group demanded appraisal rights on their entire 11mm position.
Hey, it's not fair that you hedge funds demand all these additional appraisal rights - you have to show how these new 8mm shares you bought after the record date were voted.
The hedge funds had a great counterargument:
It’s impossible to say, since there is literally no way to track how they were voted.
Remember from above, with securities held in “fungible bulk” in Cede, you can’t connect each of these 8mm individual shares with how each was voted. Just as you can’t point to a specific certificate, you can’t point to a vote either. The records simply do not exist. This feature of the custody system proved to be a major problem for Transkaryotic.
What did the judge do?
Well, since there were 17mm shares that did not vote in favor of the merger, then he figured that all these “no vote” shares were eligible for appraisal. And since the hedge funds only asked for appraisal on 11mm, which is less than 17mm, they should get that appraisal. Case closed.
Making Money by Leveraging Appraisal Rights
An interesting feature of appraisal rights is they include an attractive statutory interest rate that applies while the appraisal is hashed out in the courts. This is great for hedge funds, who get the following:
- A higher appraised value, or
- Accrued interest (5% above the Fed discount rate) on the original deal price less appraisal costs, which could result in a net profit.
In a world of ultra low bond rates, 5%-6% is a nice return. Plus, hedge funds get additional time to assess the market and take a bigger position if conditions are favorable post record date. And in the end, if hedge funds judge they can get paid in either outcome, why not? Sounds like arbitrage to me. You could build an entire hedge fund strategy around this.
And that is exactly what some firms are doing. They look for a merger with a large number of “no vote” shares that are eligible for appraisal rights, establish a big appraisal position after the record date, but before the effective date, and collect the appraisal premium from 1 or 2 above.
It’s a nice trade, but as Lefkort points out in the Wharton article, it could create some adverse consequences for other investors. Companies may anticipate appraisal arbitrage, and create a reserve for appraisal liability or settlement, and reduce their buyout price by that amount. In this scenario, the appraisal arbitrageur is thus capable of extracting value from other shareholders. As Lefkort puts it:
...average shareholders have paid the price of the Appraisal Arbitrageurs even if they don’t strike in the particular deal, a far from efficient outcome. Lest you think this is theoretical, I have seen more than one deal where this is the case.
So clearly, this can be a problem. Furthermore, Lefkort observes that many investors simply don’t vote their proxies, which can create the conditions for abuse. From the post:
You the stockholder can help this situation by voting that proxy card you receive in the mail. If you vote in favor of a merger, there are less unvoted shares for the Appraisal Arbitrageur to exploit.
So even if the deal looks like a slam dunk, if you like it, vote your proxy. It's the responsible thing to do, and may reduce future potential misbehavior by hedge funds that could hurt others.
While some forms of appraisal arbitrage can work against investors, it is also true that the existence of such appraisal arbitrageurs may discourage some transactions that are unfair. In particular, some management buyouts, where insiders know more than shareholders, can result in deal undervaluation.
In a publication posted on the Harvard Law School blog (a copy is available here), the authors note:
In the cases we have reviewed (from 2010 to date), the appraisal determinations representing the highest premiums over the merger price were all in “interested” transactions, and in none of those transactions was there a meaningful market check as part of the sale process.
So there may be some other kinds of bad behavior which appraisal arbitrageurs are suppressing, leading to more efficient price discovery. If you're an insider looking to pull a fast one and take your company private at a less than fair price, maybe you'll think twice before going for an egregious discount to fair value. Doubtless, some appraisal arbitrageurs would tell you that appraisal arbitrage is simply a way of expressing a view that a merger price is unfair.
Or as Andrew Barroway, the CEO of Merion Investment Management, a fund focused on appraisal arbitrage, put it:
The vast majority of deals are fair. We’re looking for the outliers.
Appraisal arbitrage is certainly an interesting game to play. The problem, however, is that all good games come to an end. In our role as a consultant to various family offices, we've seen this trade sold by every 3rd party marketer on the planet. The word is out. And when the word is out, the returns typically get more and more competitive. Regardless, if you aren't familiar with appraisal arbitrage, you should check it out.