By: Jamie Powell
In midst of the great financial crisis, something odd happened. Volkswagen, the German carmaker, became the biggest company in the world. For one, brief day.
Looking back a decade, as many have recently, you'd be forgiven for thinking the worst asset to own was a US investment bank or mortgage originator. But it was nothing compared to being short the Wolfsburg-based business.
Exactly 10 years (and 48 hours) later, here's how it happened.
A tale of two families
The story revolves around two of Germany's most famous automakers — Porsche and Volkswagen — whose interlocking history rivals the great family sagas of German literature, such as Thomas Mann's Buddenbrooks.
We begin in 1931, when Ferdinand Porsche founded an automotive consultancy. One of his first major projects, at Hitler's behest, was to design Volkswagen's iconic Beetle, which was designed in 1934. The founding of the carmaking arm, Porsche AG, followed in 1948, with the Porsche family remaining in control of the company through the next half century.
A long history of collaboration followed, with Porsche outsourcing much of its manufacturing to Volkswagen. But the ties ran deeper than a business relationship.
Ferdinand Porsche's grandson, Ferdinand Piëch, became the chief executive and chairman of Volkswagen Group in 1993, after thirty years at Audi. He took the position in the midst of troubling times — the company had just recorded a $1.1bn loss, its largest ever — but he turned the company around, before retiring to become chairman in 2002.
Despite running another carmaker, Piëch and his wider family still retained 50 per cent of the voting rights in Porsche stock, with the other half held by the Porsche side. (Porsche AG was listed in 1984, but the public could only buy non-voting preference shares).
According to Handelsblatt, the German business paper, Piëch did not always see eye-to-eye with his cousins:
“[By the time he joined Volkswagen], Mr. Piëch’s rivalry with the Porsches was out in the open. That the self-styled Crown Prince Ferdinand [Piëch] openly had a relationship with his sister-in-law Marlene Porsche, which resulted in two children, didn’t exactly help to minimise tensions. Mr. Piëch made no bones about how he felt about his cousin Wolfgang “Wopo” Porsche, who headed the clan. For the private school warrior, Wolfgang the Waldorf school grad was soft and weak.”
This mesh of family and business relationships formed the backdrop for one of the decade's most memorable takeover attempts. As Porsche — run by former Volkswagen board member and Piëch's choice for the job Wendelin Wiedeking — sought to swallow the Wolfsburg-based car giant whole.
An extended courtship
Wiedeking's Porsche had long courted Volkswagen, seeing a takeover as a means to not only secure access to Volkswagen's manufacturing expertise for Porsche but, due to the overlapping interests between the companies, to buffer the company against a hostile takeover. He referred to it, perhaps unadvisedly, as a “German solution”.
Piëch was open to the merger, according to Fortune, as it would have cemented his control of Volkswagen (via his own Porsche stake), and allow him to realise his ambition to “lead a bigger company than my grandfather”.
Porsche played the long game. The first move came in 2005, when it announced it had taken a 20 per cent voting stake in Volkswagen. Over the next two years it slowly accumulated more shares, eventually passing the 30 per cent threshold where it would have to make a mandatory offer for the company in early 2007. The bid failed, but in October 2007 Wiedeking was given fresh hope by an unlikely source: the European Court of Justice.
The court, in a case brought by the European Commission, overturned the “Volkswagen Act”, an esoteric German law from 1960 that required a party to own 80 per cent of Volkswagen's voting shares before it could formally control the company (versus the 75 per cent normally required). As the state of Lower Saxony owned 20.1 per cent of Volkswagen, the legislation protected the business (and its workers) from the vagaries of international capital.
With the Act now in question (although Germany would go on to fight the ruling), the door opened wider for Wiedeking and Porsche. In March 2008, he was given the all-clear by Porsche's supervisory board to increase the holding to 50 per cent. By September 16, its stake had reached 35 per cent, with Wiedeking declaring:
“Our goal continues to be to increase our stake in Volkswagen to more than 50 per cent. Today’s step is a further milestone along this road.”
And then, everything went quiet.
A tempting trade
Around the same time that Wiedeking was building the Volkswagen stake, a hedge fund strategy was gaining popularity on Wall Street: event-driven investing.
Pioneered, according to Sebastian Mallaby, by investing legend Tom Steyer at the West Coast hedge fund Farallon, the strategy expresses itself in a number of ways, but what matters for this story is one particular strain: capital structure arbitrage.
It works something like this: an investor finds two securities which should have a relationship to each other — such as the shares and bonds issued by a company. The price of both should reflect assumptions about the company's future, so if they get out of whack it can present an opportunity. The investor sells short the security it believes to be overpriced, and buys the one it thinks is underpriced, with the idea that prices will converge when Mr Market comes to its senses.
In Germany, this tactic gained traction thanks to the Teutonic tradition of dual-share classes. According to a paper by Katie Bentel and Gabriel Walter, the practice dates back to the 1980s, where preference shares — which carry no voting rights but a fixed dividend — became popular as to protect German companies from both hostile takeovers and foreign influence. The outside investors got their dividends, and local owners kept control through the ordinary shares. Everyone was happy.
By 2003, 28 of the DAX-100 (Germany's largest listed corporations) had both ordinary and preference shares, according to data cited by Bentel and Walter.
If not for SAP, it may have been 29. The enterprise software group chose to retire its preference shares in February 2001, swapping them for ordinary shares. The idea was a clearer capital structure would attract more investors.
SAP's preference shares were trading at a 20 per cent premium to the ordinaries, due to the ordinaries low liquidity. Therefore investors who owned the ordinary shares, and had sold the preference shares short, made a profit as the two securities converged in price.
According to a friend of Alphaville (who goes by BrokenBanker on Twitter and helped to flesh out the details in this story) who was working in equity sales in Frankfurt at the time, SAP's switch made several event driven hedge funds handsome returns.
With such (relatively) riskless profits on offer, investors began scouring Germany for similar situations. Attention quickly turned to Volkswagen, where the preference shares traded at a significant discount to the ordinaries, in part because Porsche's takeover demand would target the latter rather than the former.