Unlocking the hidden value in corporate actions
Corporate actions have a reputation for being operationally risky, but immune to operational improvement. Custodian banks have long agreed that their principal source of unexpected loss is the mishandled corporate event, but the problem has proved intractable. But if Matt Ruoss is right, the lavish investment by custodian banks in the standardization and automation of the issuance, notification and instruction of corporate actions has missed more than its target of lowering the rate of errors. It has missed the point completely.
Matt Ruoss is CEO of SCORPEO UK Limited, a business whose success is based on the knowledge that asset owners and their fund managers are not just running the risk of operational losses in corporate actions, but leaving a great deal of money on the table. Until now, that uncollected value was the preserve of hedge fund managers and the proprietary trading desks of the investment banks. They extracted the value by the simple expedient of borrowing stocks subject to corporate actions, and claiming the difference between the basic entitlement (whose value is returned to the lender) and a higher value alternative.
The five founders of SCORPEO, who worked at PwC, Lehman Brothers International and its London buyer Nomura, know exactly what gives rise to these opportunities. "When we talk about corporate actions, we are talking predominantly about corporate actions that have optionality, such as scrip dividends, rights issues, tenders etc.," explains Ruoss. "In other words, where there is an event on an asset that requires the beneficial owner, or their fund manager, to choose between cash or stock. In the vast majority of cases they will elect for a choice which is economically sub-optimal."
Averting the sub-optimal is what SCORPEO exists to do. Unlike most corporate actions services, it is not about automation. In fact, it is impossible to automate the process by which a choice is made between two competing alternatives. “You cannot automate for choice,” says Jonny Ruck, CEO of SCORPEO US LLC. “Somebody has to, at some point, step into the process, and make a decision.” It is to avoid this tiresome reality that investors and fund managers issue custodians with standing instructions to default to a particular option. This means the decision can be automated, but it also means that the decision is not always the right one, in terms of securing maximum economic value.
Overturning this unreflective approach has taken time. “The reason it has taken us four years to bring this service to market is the detail we have had to explore with the custodians,” says Ruoss. “We have been working behind the scenes with them for a long time, analyzing how they do things today, what the problems are, assessing the impact of the solutions we propose, and making sure that we make no mistakes. People have known this problem exists for a long time, but there is a reason this service has not been provided before. It has proved tough to solve, even by a group of people who have long experience and deep knowledge about corporate actions.”
He is not being immodest. The five founding partners of SCORPEO - Matt Ruoss, Jonny Ruck, Shivesh Jha, Sander Eijkenduijn and Ian Davey - have all worked for years on a variety of techniques designed to extract the hidden value in corporate actions. They first came together as a team in September 2008, when Nomura bought the London arm of Lehman Brothers. "We knew there was a huge part of the market that elected sub-optimally," recalls Ruoss."Investors were making choices that did not offer the greatest economic value."
Instead of taking one or both of the obvious options - sticking to orthodox stock borrowing and sharing the benefits with the beneficial owners, or establishing a risk arbitrage fund, and looking for investors - the five decided instead to offer to the custodians to institutional investors and fund managers an outsourced service which captures the value lost when sub-optimal decisions are made. “We have set it up as a service, which is transparent to our clients at every stage of the process," says Ruoss. He reckons this creates a much bigger market, by extending the benefits far beyond the limited number of investors in a risk arbitrage fund or even the quarter to a third of investors that are willing to engage in securities lending.
It does of course present the challenge of exciting custodians and their institutional clients about the potential. Although the reasons for apparently poor decision-making on corporate actions include lack of attention, sub-optimal choices can also reflect the fundamentals of an investment strategy, the nature of an investment mandate (indexed funds cannot always take more stock), or simply an inability to invest in the necessary expertise to consider any option but the default. They may even be a regulatory obligation to, say, take cash in every case.
But the largest factor in decision-making is a familiar one. "The overriding reason nobody worried about the value foregone is that corporate actions were not historically a focus, even for fund managers," says Chris Barrow, global head of sales for SCORPEO Group. "In the quantum of fund management performance, they may not be huge numbers, but that does not mean they should be ignored." The value foregone can still be significant. As the complexity of corporate actions has increased, and the proportion of sub-optimal elections has remained unchanged, that lost value has risen too.
Yet complexity has, if anything, increased the propensity to choose the default option. “Corporate actions have become increasingly complex," says Ruoss. "And with the increased complexity, it becomes easier for the fund manager or the investor to just take cash. The key factor behind the formation of our company is that we wanted to highlight how much value was being foregone, in a very transparent way, and pass that value back to the beneficial owner.” At the heart of the service is an “optimisation research team” that scrutinizes companies, and monitors the elections made by shareholders. In the United Kingdom market alone, SCORPEO identified at least £1 billion of value that was not captured in the last four years.
