Third time lucky?

Deutsche Bourse’s plans to hook up with the ISE look good on paper. But not all its shareholders are happy


An amitious plan to buy a rival stock exchange scuppered by an investor revolt? Deutsche Bourse has been here before. Two years ago the German market’s shareholders blocked Chief Executive Werner Seifert’s audacious plan to buy the London Stock Exchange. Then last year’s effort to buy the Euronext market saw the bourse lose out to the New York Stock Exchange. Now questions are being asked about its plan to take control of the International Securities Exchange (ISE), a derivatives exchange in Chicago.

News of discontent first emerged in the Financial Times newspaper, which reported that Atticus Capital, which owns an 11.7 percent stake in the bourse, had said it was ‘furious’ at the proposed $2.8bn takeover of ISE and had lost confidence in its management. London’s Sunday Times then quoted an Atticus executive as saying: “We are not against Deutsche Bourse doing deals in principle. But they must be done with financial discipline and benchmarked against doing a buy-back. What we mean is that if they can find a better deal than buying their shares back then fine. But this isn’t one of them.”

The paper said shareholders controlling more than half the German exchange’s stock have told the board they strongly oppose its plan to buy. Heavyweight hedge funds it named included TCI, Highfields Capital Management, Third Point, Lone Pine, Tiger and Tudor. They have echoed the calls made in the letter from Atticus. Together, their funds speak for 50-60 percent of the total shareholder base.

Under German corporate law, Deutsche Bourse does not need investor approval to buy ISE, but insiders said shareholders had warned the company they would seek to remove shareholder-elected members of the supervisory board if it continued to act without reference to its owners.

One investor told the Sunday Times; “This company is unbelievable. After all they’ve been through with investors, they still refuse to consult us or listen to our reservations.”

In the letter dated May 4 this year, Timothy Barakett, Atticus’s Chief Executive, wrote that he was “especially concerned about the management’s and the supervisory board’s emerging pattern of ignoring shareholder concerns and input … We have lost confidence in management’s financial and strategic discipline in analysing transactions.”

Unanimous support
In a move that was strikingly reminiscent of its attempt to quash the investor rebellion of 2004, the bourse retaliated by declaring that the deal had unanimous support from the supervisory board. A spokesman told reporters; “While some of our shareholders have expressed reservations…we are convinced this combination will create significant mid-term and long-term value for all of our stakeholders.”

Investors are also concerned about the amount the company is planning to pay for ISE. At j67.5 per share, the price represents a premium of nearly 48 percent on ISE’s share price at close before the offer was announced. The deal will combine ISE with Eurex, the options platform that the bourse joint owns with the SWX Swiss Exchange, creating the world’s largest options market.

Speaking at the company’s annual general meeting, Andreas Preuss, Head of Eurex at Deutsche Bourse, defended the bid price saying it had been set after an extensive due diligence process involving both internal and external experts. “These experts determined that the price was justified,” he said.

Mr Preuss said the premium many are quoting seems extremely high because of volatility in the US stock market, which has affected ISE shares. The premium is only 35 percent above the average value of ISE shares over the past year, which is an appropriate level for such a takeover in the US, Preuss said. Under the terms of the purchase agreement, Deutsche Bourse will contribute 85 percent of the total purchase price, while SWX will pay 15 percent.

The reasons behind the deal are pretty clear. In a sector where size is everything, the merger will create the largest transatlantic derivatives marketplace with significant dollar and euro product coverage, and with significant operations and revenues in both the US and Europe. It will also strengthen Eurex’s position as the leading global derivatives marketplace and will create the undisputed market leader in individual equity, equity index and interest rate derivatives worldwide with a combined overall trading volume of 2.1 billion contracts in 2006.

Apart from size, Eurex and ISE also say they have complementary member bases and product portfolios. This should provide significant growth opportunities across asset classes and national boundaries. They see more upside potential in joint product and business development opportunities.

Deutsche Bourse Chief Executive Reto Francioni said the merger agreement was “a strategic milestone for us that will further fuel our strong growth prospects and create significant value for shareholders.”

On the ISE end of the deal, David Krell, President and CEO, says ISE has “transformed the US options market” since the company was founded 10 years ago. “Our innovative products, electronic trading model, technology, market structure and entrepreneurial organisation have enabled us to remain at the forefront of the options industry,” he says. “Our principle strategic objective is to further grow our business both in terms of new products and new markets and in partnering with Eurex, we will be able to achieve our goal.”

