August 30, 2023 – In the context of a modern corporation, shareholdings represent ownership units in a company. A share represents a portion of ownership interest in a corporation.
This ownership confers various rights and privileges beyond ownership, including voting rights, dividends, marketability, information access, rights offerings, and more.
From a governance perspective, typically, having one vote for each share is the best practice.
“One share, one vote” is a fundamental principle in corporate governance that emphasizes the equality of voting rights among shareholders. Each share of a company’s stock grants the shareholder one vote in corporate decisions, regardless of the number of shares they hold. In other words, the voting power of a shareholder is directly proportional to the number of shares they own. The one-share, one-vote structure is prevalent and represents most voting structures within publicly traded corporations.
In addition to its fairness from a governance perspective, one-share, one-vote corporate structures are popular because they are simple. Investors prefer simplicity, while complexity can negatively affect the value of a security. All else being equal, shares with diminished voting rights tend to trade at a discount to super-voting shares (those with multiple votes per share).
However, despite investor aversion to dual share class structures, some publicly traded corporations continue to have multiple share classes. Usually, these dual share class structures were implemented for one of two reasons. Either a founder-led CEO wanted to maintain control, or a corporation required an additional share class to facilitate a financing.
In any event, a dual share class structure is generally unnecessary, and to the extent a corporation has one, historically, we have seen some seek to eliminate the complexity and undergo a dual share class conversion. For example, a company seeking to eliminate its super-voting shares would propose converting its class B shares to class A shares, subject to a shareholder vote.
Any security becoming convertible to another can become an attractive investment opportunity. Enter the arbitrageur.
In June’s merger memo, Exploring Subscription Receipt Arbitrage, we explored the arbitrage opportunity created when a corporation issues a temporary new class of shares, subscription receipts, to complete a financing contingent upon an acquisition.
Dual share class arbitrage is similar to subscription receipt arbitrage, in that it consists of a corporation converting a different class of shares into common stock. In both scenarios, arbitrageurs capitalize on the spread between both share classes by buying the cheaper share class and shorting the more expensive.
Given the similarities, dual share class arbitrage can be considered subscription receipt arbitrage’s little cousin.
Dual share class arbitrage does not occur very often. While there have been 94 subscription receipts issued over the past twelve years, for dual share class conversions, there have only been seven.
While the conversion of one share class to another is theoretically simple, conditional only upon a shareholder vote, in practice, it can be quite complex. There are two pieces of one pie, and sometimes each side fights for a larger slice.
Unique dynamics have affected some of the historical dual share class conversions. The Whitewave Foods exchange was by far the simplest – one super-voting class B share was converted 1:1 into a class A share, and the exchange closed in a relatively quick 106 days. In the Hubbell and Shawcor transactions, a significant cash consideration was utilized to take out the controlling shares of the company founder’s holdings or buy out their voting rights. In the Power Corp and Forest City conversions, the shares with greater voting rights were granted a larger piece of the pie, as exemplified by their conversion ratios of 1:1.05 and 1:1.31, respectively.
Things became quite interesting with the Telus dual share class conversion in 2012, with a story straight out of a Spy vs. Spy comic strip.
Featured as a wordless comic strip in Mad Magazine, Spy vs. Spy is a comic strip in which two nearly identical spies, one dressed in white and the other in black, engaged in constant battles of wits. The pair were constantly at war with each other, using a variety of booby traps to inflict harm on the other.
The entertaining Telus share exchange resembled the classic comic strip as it pitted hedge fund versus hedge fund.
As expected, many arbitrage hedge funds (including mine) went long the arbitrage spread, seeking to generate yield as the share spread closed upon completion of the exchange. Concurrently, one large U.S. hedge fund reversed the spread, taking the opposing position to fight the deal and capitalize on other hedge funds unwinding the trade.
While the one large U.S. hedge fund put up a valiant effort and likely spent hundreds of millions of dollars on its reverse arbitrage campaign, the corporation held the cards and could control the process so the dual share conversion ultimately closed. The regular-way arbitrageurs won the battle as the share class exchange was consummated successfully.
The dual share class conversion fun did not stop there. In fact, we just had one for the ages. The great APE / AMC battle of 2023 will go down in history as the most heavily contested and litigated dual share class conversion.
AMC is a struggling movie theater company that had become a meme stock throughout the pandemic and had seen its fortunes turn due to surging retail interest in its shares. To capitalize on irrational retail speculator buying of its stock by traders basing their decisions on conspiracy theories of short squeezes, AMC did the rational thing to capitalize on the madness by issuing as many shares as they could, expanding its share float nearly ten-fold. Unfortunately, after issuing hundreds of millions of shares into the market, its corporate charter prevented it from issuing more.
