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Porsche and Volkswagen
In a time when many odd economic events are taking place, this saga nonetheless deserves comment:
Volkswagen's shares more than doubled on Monday after Porsche moved to cement its control of Europe’s biggest carmaker and hedge funds, rushing to cover short positions, were forced to buy stock from a shrinking pool of shares in free float.
VW shares rose 147 per cent after Porsche unexpectedly disclosed that through the use of derivatives it had increased its stake in VW from 35 to 74.1 per cent, sparking outcry among investors, analysts and corporate governance experts.
This seesaw has been going on for some time and German regulators haven't done much about it, despite complaints from hedge funds. Today the share price rose by a factor of nearly five (!). So for a brief while Volkswagen became the world's largest company in terms of capitalization. Who needs Exxon and WalMart?
I thank Ben, a loyal MR reader, for the pointer to this episode.
Posted by Tyler Cowen on October 28, 2008 at 09:24 AM in Economics | Permalink
Comments
Why should German regulators do anything about it? I know many hedge funds involved in what's called the Porsche stub trade, and truthfully, it was flawed from the start. Essentially what happened is that earlier this year Porsche disclosed a sizeable stake in VW. Hedge funds figured out that the value of Porsche's stake in VW exceeded the enterprise value of Porsche, meaning in effect you were getting paid to own the operating business of Porsche. So to capture that spread, you go long Porsche and short VW. I know a number of funds that put this trade on and pitched it to me. The glaring flaw in their analysis though was that they assumed that Porsche, who had announced its intention to take a "majority" stake in VW, was going to stop accumulating at 50.1% because Lower Saxony controls 20% of VW and it was thought they would never acquiesce to a takeover by Porsche. Porsche never committed to stopping at 50.1%, and as this weekend's announcement shows, they didn't.
So what ended up happening was that the hedge funds were shorting VW as Porsche was acquiring it. It's akin to a reverse risk arb; in risk arb you buy the target and short the acquiror, here the funds were shorting the target and buying the acquiror. As would be expected, this is a recipe for disaster. Once Porsche announced they controlled 74.1% of the stock through owned shares and cash settled options (where their banks effectively control the shares), it became obvious that with only 5.9% of shares now in the free float (remember Saxony controls 20%) that the 13% of shares sold short were in a, shall we say, precarious position. Thus the single greatest short squeeze I have ever seen. VW is now valued at over 2x Toyota Motor despite being smaller and less profitable.
Posted by: joe at Oct 28, 2008 9:38:24 AM
Can someone explain why Porsche's owning of cash-settled options would decrease the free-float % of VW shares?
Posted by: Chad at Oct 28, 2008 9:52:07 AM
Seems to me that having the shorts squeezed in such a manner is a far better object lesson about the possible dangers of naked puts than government regulation could ever be. (And naked puts are sometimes quite useful and healthy things.)
Posted by: John Thacker at Oct 28, 2008 9:53:37 AM
Porsche raised its stake to 42.6% buying shares plus another 31.5% through options - thus the direct+indirect 74.1% stake. Free float is reduced because until sunday everyone thought Porsche's cash share to be just 35%.
Posted by: CRP at Oct 28, 2008 10:04:59 AM
BTW, I agree that shorters are paying for a mistake. On the other hand, Porsche has been less than transparent, stating repeatedly that they are not actively buying on the market, have no intention of reaching 75%, are not lending VW stock etc. So one might say that there has been market manipulation, and many HF fell for it.
Posted by: CRP at Oct 28, 2008 10:07:33 AM
To CRP: I thought these were cash-settled options though. Am I wrong that cash settled means that when you exercise them you don't actually get the stock and merely get the price of the stock?
Posted by: chad at Oct 28, 2008 10:17:54 AM
A possible reason for regulatory action could be that, at least in the United States, a holder of a certain amount of stock in a company must disclose its purchases to provide greater transparency in the market. If Germany has similar requirements and Porsche failed to appropriately comply, then the securities regulators would have grounds to take enforcement action. The point is not to protect naked option takers, but to enhance confidence in the the market and provide information and greater transparency.
Posted by: DWG at Oct 28, 2008 10:18:38 AM
Boy, I could lose money on this deal and not even learn anything useful.
Posted by: Andrew at Oct 28, 2008 10:32:01 AM
DWG,
According to FT Alphaville, the "relevant legislation" that would curtail Porsche's activity does not come into effect in Germany until the spring, so they would seem to be in the clear.
Posted by: at Oct 28, 2008 10:43:43 AM
chad, correct, but Porsche's goal is raise its control of VW, so they would use cash proceeds from cash settlement of options to buy VW. I think what will happen in practice is that Porsche will just go to its option writers and agree on some options-for-VW-shares scheme
Posted by: CRP at Oct 28, 2008 11:21:34 AM
And now GS and MS are down -10% to -26% on rumors that they lost bundles on VOW!
