When British sports betting giant Flutter Entertainment (formerly Paddy Power Betfair) announced that it would be taking over The Stars Group (TSG) last month, both companies’ stocks soared. Now though, hedge funds are taking a substantial short position against Flutter.
The short sales amount to around £250 million, or a little over 4% of the company’s total valuation.
Normally, short-selling like this would indicate that speculators believe a stock is overvalued. In this case, however, there may be another reason that hedge funds feel they can make money by shorting.
Short-selling a stock means borrowing and selling shares of a company with the promise to repurchase and return them at a later date. It is similar to buying put options in that it will earn the speculator money if the stock decreases in value and lose money if it increases.
Investors have generally been positive about the news of the upcoming takeover. It would be natural to assume that hedge funds shorting Flutter indicates disagreement.
In this case, though, short-selling experts say that it is an example of what’s known as merger arbitrage.
Flutter’s takeover of TSG is a stock-for-stock merger. Rather than paying cash to buy a controlling interest in TSG, Flutter will issue new shares of its own and exchange them for TSG shares at a certain ratio.
When one company takes over another like this, the ratio should tip somewhat in favor of the target company. This is because if it were a cash transaction, the purchasing company would be paying somewhat higher than the going rate to buy a controlling interest. Here, the agreed upon ratio was 0.2253 Flutter shares per TSG share.
If the deal was written in stone and the stock market was perfectly efficient, the two companies’ stocks prices should have immediately moved to produce that ratio and stayed there. Because there is still some uncertainty to the deal and because of market inefficiencies, the ratio is not exact.
As of this writing, Flutter shares are trading at £76.10 and TSG at $19.84. Taking the current exchange rate into account, that’s a ratio of 0.2023.
The plan in short-selling Flutter stock at the moment is to use the money to buy TSG stock. Assuming the deal goes through, that TSG stock will be converted back to Flutter stock at the better ratio. The hedge funds can then use those new Flutter shares to make good on their loan, while still having shares left over as profit.
That strategy is merger arbitrage in a nutshell.
Ordinarily if a stock increases in price after being shorted, the short-seller loses money. Here, the money is being used to purchase shares in TSG, whose price is linked to Flutter’s. If Flutter’s goes up, so does TSG’s.
The only realistic way the strategy can lose money is if the deal fails to go through.
Merger arbitrage is therefore effectively a bet that a deal will proceed as announced. The difference between the agreed ratio and the actual ratio in stock prices reflects the market’s uncertainty towards the deal, and hedge funds are betting that the actual uncertainty is lower.
This opportunity for merger arbitrage wouldn’t exist if there wasn’t some speculation that the deal could fall through. Analysts have pointed to two separate risks.
First, and probably more realistically, there are questions about whether competition authorities could get involved.
Once the deal goes through, Flutter will be hands-down the largest gambling operator in the world. There will likely be complaints in some markets that the takeover creates a monopoly, or something close enough to a monopoly to qualify as anti-competitive.
If that’s the case, one company or the other may have to sell off parts of its business to avoid legal action. Should it not want to do so, that could cause the deal to fall through.
Because both companies operate globally, there are a great many places this problem could arise. That said, unless the complaint came from a particularly important market — like the US — it’s unlikely it would prove to be an impediment to such a large deal.
The other way the deal could fall through is if TSG receives an better offer. According to analysts, the most likely place this could come from is GVC, which owns the sportsbooks Ladbrokes and Coral. It’s also the owner of PokerStars competitor partypoker.
A GVC counter-offer seems like more of an outside chance than interference from competition authorities, but it isn’t impossible.
There are two sides to every deal, of course. If hedge funds are selling Flutter short, it means that someone is buying. Although the short-sellers did drive Flutter’s stock down 8.5% from its highs after the deal was announced, it has already started to bounce back.
An investor who thinks the deal is likely to go through is probably better off buying TSG than Flutter. However, a Flutter purchase doesn’t require the deal to fail to be profitable, as long as it’s not being funded by shorting TSG.
There are plenty of reasons that the deal going through can be expected to bolster the companies’ combined value long-term.
Flutter has emphasized the “cost synergies” at play, which is a euphemism for downsizing potential. The combined companies will save some money by centralizing certain functions, like human resources, that can be shared between its branches.
There are other synergies as well, such as between the FanDuel brand (owned by Flutter) and TSG’s Fox Bet initiative. This new sports betting platform lacks a daily fantasy sports vertical at the moment, so opportunities for cooperation in the US market will likely arise.
Finally, one thing TSG has perhaps been lacking is experienced management. The company has grown so rapidly in recent years that it has found itself in uncharted territory. Flutter’s team has greater experience managing a company of that scale and may help TSG’s brands realize their potential.
Although the shorting of Flutter has brought shares down in the short term, then, it should not be interpreted as skepticism about the company’s future. It is, rather, a short-term play related to the details of the takeover itself.
Overall opinion about the future of the companies post-merger remains positive.