To put it simply, a split-off transaction usually comes 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 the parent company allows its shareholders to exchange parent shares for the ones of another listed company (subsidiary company). To incentivize participation the exchange ratio is usually set at a premium (e.g. $110 of new shares in exchange for $100 of old shares) with an upper limit in place to fix the max number of new shares to be received for each old share. Only a 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 the increasing popularity of these arbitrage trades).
However, all the listed split-off transactions so far have always included an 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 be accepted in the tender.
When researching a split-off make sure to check the timeline (especially the valuation date), borrow availability for a hedged trade, and decide on your trading strategy. There are two main choices you have to make – whether you will go with a hedged trade or unhedged trade, and when will you initiate the position (right after the announcement or post valuation date when the final ratio is known). All strategies have their own pros and cons, however, our analysis shows that the most profitable strategy seems to be opening an unhedged position right after the initial splif-off announcement is made.
See our Analysis Of Split-Off Trading Strategies HERE.