Hedge funds get creative in Glencore-Xstrata deal

LONDON Wed Feb 8, 2012 1:44pm EST

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LONDON (Reuters) - Hedge funds are buzzing around Glencore's (GLEN.L) bumper $41 billion takeover of miner Xstrata XTA.L after a lean year for European M&A, but are finding their usual bets tricky in the face of the eye-watering cost of shorting Glencore's shares.

After a lull in European M&A deals in 2011, merger arbitrage managers are licking their lips at the prospect of a tie-up, which will see Glencore pay 2.8 shares for each Xstrata share and which has already met some shareholder opposition.

Funds are "absolutely" eyeing up the deal, one London-based prime broking head told Reuters on Wednesday.

"They're big, it's liquid, it's established companies, so it makes it easier to play it in larger size than you would before, and that's what funds with lots of money need to do, they can't just play lots of little deals everywhere."

Merger arbitrage funds typically buy shares in the target company in a deal and short-sell 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.

Funds typically enjoy complex, all-share deals where in-depth research and patient combing through legal documents can give them an advantage over other investors.

Glencore's deal, however, presents a number of challenges, not least the high cost of borrowing its stock, given its free float is just 17 percent due to employee lock-ups. This is already beginning to dissuade some funds from getting involved.

One prime broker told Reuters that the cost of borrowing Glencore stock rose to around 8 percent when the deal was announced on Tuesday and has since risen to roughly 14 percent.

Any stock that costs 8 percent or more to borrow is in "fairly extraordinary territory," the prime broker said. The cost to borrow a stock can normally range from 2 percent to 8 percent.

"Demand far outstrips supply ... There's a relatively low level of holdings with traditional (stock) lenders," the broker added. "All the big hedge funds want to have a position, but some people are pulling out of shorting at any cost."

"BRUTALLY EXPENSIVE"

While only 3.4 percent of Glencore's shares are out on loan, this is around two-thirds of the total number of shares that can be borrowed, figures from data group DataExplorers show, indicating a scarcity of stock to borrow.

Several hedge funds that Reuters spoke to cited the cost of borrowing Glencore as an obstacle.

One U.S. hedge fund said it was tricky for arbitrage funds to play the deal because "the Glencore borrow is brutally expensive and hard to come by."

Another manager said that if the borrowing cost falls, or once the restrictions on share sales by Glencore employees begin to end in May, a lot of funds will buy Xstrata and short Glencore.

Meanwhile, Amit Shabi, partner at Paris-based Bernheim, Dreyfus & Co, told Reuters the current deal spread of 5 percent annualized was "not worth looking at."

Instead, he is considering reversing the typical merger arbitrage bet by buying 2.8 shares in Glencore for every Xstrata share he shorts, which also avoids the high cost of shorting Glencore.

Such a trade could make money even if the deal goes through, simply by the spread widening. This could happen for instance if concerns grow over opposition from shareholders or regulators, Shabi said.

Standard Life, the fourth-largest investor in Xstrata, and Schroders which together own 3.6 percent, plan to vote against the deal, which requires 16 percent of Xstrata's register to vote against it for it to be blocked, according to broker Liberum Capital.

"(The spread is) optimistic. It's 5 percent if you manage to find some shares in Glencore, which seems to be not that easy and expensive," he said. "If you short this spread you have a downside of 5 percent annually, which is basically nothing.

"(By shorting the spread) you assume the spread is not remunerating you enough and will be larger," he added. "You have a lot of future newsflow to come."

(Additional reporting by Victoria Howley, Sinead Cruise and Tommy Wilkes; Editing by Helen Massy-Beresford)

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