The principal reason for this loss of value is that the vast majority of investors choose cash, usually via a standing default instruction to their custodian bank, even when the stock option is significantly more valuable. "Markets vary, and every corporate action is different, but our research found that in 55 to 65 per cent of elections where stock is the preferable option, investors still chose cash," says Matt Ruoss. "If you factor that figure to the 25 to 35 per cent of investors that lend stock, and so cede that value to a third party, you are talking about at least 80 per cent of elections being sub-optimal. That is a staggering figure. And it is not value that depends on speculation either. This is intrinsic value that is being foregone. There are no winners or losers here - just beneficial owners who are not getting full value for their holding. That is the inefficiency we are trying to resolve."
How does SCORPEO do that? Essentially, by monitoring the relative value of the cash and stock options in every corporate action taking place, for example, in a scrip dividend, choosing stock whenever it makes sense, and selling it to realize the value. "It is a simple as that," says Jonny Ruck. "It is the difference between pushing button A and button B." However, as Ruck would be the first to admit, there is a bit more to making the right election than that. No two corporate actions are ever the same, so choosing successfully between the A and the B button does entail reading the material distributed by the issuer, and monitoring the relative value of the options until a decision has finally to be made.
Not many investors and fund managers have the time to do that. "The difficulties here are time and expertise," says Matt Ruoss. "A fund manager may hold upwards of 100 stocks in any given portfolio, and does he or she really have the time to worry about adding basis points to one position, especially if it entails reading a 150 page document and working out the tax implications at the fund level? Their time is better spent stock picking, or re-weighting positions."
Matt Ruoss cites HSBC as a stock in point. Although it is listed in the United Kingdom, the dividend is paid in US dollars, forcing sterling or euro-denominated funds to make complicated calculations about rates of exchange as well as taxation. It is to avoid the large fixed cost of making complex decisions of this kind that most buy-side firms have long preferred the default option. Now they have an alternative: outsource the work to SCORPEO. "There is an increasing demand for specialized expertise around these events," says Matt Ruoss. "That is what we aim to provide here. We aim to become the global market leader in providing that expertise on an outsourced basis."
SCORPEO offers several tools that investors and fund managers can use on an outsourced basis. The first is to commission bespoke corporate actions optimization research, to secure the value for a particular portfolio. The second is value analysis, in which SCORPEO performs a retrospective analysis of value captured or foregone within a particular portfolio. The third is proprietary research about events the firm is monitoring, which is distributed to any fund manager or investor who wishes to pay a subscription fee.
However, the main service provided by SCORPEO is what Matt Ruoss calls the Value Capture Programme (VCP) and this is remunerated by an ad valorem rather than a fixed fee. It aligns the interests of SCORPEO and the client perfectly, in the sense that SCORPEO is paid only when it delivers additional value. "When the VCP is running, there is nothing for the client to do, but they get extra money over and above what they were originally going to receive," explains Jonny Ruck. "We take a fixed proportion of the extra money only, which means that, if we get paid, clients are always guaranteed to get paid as well. We do not want to be paid a fee, because if a client is getting it right, we would be being paid to do nothing. We want to be paid for creating value, not running a consultancy."
It is a pricing model which works well for fund managers, because they do not have to charge their investors an additional fee for doing the work, but instead pass on to investors the additional value net of the sums that SCORPEO charge. This ultimately enhances investment performance. "If a manager signs up to the VCP, and any money is paid away, that must mean that value has been captured," says Jonny Ruck. "We can only get paid if managers would otherwise make the sub-optimal decision."
The VCP is distributed not directly to the buy-side, but via their custodian banks, which are already processing corporate actions notifications and instructions on behalf of fund managers and investors. "Ultimately, it is the investors and the fund managers that drive the adoption of the programme," explains Chris Barrow. "But it is delivered to them by their custodian as an add-on to their custody agreement. The custodians are of course interested in offering services that differentiate their offering and help their clients. We reach a service level agreement with the custodian, which then offers the VCP to its clients. The underlying client signs up to a service offered by the custodian, not directly by us."
Although the custodians are perfectly positioned to provide the necessary operational support and processing, the identification and capture of the value in corporate actions are undertaken not by the custodian, but by SCORPEO. "It is not the job of the custodian to get the election right,” says Jonny Ruck. “Their job is to process the instructions they are given.” Matt Ruoss adds that SCORPEO had no intention of adding to the operational risk buy-side firms are already incurring. "Our number one priority when we were building the programme was to ensure that the operational risks were completely mitigated, and that the service was as seamless an overlay on to the existing processes as possible," he says.
This is why the service took time to perfect. In fact, Ruoss thinks the main reason a corporate actions value capture service such as the VCP has not been offered before reflects the complexity of delivering it. After all, operational risk is only the most obvious of the risks it entails. There is market, credit, legal, tax and compliance risks to be mitigated as well. "The value capture programme touches on virtually every facet of the securities industry, from the issuers, to the beneficial owners, to the investment banks, to the fund managers, to the custodians,” says Ruoss. “Then it touches on all the different asset classes, from foreign exchange to equity, and then you have to add to that the various different methods by which you might exercise optionality. There are a lot of moving parts."