Fortunately for AMC, it found a loophole to continue raising equity capital by issuing shares into the frenzy of retail share buying. It created a new share class, AMC Preferred Equity (known as the APEs), to continue issuing shares. The APE shares represented the equivalent economic interest in AMC as its common shares.
Unfortunately for the company, the constant issuance of APE shares caused the shares to trade at lower and lower prices, until the share price dipped below $1.00 and the company was prevented from issuing more shares.
In order to save the company from bankruptcy, given its debt-heavy balance sheet and deteriorating financial performance, AMC proposed converting its APE shares to common shares and effecting a reverse share split. These actions would allow it to raise more equity capital and stay out of bankruptcy court.
Given the extreme differential that the two share classes traded at, despite representing an equivalent economic interest in AMC (remember the AMC common shares were a meme stock), the 1:1 conversion represented a massive 679% premium for the APE shares. The proposed conversion was only subject to a shareholder vote, and then it could be effected.
With such a large premium, the downside for an arbitrageur long APE and short AMC was significant. In addition, AMC was a retail-dominated meme stock, and individual speculators would gather on Reddit chat boards to try to manipulate the stock and engineer short squeezes. Also, because the dual share class spread was so wide and the short side of the trade was effectively 100%-retail held, short borrow was scarce and extremely expensive. At the announcement of the dual share class conversion in December 2022, the short borrow rate was already more than 100% and would surge above 1,000% over time.
Due to the massive spread, the meme stock nature of the short position, and the astronomical short borrow cost (in which an extended timeline put profits at risk), this was a high-risk arbitrage trade.
Meanwhile, as the conversion progressed, a vote was scheduled for March 2023, with the conversion to be implemented shortly after.
Unfortunately for arbitrageurs, and for reasons not known to any rational investor, AMC common shareholders filed a class action lawsuit against the conversion. Note that the conversion was necessary to keep the company out of bankruptcy.
As seen in the APE – AMC share spread graph below, the spread blew out to approximately 300% in late February. As the litigation over the conversion proceeded over the next several months, the spread remained highly volatile. Ultimately, the parties settled at a 1:0.88 APE to AMC ratio, and the dual share conversion closed in August.
While the return on brain damage of the APE-AMC dual share class conversion was negative, the transaction was completed successfully, and arbitrageurs who managed to hold throughout all the drama were ultimately rewarded.
Regardless, as most dual share class conversions can be quick and simple, like a Spy vs. Spy storyline, some can have many twists and turns as competing interests occasionally battle for a larger piece of the pie. Navigating dual share class conversions can be tricky, but for a seasoned arbitrageur who appropriately manages risk, they may potentially provide attractive investment returns.
The AlphaRank.com Merger Monitor below represents Accelerate’s proprietary analytics database on all announced liquid U.S. mergers. The AlphaRank Merger Arbitrage Effective Yield represents the average annualized returns of all outstanding merger arbitrage spreads and is typically viewed as an alternative to fixed income yield.
Each individual merger is assigned a risk rating:
- AA – a merger arbitrage rated ‘AA’ has the highest rating assigned by AlphaRank. The merger has the highest probability of closing.
- A – a merger arbitrage rated ‘A’ differs from the highest-rated mergers only by a small degree. The merger has a very high probability of closing.
- BBB – a merger arbitrage rated ‘BBB’ is of investment grade and has a high probability of closing.
- BB – a merger arbitrage rated ‘BB’ is somewhat speculative in nature and has a greater than 90% probability of closing.
- B – a merger arbitrage rated ‘B’ is speculative in nature and has a greater than 85% probability of closing.
- CCC – a merger arbitrage rated ‘CCC’ is very speculative in nature. The merger is subject to certain conditions that may not be satisfied.
- NR – a merger-rated NR is trading either at a premium to the implied consideration or a discount to the unaffected price.
* AlphaRank is exclusively produced by Accelerate Financial Technologies Inc. (“Accelerate”). Visit Alpharank.com for more information. Disclaimer: This research does not constitute investment, legal or tax advice. Data provided in this research should not be viewed as a recommendation or solicitation of an offer to buy or sell any securities or investment strategies. The information in this research is based on current market conditions and may fluctuate and change in the future. No representation or warranty, expressed or implied, is made on behalf of Accelerate as to the accuracy or completeness of the information contained herein. Accelerate does not accept any liability for any direct, indirect or consequential loss or damage suffered by any person as a result of relying on all or any part of this research and any liability is expressly disclaimed. Accelerate may have positions in securities mentioned. Past performance is not indicative of future results.