What is Flowback
Flowback describes the sharp increase in selling pressure that foreign investors place on a company's cross-listed shares in the country of issuance due to an impending cross-border merger. In some situations, these cross-border mergers give foreign investors the perception that certain serious drawbacks are so apparent that they have no choice but to sell their shares.
Flowback can also refer to an investor's right to convert an American Depositary Receipt (ADR) into its representative stock.
BREAKING DOWN Flowback
Investors should be aware of the potential for flowback when investing in foreign securities. 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 of ADRs occurs when arbitrageurs take advantage of domestic and foreign market mispricings.
Relevance of Flowback
Cross-border mergers & acquisitions have been on the rise in the last several years through 2018. 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 (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 were approximately 2,800 ADRs available for purchase at the end of 2015, according to BNY Mellon. Flowback in ADRs occurs when the ADR price of a foreign company is higher than 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.