Analysis of Split-off Trading Strategies

Split-Offs proved to be very lucrative in generating low risk arbitrage returns.  Just last week yet another split-off (ECL/APY) closed successfully with $2,100 ‘riskless’ return for hedged trades (c. +11%), while at at the same time unhedged positions delivered $10,000 (c. +50%-70%) in a month. The difference in pay-offs is clearly very material; however, higher returns seemingly come with higher risks (exposure to share price fluctuations).

In this article we look at historical data to assess pay-off profiles and riskiness of different split-off trading strategies – hedge vs no hedge as well as timing of entry and exit.

Since 2013 a total of 16 split-off transactions have been posted on SSI. All of these are listed below. The indicated returns are for the hedged odd-lot positions initiated after the transaction announcement. In most cases unhedged positions would have resulted in higher (but more risky) dollar returns.

• 2020 – ECL/APY +$2100
• 2020 – MCK/CHNG +$1200
• 2019 – DHR/NVST +$1050
• 2019 – LLY/ELAN +$900
• 2018 – FTV/AIMC +$690
• 2017 – CBS/ETM +$470
• 2016 – PG/COTY +$650
• 2016 – LMT/LDOS +$2700
• 2016 – BAX/BXLT +$335
• 2015 – GE/SYF  +$600
• 2015 – DOW/OLN +$460
• 2014 – DHR/NTCT +$1075
• 2014 – WY/TPH +$216
• 2014 – CBS/CBSO +$470
• 2013 – PFE/ZTS +$217
• 2013 – PPG/GGC +$1450

 

What is the split-off transaction?

Before we dig into data analysis, a quick overview of what split-off arbitrage entails. Those familiar with this type of special situation can skip to the next section.

To put it simply split-off is a transaction usually come in two types:

• Parent company is divesting its business unit by merging it into another listed company.
• Parent company is distributing its ownership in another listed company to parent’s shareholders.

In both cases parent company allows its shareholders to exchange parent shares for the ones of another listed company (let’s call it the ‘subsidiary company’). To incentivize the participation the exchange ratio is usually set at a premium (e.g. $110 of new shares in exchange for $100 of old shares) with upper limit in place to fix the max number of new shares to be received for each old share. Only small portion of parent company shares are accepted in the tender (around 3%-10%), therefore these split-off transactions tend to be heavily oversubscribed. As a result, only about 5%-10% of the tendered shares end up being accepted and exchanged (see proration factor graph below – proration has decreased with increasing popularity of these arbitrage trades).

However, all the listed split-off transactions so far have always included odd-lot provision, meaning that holders of 99 shares or less are being accepted on a priority basis. This allows to effectively escape the proration and have a guarantee that your shares will by accepted in the tender. Thus the ‘riskless’ arbitrage for odd-lot positions.

Obviously, this ‘riskless’ trade still has certain risks:

• Transaction might get cancelled – has not happened yet, but there is always the first time.
• Odd-lot provision might get eliminated –  has not happened for the split-off yet, but has already occurred for a number of going private transactions as well as tender offers. With ever more arbitrageurs piling on split-offs and the number of odd-lot shares participating in these special situations increasing over the years (see odd-lot participation chart below) it would not be surprising if we finally see a case where the odd-lot provision is cancelled resulting in losses for arbitrageurs (albeit these should be minor).
• The exact number of shares to be received in the exchange offer is not known till valuation dates – although in all of the cases so far this was eventually set at or close to the upper limit. This risk can be avoided by waiting till valuation dates to initiate the position, by using dynamic hedging or simply by hedging at the upper limit (has worked so far quite well).
• Short leg of the hedged trade might be forced to buy in at a loss before the expiration of the split-off. This has happened before (on one/two instances) and will likely happen again, as the pre split-off float of ‘new shares’ as well as borrow availability is usually very limited relative to number of parent shares being tendered and potentially looking for hedging.

The timeline for such transactions usually goes like this:

• After the split-off is announced, tender acceptance period to exchange shares of the parent into new shares lasts for about a month.
• Usually 5 days before the deadline, the valuation period commences (3 days) to determine the final exchange ratio (based on the average trading prices of both companies’ shares).
• About two days before the tender expiration the final exchange ratio is announced. So depending on the broker, it is usually still possible to initiate the position after the exchange ratio is set in stone.
• The new exchanged shares are received to the brokerage accounts approximately 1 week after the tender expiration deadline.

 

Different split-off arbitrage strategies

There are two important considerations one has to make before playing a split-off trade:

• Hedge vs no hedge. Hedged trade (long parent and short new shares) essentially eliminates the market risk and locks in profit at the time of position initiation. The unhedged trade leaves one exposed to share price fluctuations, but also offers a possibility of higher returns if the share price of the subsidiary company goes up after tender expiration. This is quite likely to happen as (due to expectations of increased float, indiscriminate selling by the parent’s shareholders and hedging from arbitrageurs) the shares of subsidiary company are usually under selling pressure during the exchange offer and to certain extent afterwards.
  • Hedge ratio. Before the final exchange ratio is known, hedging can be done using the upper limit (as most split-offs converge towards upper limit anyways), or by the ‘live’ exchange ratio. Then the short position is adjusted after the final exchange ratio is announced. We ran both strategies and results turned out to be virtually the same, so the charts/numbers below illustrate hedging at the upper limit.
• Timing of position entry. The second key consideration is either to initiate the position as soon as the transaction is announced or to wait till after the valuation dates when the final exchange ratio is set.  Opening right after the announcement exposes you to longer period of uncertainty – transaction termination, changes to the exchange ratio, higher borrow costs, forced buying and etc. While waiting until the final ratio is set reduces or eliminates some of these risks but also might result in lower return, if by the time the ratio is set, part of the upside gets eliminated.

