Run Over By A Porsche

Forgive me if this gets a bit nerdy. But it’s a fun story of what can go wrong when you’re a big hedge fund master-of-the-universe type, standing astride the world.

Now, if you’re a stock-trading type of hedge fund, your modus operandi is to buy stocks that look “cheap”, and sell stocks that look “expensive”. And for a long time, one stock that looked expensive as hell was Volkswagen. Caught in the same downdrafts that are right now destroying Ford, GM and Chrysler, with powerful trade unions hamstringing its ability to restructure and save money, VW looked to be in similarly dire shape to most other car companies in the world. (Troubles at its subsidiaries made things worse: Seat could build nothing but crap cars that nobody wanted, and Jeremy Clarkson (arbiter of taste in these things) was labelling Audis “cars for c*cks”.)

But - for some unfathomable reason - Volkswagen shares were perpetually priced at about 20 times earnings, while every other car company was only worth about 8 times earnings. So hedge funds would sell VW and buy something else against it - say, Porsche, which looked cheap despite owning part of “expensive” VW.

And this is where they ran into trouble. Read on.

As mentioned before, Porsche owns part of VW. Quite a sizable chunk, in fact - roughly 30%, when they declared it last December. This is the legacy of a slow-moving takeover attempt, and Porsche had said in the past that they had no interest in building up their stake. Also, the German state of Lower Saxony, home of VW, held a 20% stake in VW and was firmly not going to sell. Ever.

But if Porsche could rustle up the other 80% of VW’s stock, they’d be able to force Lower Saxony to sell their stake, and win the takeover battle. So, stealthily, this is what the smart cookies at Porsche began to do. They accumulated a 30% stake, which they had to disclose, and bought another 45% using options, which gave them the right to buy the stock at a given price - and that didn’t require disclosure of the stake, thanks to a loophole in German market regulations.

The other thing Porsche did was to sell put options on VW - giving other companies the right to sell VW shares if the price dropped - betting on their own ability to prop up the price of VW. If Porsche could hold the price up, they’d never have to buy those VW shares, and they’d pocket the cash from selling the options - adding more money to their VW war chest.

Now, back to those hedge funds. If they want to sell a stock they don’t own - betting that the stock will drop - they have to borrow it from someone. To close the position, they buy the shares back (hopefully at a lower price) and return the shares to the lender.

As the hedge funds were selling VW stock, it seems Porsche was steadily buying it, pushing the price up in their faces, and accumulating a larger and larger stake. And as the price went up, more and more hedge funds saw VW as expensive, borrowing more and more stock (probably from Porsche, indirectly), and selling more and more of it.

A week ago, an analyst at Sanford and Bernstein unraveled Porsche’s balance sheet, and figured out how Porsche was squeezing the hedge funds. (And making pots of money in the process - Porsche made three times as much from trading VW shares last year as it did from actually making cars.) He speculated that Porsche might control more of VW than it was admitting.

Yesterday, Porsche released a statement admitting that yes, they controlled somewhere near 75% of the outstanding stock of VW.

Now - at the end of last week, somewhere around 15% of VW stock was out on loan to these evil hedge-fund short-sellers, who would need to buy it back eventually. But Porsche’s 75% holding, and Lower Saxony’s 20% holding, only left 5% of VW available for purchase.

So these clever hedge funds had sold three times more VW stock than was actually available in the market.


The smart-alecs at DZ Bank speculated that all these hedge funds would try to unwind their short positions at once, creating a “short squeeze” as every fund in the trade ran for the exits. VW stock was then trading at somewhere around €300 - they slapped an arbitrary €911 price target on it. Ha ha ha.

Which, despite being a random number plucked out of the air, was exactly what happened. VW stock opened this morning at €400, and the combination of massive demand and limited supply sent it to a peak of €1000 - making it, for a few minutes, the largest company in the world. Bigger than Exxon, or Wal-Mart, or JP Morgan. Bigger than all the other American and European car manufacturers put together.

The hedge funds would have been buying at massively inflated prices, frantically closing out their positions - and Porsche would have been steadily selling at whatever price it chose, then turning around and receiving those same shares back as hedge funds closed out their stock borrowings and took massive losses. While the loss on a long shares position is limited to the amount you invest, the loss on a short shares position is potentially unlimited - and these hedge funds would have been taking losses of many times their original capital.

So Porsche has its big takeover-ready stake, and a few billion euros in its pocket - and the hedge funds have nothing but losses.

The funniest comment by far, from an FT Alphaville commenter: “I’m not paying [extortionate hedge fund fees] so they can moan about being outwitted by their car manufacturer”.