It’s a decisive week for investors looking to get involved in Johnson & Johnson’s record split-off of most of its $40 billion stake in Kenvue Inc., the maker of Tylenol and Listerine.
(Bloomberg) — It’s a decisive week for investors looking to get involved in Johnson & Johnson’s record split-off of most of its $40 billion stake in Kenvue Inc., the maker of Tylenol and Listerine.
The next few days will set the price at which J&J unloads the bulk of its holdings in Kenvue, three months after carving off the unit in the year’s biggest US initial public offering. J&J is offering a swap to its shareholders: Exchange its stock for Kenvue shares at a 7% discount, at a ratio that will be teased out between now and Wednesday.
It promises to be a complex stretch for an array of market participants, including arbitrage traders, investors looking to add Kenvue for the long term, and managers of passive funds preparing for Kenvue’s already-announced inclusion in the S&P 500 Index.
Shares of Kenvue were down about 0.8% to $23.53 at 9:45 a.m. in New York on Monday, while J&J rose 0.6% to $174.95.
J&J shareholders have the option to request to swap all, some or none of their stake, with orders due Friday. The more than 135-year-old firm’s position as a long-time fixture in both the S&P 500 and the Dow Jones Industrial Average makes it a tough stock to abandon.
“I don’t think it’s an easy or a likely decision to swap your J&J shares” for a company that’s been public for such a short time, said Michael Broudo, an event-driven equities analyst at Oppenheimer.
And yet, the degree of participation is the key variable for investors looking to turn a quick profit or buy at a discount. It will decide the proportion of Kenvue shares distributed per J&J share exchanged, with a maximum ratio of 8.0549 Kenvue per J&J stock. J&J stockholders will likely get a prorated slice of the Kenvue stock they sought, because the offering is expected to be oversubscribed.
Following is a rundown of how different investors may approach the deal:
Straight Arb
The split-off is the largest-ever transaction of its kind, said Cabot Henderson, who focuses on merger arbitrage and special situations at JonesTrading. The deal has been attracting interest from hedge funds and arbitragers, who seek to pocket the spread created by the exchange.
These players can short shares of Kenvue and create a position in J&J. The investor would then swap a chunk of their J&J shares for the discounted Kenvue stock to pocket the 7% difference. That trade has pressured Kenvue shares relative to J&J as investors build their positions, and there could be more weakness this week as a result.
“The peak short-selling pressure has historically been in the last week of the exchange offer and during the pricing period,” said Broudo.
Getting the swap ratio correct is crucial to whether arbitragers can make money on the trade. That’s because short-selling traders risk getting caught with more Kenvue stock than they wanted, or coming up short of the amount they need to return to cover their bet and capture the spread.
Synthetic Approach
One challenge for those looking to short Kenvue is the small pool of shares available. Less than 200 million of the company’s nearly two billion shares are available for trading, and as a result the cost to short the stock has skyrocketed as traders position for this week’s events.
That backdrop is leading some traders to turn to the options market for an alternative solution through what’s known as a reverse conversion, according to Henderson. The strategy involves a combination of puts, calls and shares.
The approach has driven options activity in J&J and Kenvue to an all-time high, with total open interest surpassing at least 1.4 million each, data compiled by Bloomberg show.
Arb investors have deployed similar trades in situations including General Electric Co.’s separation of Synchrony Financial.
Still, in this case, J&J’s gigantic market capitalization — roughly $450 billion — makes it harder to gauge the level of participation in the exchange, said Aaron Glick, a strategist at TD Cowen.
Long Run
All the pressure from short-sellers may be opening up a buying opportunity for investors looking to own Kenvue for the long run. The shares are now down about 15% from their May closing high. Some J&J holders could opt to exchange a portion for discounted Kenvue shares without worrying about the ratio they’re alloted.
And then there are the investors who will need to acquire Kenvue no matter what — managers who track the S&P 500.
The company’s index inclusion — potentially as soon as this month — may drive significant buying from index funds, even as industry watchers expect a number of such investors to exchange some of their J&J stake for Kenvue.
–With assistance from David Marino.
(Updates with Monday share performance.)
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