When a stock goes through a corporate action like a merger or a reverse split, often some shareholders are left with fractional shares. Instead of leaving a shareholder with a fractional share, the company will often pay them the cash value of the fractional share. Often this is referred to as “cash-in-lieu.” Is there any way to profit off these transactions?
When Does a Stock Pay Cash-in-Lieu of Fractional Shares?
Some corporate actions leave shareholders with fractional shares. One example is a reverse split, where say 10 shares are converted into a single share. A shareholder that only held one share to begin with would be left with a fractional share worth one-tenth of a full share. In a merger, something similar can happen. Say each share of the merger target will be converted into 0.1 shares of the parent company. Someone holding only 1 share would receive one-tenth of a full share of the parent. Similar examples can be found with American Depository Share ratio changes, warrants, contingent value rights, and I’m sure many other things.
The company has a lot of ways to handle fractional shares. They can return fractional shares to the buyer, although this is exceptionally rare and I’ve never seen this with a U.S. stock. They can round fractional shares down, giving investors nothing in exchange. They can round those with 0.5 shares or more up to a full share and those with less that 0.5 shares down. They can round everyone up. They can sell all the remaining fractional shares on the open market and donate the profits to charity, as Tesco did earlier this year.
Most often, though, the company will pay shareholders a cash value for the fractional shares.
Who Decides The Cash-In-Lieu Payment Amount, and How Can I Profit?
When a company pays cash for the fractional shares, called “cash-in-lieu,” how much do they pay and how is this amount determined? More importantly for the small investor, how can we profit off this?
Companies announce their plans in press releases or in SEC filings. I’ve seen three ways this cash amount is determined. In two of them, there’s an opportunity for arbitrage.
1. Last Moment Price
A common way is to pay the value of the share at the market close on the last day before the corporate action. This is often employed on reverse splits. If a reverse split occurs Thursday night, then anyone due 1 presplit share will receive a cash payment equivalent to the price of a single share at market close (4pm Eastern) on Thursday.
(Sometimes the company says they will sell the shares on the open market and distribute the proceeds to shareholders in proportion to how many fractional shares they are due. This is a similar treatment which I am putting in the same group.)
There is no legal way to arbitrage this opportunity as the cash price is unknown until the moment the opportunity has passed. There is simply no way to buy shares for less than what you know they will be worth, so any investment is simply a bet that share price will go up.
You might be thinking “what if I buy 2 shares for $1 at 3pm then sell one to my friend for $100 at 4pm?” In this situation, both you and your friend would have invested $2 total and be due $200 for your fractional shares.
While this is conceptually possible, there are two big problems. First, it’s very hard to move price that much. In any stock with reasonable volumes there are a lot of standing buy orders between $1 and $100. You’d have to buy all those up first, and that would almost certainly eliminate your cash-in-lieu profits once the stock crashes the next day.
But let’s assume there are few standing buy orders and you can quickly drive the price from $1 to $100. Because you are trading in a coordinated fashion with the intent of moving the share price, this is almost certainly market manipulation and illegal. Think no one will notice because it’s a small stock? The company will certainly notice, and will have a huge incentive to notify the SEC as they would like to avoid paying $100 to every fractional shareholder. In short, don’t do this.
2. Scheduled Average Price
Other times, the cash-in-lieu price is based on the price over some other timespan. A typical way this might be done is to pay cash-in-lieu based on the volume-weighted average share price (VWAP) over the five trading days prior to the merger. Because we have some idea of what the cash-in-lieu price will be prior to the time we need to buy, there’s an arbitrage opportunity.
In practice, it would work like this: Company X is merging with Company Y. For every share of Company X you hold, you receive 0.1 shares of Company Y. Fractional shares of Company X after the merger are paid as cash at the VWAP of the 5 trading days prior to the merger. As arbitrageurs, we want a sure thing, so we wait until the last moment, say an hour before market on the last day before the merger goes into effect.
Five days ago, Company X was at $10. But share price has dropped, and it now trades at $8. The VWAP over those five days is roughly $9 (average of $8 and $10).
So we buy 9 shares of Company X at $8 for a total investment of $72. After the merger, we are paid for all 9 shares at a rate of $9 per share, so $81. This gives a no-risk profit of $9 or 12% return in a few days.
As always, this doesn’t scale. Buy ten shares, and you get a full share of the Company Y which, because of the upcoming merger, has been moving in lockstep with Company X.
3. Net Asset Value
Some tradeable securities are not actually companies but rather funds that hold assets of something else, like crypto, gold, or other companies. The value of the thing they hold is called the “net asset value” or NAV for short. So these funds have two prices: the share price it trades at, and the value of underlying assets, i.e. the NAV.
You’d think these two prices would be pretty similar — why would anyone pay $10 for something worth $9? They are usually similar, but sometimes not, as management fees, investor enthusiasm (or lack of), and mismanagement can all cause share price and NAV to deviate significantly.
And that’s where the arbitrage comes in. Sometimes a fund will refund fractional shares with cash at the value of the NAV, not the share price. If you can buy at share price but get paid at NAV, and if the NAV is higher, one can profit.
Let’s use a real world example that’s going on as of this writing (May 6, 2021). $FXBY is a closed-end fund that is doing a 1:5 reverse split. Fractional shares are to be paid in cash at the NAV. Fortunately for us, $FXBY trades at $3.20 and has a NAV of $4.52. So we buy 4 shares of $FXBY for $12.80 total, and get paid $18.08 (4 times the NAV). That’s a low-risk profit of $5.28 or 41% return in a few days.
But Does it Scale?
Kind of. A five dollar profit is nothing to get excited about, but these can often work on multiple accounts and multiple brokers. If you’re interested, consider subscribing to my Substack or Twitter for more opportunities like these. If you’re interested in investing in reverse split arbitrage, i.e. similar investments that simply round up fractional shares to whole shares, see my Getting Started page for more information.