Market Tremors

If last year's big financial story was the return of the M&A market, then this year's big story is the rise of hedge funds.

Hedge-fund investments reached nearly $1 trillion in 2004, according to the Hennessee Group, a hedge-fund investment adviser. With annual growth rates in the 30 percent range, hedge funds are becoming a driving force in U.S. and international capital markets. In some cases, arbitrage activity can make or break a deal, and as issuers and investors seek to understand the effects of the growing power of hedge funds, the capital markets themselves are changing.

Unfortunately, as the deal progressed, AXA learned this structure also provided an arbitrage opportunity for hedge funds. "The M&A deal got caught up in the vortex of arbs trading in financial instruments, and the MONY stock no longer traded in a rational way," says Michael Blair, a partner with Debevoise & Plimpton, which represented AXA in the transaction. "MONY stock was consistently trading over the deal price, even though our deal had been out there for months and it was crystal clear there would be no topping bid. One would have expected it to trade at a slight discount to the bid price."

MONY's price went up because hedge-fund investors around the world were buying up the company's shares, as part of a hedge against AXA's convertible bond.

of arbitrageurs.

One example is Calpine Corp., a California-based developer of independent power plants. Calpine's credit ratings and financial position have suffered greatly over the past few years, largely because of a crisis in the merchant power business. The same crisis drove other companies into insolvency--companies such as Dynegy, Mirant and NRG. "Almost every worst-case scenario that these companies and their lenders considered possible, but remote, has become [the] base-case scenario," said Standard & Poor's in a 2004 report.

Even so, the transaction held a couple of surprises for Calpine; for example, the company's stock dropped more than the company expected--12.4 percent--when Deutsche Bank sold the 89 million borrowed shares. However, Calpine's share price rebounded within days of the transaction. The company redeemed the outstanding High Tides I and II securities and other debentures in October 2004, positioning the company to conduct several other project financing transactions in the months that followed.

"The hedge was better for shareholders in the long term," Kelly says. "If we had it to do over, we'd sell the securities over three days to give us time to explain to the market what the structure meant. But it worked out the way it should, and we couldn't have done it without the borrow facility."

While few companies have suffered as greatly as LION has in the U.S. public markets, many are feeling similar pains. "I see this playing out at other companies," Snyder says. "Even mid-cap companies are taking a serious look at whether the benefits of being publicly traded are worth the expense and management time and energy. It takes a lot of resources, and I predict we'll see more companies--not just micro-caps--deciding that the burdens outweigh the benefits."

That's the decision LION reached, and subsequently the company delisted its ADRs from trading on the NASDAQ in December 2004. Although the securities are no longer traded in the United States, they can be sold or exchanged for LION shares in Germany. However, LION remains subject to SEC regulation because it still has more than 300 shareholders in the United States. So now the company is working to implement its deregistration plan, which focuses on reducing the number of share owners to 300--not an easy task.

Canadian law allows this kind of deck stacking, but in the post-Enron, post-Parmalat era, investors in many markets around the world are holding companies to higher standards. Molson's approach elicited criticism in the financial press and galvanized dissident investors' opposition to the deal. Before long, Molson was forced to back down.

In October 2004, the company modified its proposal, scrapping the plan to allow option holders to vote on the merger with Class A shareowners, and amending change-of-control provisions for two executives--provisions some investors criticized as being exorbitant and unnecessary. And in November 2004 the suitors upped the ante with a special dividend for Molson shareholders, totaling about $316 million. Notably, Pentland Securities, the holding company for Eric and Stephen Molson's shares, agreed to forego participating in the dividend.

Such factors, viewed against the backdrop of higher governance standards and empowered shareholders, complicate the environment for M&A and other transactions.

"A new level of sophistication and foresight is required," says Jeff Rosen, a partner at Debevoise & Plimpton. "The lesson of all this smart money is that banks and issuers need to think harder about creating something that will circle back and affect the deal."


Michael T. Burr

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