What is Flowback?

Flowback describes the sharp increase in selling pressure that investors place on a company's cross-listed shares in the country of issuance due to an impending cross-border merger or acquisition. In some situations, foreign investors have no choice but to sell their shares when the merger results in an investment that no longer meets their investment objectives. 

Flowback can also refer to an investor's right to convert an American Depositary Receipt (ADR) into its representative stock.

Key Takeaways

  • Flowback is increased selling pressure due to a cross-border merger or acquisition.
  • The selling occurs because investors may not want to hold a new foreign investment or the new company may no longer meet the investor's or fund manager's investment criteria.
  • Flowback in ADRs can also occur based on price discrepancies when a company is listed on more than one global exchange. Arbitrageurs will sell the overpriced shares and purchase the underpriced ones.

Understanding Flowback

Flowback occurs when a security sees increased selling pressure as a result of an impending cross-border merger. This occurs because the newly merged company will no longer be domiciled in one of the countries. The investors in the country in which the company will no longer reside may sell their shares because the shares will soon represent a foreign investment, instead of a domestic one. Fund managers may be forced to sell their shares because the merged foreign company may no longer meet the fund's portfolio criteria.

For example, country A's tech index fund only deals with tech stocks from country A. Country A's leading tech company, ABC, decides to merge with country B's leading company, DEF, and incorporates the new company, ABEF, in country B. 

The net effect of this action would force the previously mentioned index fund to sell all its shares in ABC, because the company will no longer fit into the fund's investment thesis. In such cases, companies should examine flowback that occurs as a result of corporate actions to prevent share prices from tumbling. 

Flowback in ADRs occurs when the ADR price is higher than the share price of the company’s ordinary shares that trade on a listed exchange in their home market. Arbitrageurs can profit by selling the overpriced shares and simultaneously purchasing the underpriced shares.

Relevance of Flowback

Cross-border mergers & acquisitions have been on the rise as global markets become more interconnected and companies see potential synergies by merging with cross-border companies. Much of this action has been driven by more favorable tax treatment of corporations in countries outside the United States. This has led to a series of large consolidations, called corporate inversions, where the merged company domiciles its headquarters in a low corporate tax country such as Ireland or England. Some of the largest inversions have involved health care companies Allergan, Mylan, and Medtronic as well as industrials company Johnson Controls.

These deals have not resulted in serious flowback but they have hit shareholders of the company moving its tax domicile to a foreign country. Under IRS rules during the height of the inversion frenzy between 2012-2016, investors in these companies were taxed as if they had sold all their shares.  

ADRs and depositary receipts for foreign stocks to trade in markets where they are not domiciled have grown in influence, creating more opportunities for flowback. There are more than 2,200 ADRs available for purchase as of the end of 2018.

Example of Flowback in Real World

In 2004 Spanish bank Santander purchased the UK's Abbey National bank for £8.5billion in cash and shares. While the bid for the company was going on, 14 of the 20 largest shareholders in Abbey reduced their positions by 56%, according to the Finacial Times. This is significant selling pressure as a result of the acquisition, called flowback.

To avoid further flowback, Santander tried to appease UK shareholders by allowing them to receive dividends in pounds sterling. This allowed the UK holders to avoid the costs of converting euro dividends into their home country's pounds sterling. The acquisition was finalized in late 2004.