 

Historical results of different strategies

We analysed previous 16 split-off transactions and calculated the returns for each using 4 different arbitrage strategies – hedged vs. unhedged and with different timing for initiating the position. Borrow fee was not included in the calculations as for the majority of cases its impact was minimal (<1% upside consumed) and would not change the overall results. Short positions are usually held for a short period of time – about 1 month (if made after announcement) or 1 week (if opened after the final ratio), so even in the situations where borrow fee got very expensive (e.g. borrow for LLY/ELAN appeared 3 days before final ratio was set and was priced at 70%/year), the actual cost of hedging decreased upside only by 1%-1.5% due to short holding period.

Note: Unhedged position results provided in the charts below were calculated assuming that the trade will be closed on the same day as the exchanged shares are received. However, we also checked if different exit dates make a difference (see “Timing Unhedged Position Exit” section below).

The results are:

• Unhedged split-off positioning on average generated 5.5% higher returns vs hedged trades irrespective of when the position was opened.
• Timing wise, it appears that opening the position right after the initial split-off announcement results on average in 4% higher returns for both hedged and unhedged trades.
• All in all, the most profitable strategy seems to be opening an unhedged position right after the initial announcement is made (14.9% returns on average).
• Importantly, the recent MCK/CHNG as well as ECL/APY split-offs are outliers in terms of losses/returns for the unhedged strategies (see detailed chart below). Nevertheless, even if these two are excluded from the set, the results remain virtually unchanged – unhedged position opened right after announcement is still the winning strategy by far.

 

Returns of the individual cases for each strategy:

 

Table below indicates the difference between unhedged and hedged (with positions opened right after announcements) strategies for the individual cases:

The difference between strategies is even more pronounced if returns are calculated in dollar terms rather than percentages. Unhedged strategies result in 2x higher average returns compared to the hedged ones.

Total returns if one would’ve participated in all 16 split-off transactions (with odd-lot positions):

 

Timing Unhedged Postion Exit

For the unhedged strategies the numbers above were calculated assuming the position gets closed on the same day when the new shares hit brokerage accounts. We also considered strategies of holding on to these new shares for additional 1 or 2 weeks. The argument being that the share price of the subsidiary company is depressed during/after the transaction due to arbitrageurs and expected selling pressure from the 2x-5x increase in float (in some cases new shares make up 80% of total outstanding shares).

The chart below indicates average returns of different exit times for the Unhedged After Announcement strategy – the difference in returns is not that material neither on average nor for the individual cases, but closing right after receipt of new shares seems to be a better option even without considering the risks of keeping exposure open for another two weeks.

Other Observations

• In 12 out of 16 cases the unhedged trades resulted in higher profits compared to the hedged trades. However, despite higher returns, the risk is also substantially larger as illustrated by MCK/CHNG example above – transaction was announced on the 10th of Feb and due to the market fall in March unhedged position resulted in 37% losses for trades opened/ right after announcement and -30% for trades initiated after final ratio was set. Meanwhile, hedged positions returned 11% and 6% for positions opened after announcement and after final ratio respectively.
• Out of the 16 unhedged positions only MCK/CHNG resulted in negative returns. For the hedged positions there was also only 1 case (although only opened after the announcement), which turned into loss – PPG/GGC (-6.4%). This happened because its final exchange ratio turned out to be 18% below the upper limit (the strongest deviation out of all 16 cases), while in the meantime the share price of GGC increased significantly (+23%), so investors had to close a considerable portion of their short position at a loss.
• Overall, opening the position right after the announcement proved to be significantly more profitable. For the hedged positions there were only 3 cases, which showed better results when initiated only after the final ratio was set (8% on average).  For the unhedged positions there were 6 cases that performed better when opened after final ratio and had on average 3% better returns.
• 2 out of 16 hedged cases had their upside almost completely eliminated because of waiting for the final ratio: DOW/OLN (13.1% vs. 1.2%) and DHR/NTCT (11% vs. 0.7%).
• In 1 out of 16 transactions (GE/SYF), borrow fee exploded (and borrow became unavailable) to the extent that arbitrageurs were forced to buy-in (close short positions).
• In 12 out of 16 cases the final exchange ratio was set at the upper limit (or at 99% of it). For the remaining 4 the difference between the upper limit and the final exchange ratio was more than 5%. However, the returns were virtually the same irrespective whether the hedging ratio (for the hedged strategy with positions opened right after the announcement) was calculated based on the upper limit or based on share prices and indicated upside right after announcement.
• For one case (DHR/NTCT) the upper limit was adjusted after the upside was eliminated nearing the expiration of the offer. The adjustment was made to incentivize shareholder to participate in the tender. This doubled the profits of those who entered the position right after the initial announcement.

 

Number of Odd-Lot Shares and Proration