It serves them right for taking on the Largest Company in the World!
They've come out with statements refuting this (and we heard it from other sources), but rumors have a life of their own.
Posted by: Nick at Oct 28, 2008 12:18:15 PM
Porsche's stake in VW was worth 105b Euros while it entire market cap is something like 9.05 billion Euros talk about dislocation...
Posted by: hank at Oct 28, 2008 1:07:34 PM
And now GS and MS are down -10% to -26% on rumors that they lost bundles on VOW!
No problem, Paulson's got tens of billions lying around to help them out. It'll be good for main street. Good for America.
Posted by: guy in the veal calf office at Oct 28, 2008 1:09:06 PM
The free float is actually around 15%. Lower Saxony owns about 20% of VW.
Wolfgang Porsche has always wanted to bring Porsche and VW together even though he doesn't like the Piech side of the family tree. Porsche has been building this stake for years and doing it in this exact manner. Although, I suspect Porsche may been using derivatives to hedge the exposure (or take outright bets) on their VW options and shares.
While the short position on VW's fundamentals makes perfect sense, everyone knew they were going to eventually take over VW. While I'm sympathetic to complaints that the whole thing is shady, that was the side any shorts had to play against, and a hedge fund "in the know" should have known that was a risk.
Posted by: Nate at Oct 28, 2008 2:21:08 PM
I can barely understand it, but it sounds hilarious.
Posted by: Phil at Oct 28, 2008 2:38:12 PM
I've no idea what you're all talking about.
Posted by: Sune at Oct 28, 2008 2:45:56 PM
Phil and Sune: hedge funds noticed Volkswagen shares were way overpriced, and shorted them. However, Porsche had secretly cornered the market in Volkswagen shares, and publicly revealed this fact a couple of days ago. Short-sellers were forced to buy back VW shares at ruinously ever-higher prices.
Shorting shares means you try to sell high and buy low, in that order. If the price spikes in the meantime, you lose. Just like panic selling can drive the price of shares down (a familiar scenario lately), panic buying by short-sellers can spike the price upward, which is known as a "short squeeze". This was the mother of short squeezes.
The money quote:
“I have hedge fund managers literally in tears on the phone,” said one London-based auto analyst.
P.S. when Porsche casually revealed that they controlled far more VW shares than they had previously been thought to own, they disingenuously stated:
The disclosure should give so called short sellers [...] the opportunity to settle their relevant positions without rush and without facing major risks.
Which only goes to show that sadistic Teutonic humor is alive and well.
Posted by: at Oct 28, 2008 3:44:25 PM
By the way, the Dow Jones and S&P 500 were both up more than 10% today. Coincidence? Although Volkswagen was a unique situation and Porsche's maneuver would probably run afoul of the regulatory authorities in most jurisdictions (but not Germany), still, I can't help but wonder if short sellers across the board suddenly decided to rethink their positions and get a lot more cautious. After all, if they didn't see that one coming, what other surprises might be in store?
Nevertheless I wouldn't count on this marking the bottom. As Nouriel Roubini has pointed out, the worst is yet to come.
Posted by: at Oct 28, 2008 4:15:15 PM
It's amazing that hedge funds are so despised that people don't seem to mind that porsche lied (yes lied) about their intentions and blatantly manipulated the market. But hey, if the counterparties are american and english "locusts", then i guess it's okay to let them suffer. I am not short VW shares, but I continue to follow this story and I think it has several more interesting turns to take. What Joe did not mention in his good summary of the situation is that Porsche had stated publicly earlier in the year that it would not seek to go to 75% and only very recently (3 weeks ago) did they mention that going to 75% was a "theoretical possibility". I guess "theoretical possibility" actually meant they were buying boatloads of options to take them to 75%. I have heard that privately porsche was telling investors the share price was too high and thus egging on short sellers. So hedge funds that were caught short were a little naive, but the "flaw" Joe points out is really that they took Porsche management at their word. And that turned out to be a huge mistake.
Other tidbits:
1) Porsche has disclosed they own options to take porsche to 75%. . but these could be way out of the money call options that as of last week (pre announcement and squeeze) had fallen tremendously in value as VW fell 50%.
2) Porsche has also sold puts in the market (perhaps to fund buying all these calls), so last week's sharp decline also was probably killing them on put liability.
