Europe's Hedge Funds

Deliberations among the nations of the European Union about a new level of regulations for hedge funds there have reached an impasse.

I wrote here 11 months ago that the draft directive circulating at that time was dead as written. There have been lots of developments since.

The U.K., where most of the Europe-headquartered funds actually are, has been working to water down the more draconian aspects of these proposals from within the EU system, and the U.S. has been exerting some pressure from without.

The Brits are worried that this will hurt London's status as one of the world's great financial hubs, while the U.S., and in particular Treasury Secretary Geithner, worries that the EU is going protectionist -- that it will put barriers in the path of any institutions and high net worth investors there who want to entrust their money to operations in New York.

Meanwhile, the French and the Germans are pulling in the other direction, to make the regulations tougher on the nasty hedge funds, whether of New York or London, than the drafts of the directive would have it.

There is an idea circulating in some quarters that hedge funds were at fault in the 2007-08 credit crunch. That is utter nonsense. Quite old-fashioned, supposedly conservative and stodgy, institutions like banks were the real trouble makers. The hedgers generally did a good job of keeping their head while bankers all around them were losing theirs.

At any rate: the news this week is that EU diplomats tried to push the process forward at a meeting Monday, the 27th, but they failed.

A big possible winner is Switzerland. A map will tell you that the Swiss are in Europe, but they don't act like it. They've stayed away from the EU, and if EU rules do become too onerous for HFs, we might see a lot of them developing a taste for Alpine air.

Porsche and VW

VW shares shot up on the Deutsche Börse over the last two days in what looks like a classic "short squeeze." I'll take this as an opportunity to go into full-pedantry mode and explain what a short squeeze is. Those of you who already know, or who neither know nor care to learn, are of course free to click yourselves elsewhere at this point!

The price of a share of equity in Europe's largest auto manufacturer increased by 147% Monday, and is up again, though somewhat less dramatically, today.

Here's a closely-related fact: as of last Thursday, 12.9% of VW's shares were on loan to short sellers.

A short squeeze in an uncomfortable event in the life of a short seller. Specifically, it is what happens when a substantial share of a company's stock is out on loan for purposes of a short play, and the stock's price unexpectedly starts to rise. The short sellers need to cover, and they all may decide they need to cover at the same time, because they now expect the stock price to continue rising and they have to cut their losses. So they head for the same exit door at the same time, shouting "buy, buy, buy!"

This of course makes the price of passage through that exit increasingly expensive.

That, then, is what is going on with VW. Over the weekend, Porsche unexpectedly disclosed that through the use of derivatives it has recently accumulated a 74.1% stake in VW, up from 34%. The state of lower Saxony owns 20.1% This means that there is a "free float" of only 5.8% of VW's capitalization. It also means, as a matter of arithmetical necessity, that some of those shares on loan must actually be the property of Porsche or Saxony, though the short sellers presumably obtained them through the services of a prime broker.

It didn't take long for short sellers to do the math and decide that the exit door was shockingly narrow.

VW is one of the shares on which the Teutonic DJIA, the Dax index, is built. So Dax has shot up along with VW. This morning the Financial Times quotes one analyst thus: "This is a special situation and I think it will go on as long as Deutsche Börse doesn't make a decision regarding these extreme movements in VW shares."

Daimler and the locusts

Share prices of the German auto company Daimler have risen more than 4% in recent days, apparently on the strength of rumors that an unspecified hedge fund is building up a position in the company.

The magazine, Focus, citing a supervisory board member, said that it has confirmed the rumors that Daimler is "in the sight of the foreign hedge fund."

A spokeswoman for the company, responding to the magazine story yesterday, said the company has no indication that any hedge fund is interested.

The rumors seem to have gotten more specific since that statement. This morning, the newspaper Sueddeutsche Zeitung is reporting that the Swedish investment fund Cevian Capitalis buying up shares.

The meaning of the labels can be slippery, especially since the laws vary from one country to another, but Cevian seems from the description on its website to be more of a private equity fund than a hedge fund. Still, if it is buying a large chunk of Daimler, it probably wants to shake things up. That website refers to its strategy of "active ownership."

The terminological distinction is important because German politicians have taken to denouncing foreign hedge funds as "locusts." Maybe a foreign (but European) PE fund seems less threatening.

At a maximum (and I'm engaging in nothing more than blue-skies speculation here folks) this sort of news can put a company "in play" as an acquisition target. I doubt Cevian would want to acquire such a "big fish" outright, but there are other companies in the world that would want Daimler.

German corporate law.

It appears that German corporate law requires that, unless a corporation's by-laws provide otherwise, certain decisions can only be made if they are opposed by fewer than 25% of the proxy shares voted. This makes the figure 25% the "blocking minority."

Volkswagen has written into its own bylaws a still more generous provision for dissenters. It has a blocking minority of only 20%.

Twenty percent is also the share of the equity of VW owned by the government of Lower Saxony, VW's home state.

That not only gives Lower Saxony blocking power, but it makes that state the second largest of the company's shareholders. The largest shareholder is thw sports car maker, Porsche.

A ruling last year by the European Court of Justice has pressured VW toward making some corporate governance changes, fitting in more coherently with the rest of the EU. Porsche understands the ECJ to mean that VW should increase the blocking percentage. This wouldn't mean a shift to simple majority rule. It would probably be an increase to the German default option of 25% block. But even so, it would mean that in order to prevent some change that it didn't like, Lower Saxony would have to find shareholder allies.

This would be, if you will, a sort of deregulation.

Unsurprisingly, Lower Saxony doesn't see the ECJ ruling the same way Porsche does.

My sympathies are always against the government. Go, Porsche!

The punchline of an old joke says it best. "It's not a porch, it's a Mercedes."