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Barely legal ...

Porsche, VW – and hedge funds

Published: October 21 2008 09:32 | Last updated: October 21 2008 22:38

Fast cars and fast money make a terrible combination. Mix in a banking crisis, an attempted takeover of Volkswagen and several billion euros of share options and you also get German takeover rules in urgent need of change. Although Porsche is not the only company to use cash-settled call options to buy a German rival by stealth – car parts maker Schaeffler recently did the same – it has done so with more spectacular effect than anyone else.

The mechanics surrounding Porsche’s attempts to buy VW are obscure because its option positions need not be disclosed. But the wheeling-dealing goes something like this: to increase its 35 per cent stake above 50 per cent, Porsche bought options over much of VW’s freefloat. The banks that sold these options meanwhile hedged their exposure by buying VW shares. Hedge funds, drawn by VW’s pumped-up valuation – 24 times forecast earnings, eight times as high as the sector average – then shorted VW as fast they could.

So far so normal. The rest is speculation. As hedge funds sold short their VW shares, that stock had to be bought by others; perhaps by Porsche, given its €10bn credit line. This buying more than countered the short-selling pressure, boosting VW’s share price. Facing growing losses from their positions, plus redemption calls from panicked investors, the hedge funds had to cover their shorts and buy back the VW shares they had just sold – again, perhaps, from Porsche. As the hedge funds’ losses mounted, so did the short covering. VW’s share price was squeezed to such heights that it became the 11th biggest company in the world, worth more than other European and US carmakers combined. Absurd. Even more absurd is that this false market is legal in Germany. Stranger still is that Porsche and its managers – even though VW’s share price has fallen – may well have made money from it all. Last year, the company earned €3.6bn from option operations – some three times as much as from cars – profits that will help it buy VW. Porsche used to be the emblem of a go-go City trader. Now it has become one.