3) So whatever options they own, Porsche has clearly levered up to buy them (Porsche is a tiny company compared to VW). When VW stock fell last week, all of a sudden Porsche could have found itself in a terrible liquidity crunch. Thus the press release about owning options to go to 74% and the very weird statement about allowing shorts to exit their positions in an orderly fashion (hahaha).
the whole thing is totally bizarre. and Sunday's announcement smelled more like panic than triumph to me. it is too bad there aren't more financial journalists looking at this situation from the correct angles. . .i feel like it's another fantastic story from 2008 featuring games with derivatives which have gone bad. if porsche does not get away with cornering the market here, they could be totally screwed. given their bad behaviour, they deserve it.
Posted by: jeff at Oct 28, 2008 5:16:24 PM
I guess hedge funds are in part to blame for some of the mess we've been seeing in the past few months. Financial markets are very much disconnected from underlying fundamentals these days, and that's both dangerous and unhealthy.
Not much pity for those beaten hedgies. That may also be why the German regulators didn't bother to intervene.
Posted by: Pete at Oct 28, 2008 6:16:55 PM
porsche lied (yes lied) about their intentions and blatantly manipulated the market
Welcome to the poker game.
Posted by: Anderson at Oct 28, 2008 6:17:53 PM
Okay I think I get it now. What made people short VW in the first place?
Posted by: Sune at Oct 28, 2008 6:29:47 PM
"Okay I think I get it now. What made people short VW in the first place?"
Fundamental overvaluation. A stupid reason in this case.
Posted by: IWantCookieNow at Oct 28, 2008 8:13:12 PM
Now does anyone here think that Porsche did all this themselves?
As one of the recent posters points out, Porsche may have have themselves gone out on a limb selling puts, buying Way OOT calls, etc. Perhaps, perhaps not.
Others imply that there was manipulative intent in all this as well.
This sounds to me like there was some good advice (especially with regards to current disclosure law in Germany) by financial engineers.
Does anyone know which bank/i-bank is advising Porsche?
They will be the real culprits screwing the hedgefunds.
Would be interesting to find out!
Posted by: murray teynnensw. at Oct 28, 2008 8:50:41 PM
Everyone of those traders is whining, but are not options volumes available? Wouldn't due diligence be to know what those are?
And Jeff, selling naked shorts should be dangerous; traders should bare the risk.
And why is it so damn different if Porsche buys those options or Warren Buffet?
Why should one have to disclose and the other not?
The point that everyone seems to have forgotten is that being a trader involves risk. Risk is a part of the reason you get paid the large sums you do. If you don't like the blow-up, don't pick up pennies in front of the steamroller. You guys got your bailout now stop whining that its too damn risky.
Posted by: R. Pointer at Oct 28, 2008 9:08:15 PM
Looks like the world's second biggest short squeeze.
The world's biggest short squeeze, of course, is still underway in the US dollar.
Posted by: Russ R at Oct 28, 2008 9:08:17 PM
In a credit crunch, when banks and private equity falter, it's heartening to see hedge funds step up to the plate and provide the financing for a leveraged buyout. :)
Posted by: at Oct 28, 2008 9:22:13 PM
To flesh out the cash settled options thing a bit:
1. Porsche buys (OTC) cash settled call options from Banks
2. Banks hedge their exposure by buying physical call options from MarketMakers
3. MarketMakers hedge their exposure by buying underlying shares of VOW on the Exchange
then:
4. MarketMakers lend the underlying to the HedgeHunds for a bit of profit
5. HedgeFunds sell the underlying back into the Exchange, buying Porsche
the cycle continues, and now the various parties start getting worried.
6. Porsche worries it could be owned by the HedgeFunds
7. The Banks worry the option expiration could be horrible as they are forced to sell off a huge VOW position to pay off the cash option obligation
so...
8. Porsche tells the market that it will acquire physical with cash at exercise
9. the Banks breath a sigh of relief - they are hedged nicely and price of the underlying will not fail near expiry - no need to panic sell
10. the HedgeFunds start buying back those shares from the Exchange they will need to return to MarketMakers
11. underlying price rises, MarketMakers now buy more shares too so they stay delta-hedged.
Suddenly, a "good" trade turned into a prisoners' dilemma: one Porsche and lots of hedge funds means the funds couldn't act in a co-ordinated fashion. Many start unwinding to protect themselves, and Porsche wins.
Who loses?
1. The HedgeFunds. The arb blew up.
2. The Exchange. Some HedgeFund counterparties default.
3. The MarketMakers. Nasty gamma there, hope they had good models.
Did I miss anything?
Posted by: Gorobei at Oct 28, 2008 9:52:53 PM
Why should German regulators do anything about it?