Gary Katz, ISE’s Chief Operating Officer, stressed that the company already has a strong working relationship with the management at Eurex. “We also share a common vision that the exchange model is evolving toward global, multi-asset class, electronic marketplaces,” he says. “Our combination will allow both of our organisations to remain at the forefront of this competitive industry. Our cultural fit and common vision will serve as the basis for our successful future collaboration.”

The merger of Eurex and ISE combines two of the fastest growing players in the financial services industry, both with proven track records of innovation. ISE pioneered electronic trading in the fast growing US equity options market and continues to show strong, positive financial performance on the back of market leadership in the US.

ISE’s extensive membership base will significantly strengthen Eurex’s position in the US. Some 164 registered US broker-dealers are ISE members while Eurex currently has 63 US members. It also adds 600 million traded contracts to the number of contracts originated in the US; at Eurex, 112 million contracts originated in the US. ISE’s product portfolio is fully complementary to that of Eurex, and with the acquisition, Eurex is investing in a high growth business while further balancing its product portfolio.

The combined group will be the largest transatlantic derivatives marketplace with powerful distribution capabilities in two of the world’s most important capital markets. Its wide range of both US dollar and euro denominated products will be unique in the market, the parties say. The combination will be home to the eurozone interest rate and equity index benchmark derivatives products and will offer options on all major US and European companies. A combination of the two companies will offer huge growth opportunities, mostly through cross selling of existing products in both markets, as well as through the introduction of new products in the future, they claim.

Significant value
Despite the carping from some of its shareholders, Deutsche Bourse says the merger will create significant value for them, and for shareholders in the SWX Swiss Exchange. There are estimated pre-tax synergies of $50m a year that have already been quantified. Half of the total synergies will be achieved in 2010, with the rest in 2012. That figure includes $15m of efficiency gains and around $35m from revenue synergies, mainly through the cross selling of existing products.

The merger has certainly come at a time when both markets are on the up, at least in terms of trading volume. ISE’s volume in equity options has grown at 55 percent a year over the last five years, outperforming the market for US equity options. It now has a 32 percent share of the overall US equity options market, making it the leader.

Trading volumes on Eurex are at record levels. Volumes in April increased by 24 percent year-on-year to 151 million contracts. Average daily trading volume was roughly eight million contracts. Total trading volumes in 2007 reached 618 million contracts in the first four months – again, a 24 percent increase year-on-year. In April, equity derivatives set a new record with a total of 53 million contracts, an increase of approximately 50 percent.

Naturally, rival markets are not just going to sit around watching all this happen. The Chicago Board of Trade, the second largest US futures exchange, is pondering two competing offers, but is under increasing pressure to walk away from both. The call is for it to retain its independence or seek a richer bid next year.

The option of walking from a deal agreed in outline with the larger Chicago Mercantile Exchange is becoming increasingly popular. The value of the deal has fallen to 31 percent below a competing unsolicited offer from the Intercontinental Exchange, which is now worth $10.6bn. Both offers are all-stock and their value has see-sawed since the ICE sought to break up the all-Chicago tie-up, which was agreed last October. If that deal went through it would create the world’s largest futures exchange.

Retaining independence
The slumping value of the CME deal has encouraged some CBOT members to push for it to retain its independence. They argue the franchise has been strengthened by the successful launch of side-by-side electronic trading of agricultural futures last August. While trading of financial futures, mainly treasury bonds, dominates volume at the CBOT, the volatility in the corn and soybean markets helped push agricultural dealing up by more than 50 percent over the past year. More than half of the deals are now made electronically, and agricultural trades carry fatter margins than the financial futures.

The ISE/Eurex deal has also encouraged some CBOT members – who retain 80 percent of its shares – that premiums are likely to remain in the exchange sector. CBOT shares would fall in value if it said no to either deal, but the thinking is that they would soon bounce back, and a better offer might emerge. The CME would have to raise its current offer by 40 percent to reach what people say is the knock-out level – over $2.10 a share. Under the terms of the agreement with CME, CBOT can change its terms up until a meeting scheduled for July 9 this year.

So that could mean two done deals are not quite as buttoned-down as they at first seemed. For CBOT, jilting both its suitors in the hope of a better deal might prove a sound strategy. But the options for Deutsche Bourse are more bleak. If it doesn’t tie up the marriage between Eurex and ISE, it will be its third failed deal in as many years.