How collars can choke a market

Generally put in place when shares are used as security for a loan, collars can have unintended consequences.
Derivative transactions can cause severe share price stress, and ordinary shareholders feel the impact much more when the market is dropping than when it’s rising. Image: Moneyweb

Not too long ago companies were lambasted for having what was rather quaintly referred to as ‘lazy balance sheets’. The term, referring to a cash-comfortable balance sheet, conjured up images of a rather overweight, sluggish corporate entity that didn’t quite make the grade. Remarkably even a company as slender and dynamic as Mr Price was tagged with the epithet at one stage.

The ‘lazy balance sheet’ jibe was directed at companies with comfortable levels of cash; it seemed designed to encourage executives to consider increasing dividend payments or, more enthusiastically, buying back shares.

Sweating a lazy balance sheet became a popular and generally lucrative sport for bankers and analysts.

And because it improved return on equity, it invariably lifted the share price. Being part of a fashionable practice also helped.

Soon it wasn’t just companies that were targeted by the financial gymnasts. Corporate executives with humungous amounts of their wealth tied up in shares were encouraged to do a bit of balance sheet sweating. In what now seems like a different lifetime, just one year ago Capitec chief financial officer André du Plessis described Michiel le Roux’s multi-billion-rand collar as “an efficient way for Michiel to sweat his balance sheet while not losing ownership of his Capitec shares”.

Collars are generally put in place when shares are used as security for a loan as this means less security is demanded by the bank. It provides insurance, or a hedge, against the share price dropping below a predetermined level or strike price; in exchange the gains from share price increases are limited to a predetermined level.

Covid-19

Fast forward to early March 2020 and the midst of a Covid-19 panic. As the Capitec share price tumbled 39% to just above R550, a level last seen four years ago, Le Roux’s strategy didn’t seem quite so efficient.

Management issued a statement “explaining” why R49 billion had been wiped off the bank’s market value in a matter of hours.

International shareholders impacted by the weakening of the rand were inclined to sell the share and algorithms used by professional traders enforce disposal of a share when the price declines below a certain level, explained Capitec, before adding what was possibly the trigger for the steepest part of the decline: “Banks that are counterparties to collar transactions are inclined to sell the underlying share when contracted limits are breached.”

Le Roux is not mentioned but it is likely, given Capitec’s shareholder spread, that the collar transactions referred to were largely his. And it is inevitable, given the lack of liquidity in Capitec shares, that the sales by the banks considerably aggravated the weaker trend.

Le Roux, who co-founded the bank in 2001, holds an indirect 13.3 million Capitec shares, making him the second largest shareholder behind PSG. A combined 3.75 million of his shares are tied up in collars, which were put in place in recent years to provide security for bank loans.

Le Roux said last year that he had hedged the risk on 3.75 million of his shares: “I am growing older and need to acquire a little bit of balance in my personal portfolio.”

The most recent collar, involving 1.25 million of the 3.75 million shares, was put in place last June. The strike price was R1 161.99, and it now seems that as the Capitec share price approached that level the banks were forced to sell more and more shares to hedge their position.

In the last few years directors, not just Le Roux but also Shoprite’s Christo Wiese, Redefine’s Harish Mehta, Discovery’s Adrian Gore and executives at EOH, Aspen and Ascendis, have all used collars to ‘sweat’ their personal balance sheets.

Remarkably, until last December there was no requirement for directors and prescribed officers to disclose these sorts of derivative transactions.

Sasfin’s David Shapiro says the disclosure requirements should have been introduced much earlier. Derivative transactions can cause severe stress on the share price, says Shapiro, and ordinary shareholders need to know what’s going on. He calls for improved levels of disclosure to allow the market to see both sides of the derivative contract.

Impact

“We feel the impact of these transactions much more when the market is dropping than when it’s rising,” he says, referring to the recent collapse in the Discovery share price.

Last week Gore’s previous expectations of an uptick in the Discovery share price proved horribly wrong as it dropped towards the R83 floor price of his collar. Selling by the banks saw the share plunge to a low of R54.50.

Four months ago Gore had rolled over a hedging contract involving 8.8 million of his shares for a mere four to seven months, explaining that he hoped market conditions would improve. He told investors the expected stronger sentiment would provide a better opportunity for him to commit to a new three- to five-year hedging contract after the short term contract expired.

As is to be expected, the US is the global leader in the practice of ‘sweating balance sheets’. According to Bloomberg, since 2010 the big US airlines have spent 96% of their free cash flow on share repurchases. They are now asking the US government for a $25 billion bailout. While no company or executive can be admonished for not anticipating something as devastating as the Covid-19 outbreak, they can be rebuked for reckless levels of gearing combined with share buybacks.

Those ‘exacerbating’ factors …

US-based Jonathan Tepper, who runs a research group catering to asset managers, reckons the stock market reaction to the coronavirus would not have been very big “had we not been in the middle of an orgy of borrowing, speculation and euphoria”.

Share prices certainly would have fallen, says Tepper. “But it’s unlikely they would have crashed the way they did without those exacerbating factors.” Without the high levels of corporate debt the prospect of a slump in sales would not have driven so many stocks to the verge of collapse.

Certainly South Africa didn’t get caught up in the same level of euphoria but the combination of increasing debt, low growth and uncertain government policy has resulted in considerable corporate fragility. And derivate transactions, which are inevitably procyclical, compound this fragility.

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If you ask him at the braai what happened he will reply –

They suggested that I spend my dollar
on this thing they call a collar
so I bought a Put and I bought a Call
and now, I have f-all.

Would you be buying Discovery at R62 ?

Having run an equity derivatives book, the desk will be selling stock from the outset in order to make overall position (short put / long call / short stock) delta neutral for the vast majority of the time.

Ann Crotty implies that the position is statically managed up to a point and then after that it becomes dynamic. Nothing could be further from the trutth

I seriously doubt that any “waits for particular level” to sell. If that is in fact then that equity derivs desk has been killed. I would make a proposition that the gamma on their position got too large (negative) and the desks tried to then get ahead of the delta for the next few days – result – the freefall we witnessed last week.

In addition if an insider is buying a protective collar from a bank where he is writing a call to finance the put there are many reasons why he/she would do that – one of them is NOT that he/she thinks the stock is going up!!

The desks who wrote these collars for the “insiders” now have proper negative gamma. Expect volatility to continue for some period as they grapple with that position. Nasty stuff indeed.

Would it not have been less disruptive to all concerned to double the number of shares given as security for the loan or manage the gap? ie as share heads towards put price, increase the number of shares pledged?

I am anyway certain that these schemes are in effect just schemes to disguise the substance of the transaction which is selling of shares, which would have triggered a very substantial tax event. is selling a share much different than using the share for a cash loan? If SARS wanted to get nasty they should deem this a sale much like they deem you to have sold all your global assets the day you die.

I believe derivatives is an essential tool in financial markets for managing portfolio risk especially in pension funds.

However, the JSE rules are inadequate informing investors about these big derivatives transactions by JSE listed company directors.

Essentially a company CEO can have a million shares in a company and he can take a opposite single stock futures position essentially negating his whole underlying position to zero and the market will be totally unaware that the CEO has zero net interest in the company.

This is something that gets hugely abused by many CEO’s and founders, they keep the voting rights in the underlying shared but their net real position is a very different story.

This is a case where I believe it’s not in the interest of the JSE to recommend rules like these as it will undermine their derivatives businesses but for transparency in the markets these “rules” are a must !!

End of comments.

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