Because an public offer is mandatory
Posted by: k at Oct 28, 2008 10:16:35 PM
LIBOR OIS & TED spreads ended the week down 21% and 27%CP Yields on 90day paper increased to 4.9% on Firday, posting a 14% decrease for the week
5 year spreads on A-rated corporate bond increasing 4.9% and B-rated bonds increased 3.7% for the week.
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Posted by: suner at Oct 28, 2008 11:13:08 PM
Mmmmm, gotta love that new A4! I know VW has stated that they have been holding up well in this global economy. I know I could not live without my older A4.
Jesse W.
http://www.subprimeblogger.com
Posted by: Jesse W. at Oct 29, 2008 12:28:49 AM
So if VW is the largest company in the world, and Porsche owns VW, doesn't that make Porsche the largest company in the world?
Posted by: doctorpat at Oct 29, 2008 12:47:08 AM
Doctorpat: no, that's what got the hedge funds into this in the first place: Porsche (excluding its VW holding) has negative value.
(Also Porsche only owns 75% of VW, at most).
Posted by: Sammler at Oct 29, 2008 5:54:05 AM
What is going on here? Should I invest in VW or PORSCHE?
Posted by: Al Dickman at Oct 29, 2008 7:36:01 AM
Doctorpat, presumably Porsche borrowed fortunes to pay for those shares.
The trick, as far as I can tell, is that German law requires a company to tell when they buy a significant share in a company, and also when they take physical options on a significant share, but not when they take cash-settled options.
So Porsche and their banks played a trick, where the banks buy shares (or physical options) instead of Porsche, and Porsche took cash-settled options. For all practical purposes, Porsche owns the shares, but they do not have to disclose this information.
Posted by: Zamfir at Oct 29, 2008 9:48:34 AM
It sounds like Porsche and Volkswagen screwed some people over. From what I see Porsche did this by having invested more in Volkswagen than anyone new. I am just glad that this situation has nothing to do with me because it sounds like a lot of people lost a lot of money.
Posted by: JH at Oct 29, 2008 10:58:57 AM
Two comments:
Gorobei writes:
"6. Porsche worries it could be owned by the HedgeFunds"
NO, there is no reason to worry, as the HFs only OWN preferred no-voting right shares, thus they can exert NO control at all. All common stock is owned by Porsche and Piech family!
Sammler writes:
"Doctorpat: no, that's what got the hedge funds into this in the first place: Porsche (excluding its VW holding) has negative value."
Theoretically true, but it shows the conceptional error of the market-cap notion here.
Of course Porsche does NOT have a negative value, that only appears when one values Porsche's stake of 42% in VW at the current market price of the last trade.
These prices are ALWAYS set at the margin, and thus only stand for a trade with a like margin/free float ratio.
If a large block were to ever hit the market, that ration changes.
Thus multiplying the total shares outstanding with the marginal price of the last trade is a BS notion, and leads to fictitious market caps in many if not most companies.
Imagine if Bill Gates were to sell 50% of his MS shares? Do you think there would be no change in the "value" of MS, and thus that he could realize the corresponding share of the so-called current market cap? Of course not.
This is true whether or not the huge share portion were to hit all at once, or whether it would trickle-in, on piecemeal divestiture. In the latter case it would just not be as noticeable.
Same in Porsche's case. If anyone were to try a buy-up and break-apart of Porsche and VW, they could never realize the 42% times 200 billion sum on the VW sale, just as Bill Gates could not extract his 20-30 billion (or whatever his share is supposedly currently worth).
Posted by: murray t. at Oct 29, 2008 11:47:24 AM
Is there such a thing as business ethics? It was known that Porsche wanted to take control of VW. This might have been an efficient way of doing this, but at what cost VW already manufactures at least three models of Porsches now that the companies will be integrated how well will their efficiency be with all the mixed feelings about how they assumed control. What is to be gained if a company saves a little money but causes internal problems and damages its public image?
What about the millions of dollars hedge funds lost? Without regulations that require a companies intentions to be transparent it would be hard for investors to make sound decisions upon were or who to invest in. it seems that Porsche misled the market and took advantage of legislature in order to acquire majority control of VW. The market should be competitive to stay healthy this is understandable but, it should be fair.
The short run VW stock has rocketed upward but will the long run prove to benefit them as well? What exactly does Porsche has to offer a company who produces more fuel efficient and cost efficient cars? It seems that Porsche will get the best end of this deal and due to the nature of the merger will have escalated already hostile conditions between two rival companies
Posted by: lilly at Oct 29, 2008 11:57:32 PM
It's worth noting that Max Warburton of Sanford Bernstein apparently figured all this out a week or so before Porsche pulled the trigger (note date of October 17). Maybe the hedgies should have been reading FT Alphaville.
Posted by: at Oct 30, 2008 6:50:02 PM
