It wasn't as if hedge fund managers needed another reason to dislike Germany, what with its insistent calls for increased regulation of the industry, but last week's game played by luxury auto firm Porsche has left many managers seething with anger.

Porsches' steady buying of Volkswagen shares, in a three-year quest to take control of Germany's largest car manufacturer, had driven up their price to above the level at which it would make any financial sense for Porsche to add to its VW stake. Hedge funds and other investors accordingly sold VW short, with short positions reportedly reaching as much as 14 per cent of the company's outstanding shares.

However, on October 26 Porsche announced that it owned nearly 43 per cent of VW's shares outright and held cash-settled options to acquire a further 31.5 per cent, enabling it to control 75 per cent of the company next year. With a long-term stake of 20 per cent owned by the state government of Lower Saxony and more shares held by index funds, this left an effective free float of less than 5 per cent.

This forced hedge funds and the other short sellers to buy shares at any price, driving up VW's share price from around EUR 200 to more than EUR1,000, making the company temporarily the largest in the world by market capitalisation. Porsche made a paper gain of up to EUR40bn and may have made real gains of as much as EUR12bn after selling off some of its options to free up the market in VW shares.

Porsche says it never intended to make money on its options strategy, but there is some reason to doubt this. In the 12 months to July 2007 Porsche earned three times more money from trading derivatives - VW options - than it did from selling cars: EUR3.6bn of its EUR 5.86bn pre-tax profit. When analysts said the company looked like a hedge fund investing in just one stock, a Porsche spokesman laconically replied: 'We make money from hedging and building cars. The difference is that hedge funds don't make cars the last time I checked.'

Analysts believe the biggest loser in the affair - apart from the hedge funds, investment banks and others who have lost money - is the reputation of Germany's capital markets. In other jurisdictions investors would not have been allowed to corner the market in a share through options positions without having to disclose it.

The country's financial authorities may not be too bothered - they may if anything be pleased - if hedge funds and other investors they regards as speculators shun their market as arbitrary and ill-regulated. But ultimately German companies may lose out if the result is to make capital-raising for them more difficult and more costly.


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