These moving parts have to be managed. “The risks exist, but the value capture programme does not increase them,” says Ruoss. Jonny Ruck adds that it can even be argued that SCORPEO reduces risk by providing the buy-side with an independent review of each corporate action – which no custodian has ever offered. “If the custodian gets the instruction wrong, the custodian will make the investor whole,” he says. “Our product aims to make sure the custodian never processes an instruction that makes the wrong choice. We are not creating instructions for custodians, and walking away. We are following a complex decision-making process all the way down the chain.”
That chain can be both extended and unbending. An investor holding shares which pay dividends on a quarterly basis, for example, will four times a year have three to four weeks to choose between taking the dividend in cash or a fixed number of new shares (with a failure to choose generally defaulting to cash). "Until the investor makes the election, those two options will very rarely be the same," says Ruoss. "One will always be worth more than another. If the investor is looking at the decision purely in economic terms, he or she will choose the option which is worth more when the deadline finally arrives. It is when stock is more valuable on the final day that the SCORPEO value capture programme kicks in. Essentially, it is a safety net."
The term "safety net," adds Ruoss, reflects the fact the value capture programme operates without impacting the day-to-day decision-making of fund managers and investors: all they need to do is remember that SCORPEO will capture any value they would otherwise forego. "The beauty of the service is that it does not impact on the day-to-day decision-making of the fund manager," explains Chris Barrow. "We run the programme for the manager, in the background. They do not have to worry about it at all, because they know any potential loss of value will get picked up by us."
Unlike a stock loan, the underlying holdings never even have to leave the custody account of the client, and there is no need to incur the market or reinvestment risk of the collateral received in return for stock lent. "The service is not in competition with securities lending," emphasizes Matt Ruoss. "We have designed it to be very much complementary and in the background to securities lending."
The SCORPEO service works even if economic value on the deadline date is not the sole criterion at the election. A fund manager who believes in a stock may insist on choosing the scrip dividend, despite the fact the cash option is worth more. In these cases, SCORPEO unlocks the additional value by opting for the cash dividend, and purchasing the stock at a cheaper price than the scrip. If the manager chooses cash, even though it is worth less than the scrip dividend, SCORPEO elects for the stock and sells it for cash. "If the cash option is worth six cents a share, but the scrip option is worth nine cents a share, you will be getting cash plus three cents," says Matt Ruoss.
This may sound too good to be true, but it is not: SCORPEO is fixing on behalf of investors an inefficiency which other market forces have failed to resolve. Like all such forms of arbitrage, it opens an interesting question: will SCORPEO ultimately work itself out of a job, by making corporate action elections more efficient?
One reason that is unlikely to happen is that there is still plenty of room for growth on a global scale. After all, there are corporate events in every market. Clients are already driving the firm into new markets and asset classes through the bespoke research exercises carried out by the firm. Eventually, SCORPEO intends to extend its offering to the fixed income markets as well. For now, the firm is focusing on equities in the United Kingdom and the United States. A Boston office was opened in the autumn, led by Jack McNally, who ran securities lending at Credit Suisse.
Persistent market uncertainties mean SCORPEO will have more than enough to do. As long as there are options, and investors and fund managers are given weeks to choose between them, their relative value will fluctuate. In theory, fund managers and investors could monitor the fluctuations themselves, but the sheer length and complexity of the information that has to be mastered continues to erect a barrier, which Jonny Ruck argues is getting higher all the time.
"Even in a simple scrip dividend, the length of the document the company puts out is likely to be 150 pages," he says. "And that is the most plain vanilla corporate action of all, in terms of the simplicity of the choice. When a corporate action gets more complex, we are talking of a 1,000 page document. That is where our expertise is vital, because there are so many things in that document which may or may not affect what happens. How many fund managers have the expertise, or the time, to read that much? But if they do not, there is a risk that they will have got it wrong. They should outsource the work, particularly the high volume, day-to-day work they do not have the time or resources to do in-house. It will free up their time to focus on the more complex - and almost certainly higher margin - issues."
Chris Barrow adds that the SCORPEO research-by-subscription service is proving popular with fund managers precisely because it points to those higher margin opportunities. But what will ultimately govern the success or failure of the SCORPEO service is not just its ability to create value for the buy-side, indirectly or directly. In era of widespread distrust of financial intermediaries, and growing regulatory pressure to disclose more information, the value capture programme is a remunerative way for fund managers and custodians to demonstrate that they are fulfilling their fiduciary duty. “For custodians, this is a value-added service they can offer to their clients,” says Chris Barrow. “For fund managers, this is a way of adding to investment performance without needing to devote any time to the opportunity.”
The timing of the launch of the VCP looks ideal for SCORPEO, with a number of broader industry trends working in their favour. Pensions have deficits, which any source of additional value can help to fill. Investment managers are under increasing regulatory and fiduciary pressure to demonstrate that they are acting at all times on behalf of their clients rather than themselves, and to be fully transparent about how they are fulfilling that obligation. Simultaneously, capital constraints are making securities financing a more challenging activity for the banks, and custodians are suffering from narrower net interest margin and downward pressure on revenues from securities lending. “The services offered by SCORPEO are well-designed to alleviate these issues,” concludes Chris Barrow. “It is hard to see how the VCP will not be useful to all of these parties.”