The US economy, driven by a hard-charging stock market, large cash reserves, tax reform, and a relaxed regulatory environment, has fueled an uptick in deal-making in 2019 with no slowdown in sight. Merger activity for Q1 in the US came in at $537.6bn across 2,158 deals*, shattering the previous year’s mark of 518 deals in 2018. Led by Bristol-Myers Squibb’s offer to acquire Celgene for $96.8bn, and Danaher Corps acquisition of GE Biopharma for $21.4Bbn, healthcare accounted for the bulk of the deals followed by technology. The second quarter has been loaded with energy deals most prominently led by Chevron agreeing to buy Anadarko for $33bn.
While the global stock markets are soaring, securities lending revenues have been relatively muted on a year over year basis. Historically, securities lending revenues have largely been driven by some degree of volatility in the Mid and Small Cap Indices. Hedge Funds seek negative exposure to a company through short selling their equity thought to be overvalued. This requires a Prime Broker to borrow it for a fee, thereby driving revenue to the beneficial owner who loans the security. With little to no volatility recently, and markets on a straight path north, Hedge Funds are staying mainly long and enjoying the returns. Fortunately, these market conditions can still present opportunities for strong returns albeit from a single stock.
Often one security can drive the yearly securities lending revenue of an entire portfolio. In many cases blue-chip or “gc” portfolios can suffer from poor returns in a down-cycle borrowing environment. But in a market that is suited for merger activity, often these liquid blue-chip stocks can be highly lucrative.
At the start of February 2019, Eli Lilly and Co. announced its intention to spin off its remaining stake in Elanco Animal Health to its shareholders through a tax-free exchange offer. Eli Lilly owned 293mn Elanco shares representing 80.2% of the shares outstanding. Under the terms of the exchange offer, Eli Lilly shareholders had the right to exchange all or a portion of their Eli Lilly shares for Elanco shares at a discount. At the time of the announcement there were over 150 million shares of Eli Lilly available to borrow with only 30 million shares on loan at very thin spreads. Truly, not a special borrow. However, due to the nature of the deal, Hedge Funds were able to structure trades that would create a lucrative spread, which required the need for a stock borrow, enabling owners of blue-chip Eli Lilly to attain attractive Lending fees anywhere from .50/share to $1/share.
While these deals are not common, they are not rare either. In a certain market growth cycle, or economic environment, they can occur multiple times a year. Recently blue chip names such as Dell Technology were traded as they brought their company public again through a buy-back structure. Similarly, entertainment giant CBS has been traded as they continue restructuring is company by spinning off multiple units, cosmetics manufacturing giant COTY as they divest themselves of other units, and finally multiple years back Citigroup as they converted Preferred shares to Common.
The silver lining is that no matter the composition of your Securities Lending portfolio, over time, the changing market conditions can yield strong results.