It’s a no-brainer arbitrage trade: Pocket the $5 gap in AMC Entertainment Holdings Inc.’s proposed conversion of preferred stock into common shares. However, Wall Street pros are discovering the bet is anything but easy to pull off.
(Bloomberg) — It’s a no-brainer arbitrage trade: Pocket the $5 gap in AMC Entertainment Holdings Inc.’s proposed conversion of preferred stock into common shares. However, Wall Street pros are discovering the bet is anything but easy to pull off.
What’s the hang up?
“It’s simple, but not easy,” said Julian Klymochko, chief executive officer of Accelerate Financial Technologies. “It’s a relatively simple dual-share class conversion, but hedging it correctly and affecting it profitably is actually quite difficult.”
The cost of hedging the trade is exploding because it’s hard to find shares of the meme-stock posterchild to borrow and short. To make matters worse, a recent court case against the movie-theater chain’s share proposal adds to uncertainties over whether its restructuring will even occur.
It was supposed to be a straightforward bet. The conversion of AMC’s preferred units (ticker APE) into common stock would get investor approval, and the price gap between them would vanish as arbs captured that spread. But it isn’t playing out that way, as lawsuits are potentially delaying the restructuring, and retail traders are helping to drive the common shares higher.
With the vote less than two weeks away, the spread is around $5 and reached the widest since December earlier in the week — with AMC outperforming APE. And there’s probably no relief in sight.
Squeeze Risk
While AMC has the green light to move ahead with the shareholder vote, it won’t actually be able to implement any changes until the judge finishes weighing an injunction bid by a pension fund and other investors leading the litigation. A hearing is scheduled for April 27.
That means, those investors who have set up their trades through stocks and options would have to hold their wagers for longer — eating into any potential profits.
“The lawsuit extends the timeline and increases uncertainty,” Klymochko added. “Until the reorganization closes, the short squeeze risk is real.”
The trade, which a market strategist once called an arbitrage “home run,” implies selling AMC stock short and buying APE in hopes of covering the bet after the conversion is approved.
But the straightforward strategy is dicey in part because the cost to borrow AMC shares is “punishingly high,” according to JonesTrading’s Cabot Henderson. Further complicating the trade is the difficulty of even finding shares to sell short given the meme stock’s propensity to surge in a short squeeze.
Retail traders have been captivated by AMC — referring to themselves as “APEs” — as they bid up shares and tout their bets on social-media platforms, such as Reddit’s WallStreetBets and Stocktwits, where they encourage others to help squeeze investors betting against the stock.
That’s been burning traders mimicking the arbitrage approach unveiled by famed short-seller Jim Chanos. The founder of Kynikos Associates told CNBC last year that he believed the share classes “should be the same price, or roughly the same price.” Chanos said he was “counting on them to close,” and thought “ultimately they’ll all be the same class.”
Earnings
Both AMC and APE slumped after the the movie-theater chain reported fourth-quarter results, as investors and analysts shifted their focus to the deal vote. Analysts including B Riley’s Eric Wold reiterated calls that investors will approve the restructuring, making the lawsuits moot.
“If that plays out, we feel it would be tough for a judge to rule the proposals are not in the best interest of shareholders if they vote that way,” Wold, who rates the stock at neutral, wrote.
AMC sank 8% to $6.57 on Wednesday, putting its gap relative to APE at $4.70.
Meanwhile risks abound. Around 25% of AMC shares available for trading are currently sold short, according to S3 Partners data, with the fees to short the stock almost tripling this year. And then there’s the volatile nature of meme stocks, whose valuations are often detached from reality.
Placing a wager on a meme-stock means accepting the fact that you’re trading in “uncharted territory,” said Churchill Capital’s Nick Pappas.
Synthetic Borrow
Alternatively, some traders have been utilizing options structures to borrow shares of AMC, said Chris Colpitts, director of event-driven strategies at Cowen.
A so-called synthetic borrow, or reverse conversion, addresses the concern of borrowing stability, but the cushion only lasts until options expire. Now, given the expected delay, traders have to either roll the options package to a longer dated expiry, for an additional cost, or unwind the positions.
AMC’s one-for-one exchange of preferred stock into common shares is part of the company’s strategy to raise cash and keep the lights on. It’s also proposing a 10-to-1 reverse stock split.
Looking at that wide exchange spread, traders can still pocket an incredible potential return in a short period of time. But it’s probably just for those who could stomach the unruly and highly volatile turns, said Klymochko.
“It’s quite perilous,” he noted, “there are all sorts of ways to potentially lose money.”
(Updates throughout)
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