Arbitrage opportunities in European rights offerings

From Institutional Investor:

PORTFOLIO STRATEGY
The Rights Stuff

19 Dec 2007
Eric Uhlfelder

Rights offerings and other foreign corporate actions can sometimes create remarkable opportunities for U.S. investors.

It will be months, if not years, before it becomes clear whether a Royal Bank of Scotland–led consortium secured a good deal with its record €71.1 billion ($104 billion) takeover of ABN Amro Bank in October. But the acquisition has already created a juicy opportunity for canny U.S. investors.

Fortis, the Belgian-Dutch insurance and banking group that is taking ABN Amro’s domestic Dutch banking business as part of the deal, financed its share of the takeover by making a €13 billion rights offering. The September issue created a quick windfall for buyers of Fortis’s American depositary receipts because of a pricing anomaly between those ADRs and the group’s Brussels- and Amsterdam-listed ordinary shares. What’s more, the growing number of rights issues by international companies can offer similar arbitrage possibilities to investors, fund managers say.

Ed Cofrancesco, president of Orlando, Florida–based broker-dealer International Assets Advisory, which has $300 million under management, took advantage of the Fortis rights issue immediately after the company’s ordinary shares went ex-rights on September 25. The ordinaries opened down €4.20, or 16.6 percent, from the previous day’s close of €25.30, reflecting the loss of the right to buy new shares. The ADRs, however, opened just $2.15, or 6.1 percent, lower than the previous day’s close of $35.40, then proceeded to sink to an intraday low of $28.50 before recovering to close at $33.25.

“Market makers were pricing the ADRs as though they had gone ex-rights as well,” recalls Cofrancesco, “but ADRs typically go ex-rights weeks after the ordinaries do because of the time it takes the respective U.S. depositary to determine the value of the rights.”

The reason for this time lag, explains Claudine Gallagher, global head of depositary receipts at JPMorgan Chase & Co. in New York, is that most rights offerings for international companies are not registered in the U.S. This means that American investors can’t purchase the new shares. But the participating depositary still receives the rights and then sells them abroad on the secondary market during the time in which the rights trade — a period that typically runs several weeks. “Only after we sell all these rights and repatriate the proceeds into dollars can we determine their value for U.S. investors and set a record date,” explains Gallagher. “Until this is done, the ADRs trade with rights.”

Cofrancesco began buying the ADRs when he saw the price drop below $29, then sold out of his position later the same day after the price rebounded to $33, earning a profit of nearly 15 percent in a matter of hours.

Such quick returns on foreign rights issues aren’t unusual, says Christopher Meyers, a former market maker who now runs the New York–based investment partnership Q 4 General Partners. “It takes time,” he says, “for investors to discern the value of certain corporate actions across markets, especially when one of the two may be closed and when fungibility is suspended — as is the case after local shares go ex-date.”

Investors have a good shot at finding arbitrage opportunities, given the tremendous growth in rights offerings. The value of non-U.S. rights issues this year through mid-November soared to $78.1 bil­lion, compared with $56.5 bil­lion in all of 2006 and just $26.1 billion in 2002, according to data provider Dealogic.

Meyers believes arbitrage possibilities are more pronounced when they involve Pink Sheets–traded ADRs, the pricing of which is dependent upon market makers. Their pricing programs often do not take account of rights issued because there’s no data to input, explains Meyers.

Spin-offs and regular dividend payments can also create arbitrage windows, Meyers says. An example was Volvo’s 2004 spin-off of its 24.8 percent stake in truck maker Scania into a new holding company, Ainax. At the time, Volvo’s ADRs, listed on the Nasdaq Stock Market, were trading below the implied value of its ordinary shares plus the spin-off.

“The deal was a bit complicated, with investors having been offered two shares of Ainax,” Meyers recalls. “But the implied value of the ADRs became increasingly transparent as Ainax began trading publicly in Stockholm before Volvo’s ADRs went ex.” On June 4, eight days after the Swedish shares went ex-rights, the shares plus the spin-off were worth the equivalent of $35.31, but Volvo’s ADRs traded down to an intraday low of $33.69. Going long the ADRs and short the ordinary shares secured a profit of 4.5 percent in less than two weeks. Meyers surmises that many institutional investors were doing just that as ADR daily trading volume soared tenfold between the two ex-dates.

Joshua Duitz, a research analyst at Alpine Woods Capital Investors and a former trader at Bear, Stearns & Co., says that rights arbitrage opportunities can also be found with ADRs listed on the New York Stock Exchange. British water company United Utilities raised £1 billion ($1.57 billion) in a two-tranche rights issue that began in 2003. On the day the shares went ex-rights, the company’s Big Board–traded shares moved down as well, falling from the previous day’s close of $17.21 to an intraday low of $16.10. With the ADRs still trading with rights, their implied value based on the local share price plus the rights was $17.34. Five days later, while London shares remained flat, the ADRs traded $1.47 higher.

“The instantaneous flow of information across the globe and the inherent pricing inefficiencies between markets makes arbitrage possible,” observes IAA’s Cofrancesco. The increasing size and number of offerings is expanding the opportunities for investors who want to do the homework.

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