The Hedge Fund Report: Class Warfare

The existence of dual share classes offers arbitrage opportunities for hedge funds. Investors may be wise to take note as well. Here is how it works. Different shares of the same security often trade for slightly dissimilar prices because of a number of factors, including different voting rights, or the shares' relative liquidity.

Investors may want to consider taking a look at companies that offer share classes with different voting rights, such as News Corp. (NWS). "It happens that the holders of shares without supervoting power will pressure management to eliminate the unfair treatment," says one merger arbitrage hedge fund manager who requested anonymity.

When the pressure works, companies may buy back the non-voting shares at a premium or combine both share classes. In both cases, whoever bought the cheapest share class ends up winning.

Take the case of Eagle Materials(EXP), a Dallas-based company that manufactures cement and concretes. In January, Eagle Materials announced that it would reclassify its two classes of stock into one on April 11 at its shareholder meeting. The two share classes were created when the company was spun off from Centex(CTX) in 2004.

For the past two years, the B shares (under the symbol EXPB) have consistently traded at a discount to the A shares, most likely because they are relatively illiquid compared with the A shares. Average volume for the past three months was 135,000 shares for Class B and 1.11 million for class A.

Before the January announcement, the B series were trading at a discount of 90 cents to $1.25 to the A shares, says Jerry Paul, founder of Quixote Capital Partners, a merger arbitrage hedge fund, who has been buying the cheap B shares over the past few months. "It's highly unusual when a company combines two share classes into one," says Paul, who took advantage of the arbitrage opportunity early on.