What Lehman Wants: Options, Warrants And Partial Stakes

Posted by John Carney, Aug 19, 2008, 5:07pm

CNBC's Charlie Gasparino, who broke the Neuberger Berman story that everyone else is pretending they broke today, is now reporting that Lehman CEO Dick Fuld and President Bart McDade are mulling a complex transaction that would involve Lehman selling a warrants for a 25 percent stake in itself as well as 70 percent of its investment management business. The deal would include an option for Lehman to buy back the investment management business later.

The particulars are as follows: Lehman would sell 70 percent of the investment management business, while holding on to the remaining 30 percent. It would have a call option on the 70 percent. The buyer, most likely a private equity firm, would get warrants for a 20 to 25 percent stake in Lehman itself.

This is the deal that Lehman is pursuing with private equity firms, apparently. It would allow Lehman to raise a large chunk of capital without permanently giving up the upside in its investment management business. Our own sources suggest that Lehman executives believe that after the current credit crisis passes, they will be able to rebuild the bank.

Gasparino suggests that Lehman may not have the leverage with buyers to force them to take this deal. With time running out and write-downs looming, Lehman could be forced to permanently part with its prized asset management assets.

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Posted in: Lehman

Comments

1

Posted by guest, Aug 19, 2008 5:21PM

LEH just doesn't get it which is why the will ultimately burn.

They don't have the leverage to dictate the terms of the deal - the leverage is reserved EXCLUSIVELY for the buyers.

I am not an expert, but in my naive eyes, the deal as laid out by LEH will not get done. Why would any buyer take this deal when the know that LEH is on life support and they can get all of Neuberger?

2

Posted by guest, Aug 19, 2008 5:57PM

Let's assume the above is correct and they are paying $10bn for 70% of Neuberger. Assume option on LEH is at today's stock price of $12.50.

They have a right of first refusal on the rest so six months go by, LEH still sucking, they get the other 30% at a potentially discounted price.

Let's say you really think that LEH is a survivor (let's hope so - they are one of the least inept shops out there) and stock returns to $50 in two years. Options are worth $7.8bn and they still have the 70% stake in Neuberger that ought to be worth at least $10bn. So, in two years, $10bn turned into $17.8bn. IRR of 33%.

I think I would do that deal.

3

Posted by guest, Aug 19, 2008 6:32PM

#2. You're too plain stupid that words can't describe the brain cells you are killing worldwide with your comments.

Why the fuck would they do that when they can simply

1) Buy all of Neuberger cheaply
2) Buy call options on LEH on the options market if they are bullish on LEH.

There you go. You can have your cake and eat it too.

4

Posted by guest, Aug 19, 2008 7:39PM

#3

its size stupid. They couldn't buy options on 25% of Lehman without giving up a lot of their profits on bid/ask. By getting the warrants directly from Lehman they buy options in size without blowing out the bid ask spread. They can just go short a shit load of lehman shares and capture the arbitrage.

5

Posted by guest, Aug 19, 2008 7:48PM

#3. A couple of issues with your "plan"

1) This is not buying 500 shares. This is a deal, where two parties have to come to some sort of agreement through negotiations. Typically, it is also customary for the buyer to choose who it sells to.
2) LEH has other options aside from Neuberger and will do some analysis around the relative value of (a) a common sale, (ii) a rights issue, (iii) further asset liquidation and (iv) the sale of Neuberger. It is not like it has to sell Neuberger "cheaply" to survive. They have options.
3) 33% IRR is pretty freaking good. Think $1.4bn in carry. Would you walk away from that because you want to "buy all...cheaply"?
4) Buying 30% of LEH through options would be difficult at best, probably impossible. With Jan 10 12.5 at 5.40, you're talking about $1bn, or 10% of PP, before you move the market.

KKR actually did something similar in the 90s with BancBoston and made a killing.

P.S. I bet you work(ed) on a mortgage desk that busted. I

P.S.S. If not a mortgage desk, you've put together pitch books for the last [fill in the blank] years of your life, impressing women with your tales of working hard and MAYBE did a real deal, but unfortunately weren't invited to any of the substantive discussions because your idiocy would likely been a Dealbreaker.

6

Posted by guest, Aug 19, 2008 8:15PM

#2 is right, #3 is an idiot.

7

Posted by guest, Aug 19, 2008 8:56PM

Now that I think about it, this thing isn't even a sale. Its an asset backed PIK note, with an equity kicker. You can definitely sell this, this is the type of thing Buffet put into Williams back in summer 2002. I'd say that's about the right analogy, energy trading summer 02 was about as much of a pariah as financials are now.

Again, you could lock in an arbitrage by shorting the lehman common.

8

Posted by guest, Aug 19, 2008 10:18PM

Dick Fuld is caught in a dileema of between (i) keeping his firm afloat and make sure it qualifies for a bail-out from the Treasury should shit really hit the fan and (ii) finding a private sector solution to Lehman's precarious situation.

(i) Lehman has not done as much as they should in shrinking it's balance sheet. Lehman is still going for profits and haven't pulled back their trading activities. I think Fuld is doing this because he wants to make sure Lehman to continue to be a big active participant in the financial markets and be a big counterparty to all other banks and brokerages. This ensures Lehman will be "too important to fail" and the Treasury and the Fed will have no choice but to bail out Lehman. On the other hand, a shrunken Lehman may be allowed to fail by the Treasury. Oh, forget all the "hedges" Lehman has in place. They're all freakin' trading positions that will blow up in their faces like last time when Erin Callan was still carrying a Lehman business card.

(ii) This option, warrant, asset sale deal is nothing more than a fancy long-dated repo deal. It allows Lehman to survive in the interim (should buyers take the plunge) by using the cash proceeds to bolster its balance sheet while buy back the asset when things get better. The Italian carmaker Fiat (facing bankruptcy at the time) did a repo deal like this in 2002 selling a 34% stake in Ferrari to Mediobanca. Fiat/Ferrari bought most of the stake (29%) back via the original repo arrangement in 2006. Mediobanca did sell some of the Ferrari shares to Lehman at that time. I definitely see traces of this deal in Lehman's latest desperate attempt to save itself.

9

Posted by guest, Aug 19, 2008 10:32PM

What about the D.E. Shaw stake? That has to be a significant portion of the Lehman share price at these levels (20% stake, possibly worth $2B).

10

Posted by guest, Aug 19, 2008 10:51PM

Get off my nuts 10:18, a repo is just a short dated PIK note. Since lehman has an option on the neuberger asset, the "buyer" doesn't even really get control of the asset unless lehman decides not to buy it back. You can just consider the event of lehman not buying neuberger back as the default, in which case the "buyer" would seize the neuberger asset. And the call option is a little mez piece so that lehman isn't the only one who gets to participate on the upside.

I bet George Walker is wishing he was still at Goldman right about now.... Maybe he can get his daddy to have Stifel Nicolaus buy Lehman.....

11

Posted by guest, Aug 20, 2008 12:09AM

Interesting discussion. Frankly, though, Lehman has one foot in the grave and people, esp. Fuld, are in denial about the time it has left.

I don't see another bail out. Paulson is already mulling about firms he would "let" fail, and the federal government already has massive worries about Fannie Mae and Freddie Mac slipping further out of control.

Paulson would like to see a whole package of new regulatory laws in place before another firm or bank fails, but it's not going to happen unless there is one or two more seismic failures. And then, what kind of time frame does Congress have left in 2008?

There's an election in the fall -- and then the end of the Bush Administration.

12

Posted by guest, Aug 20, 2008 12:37AM

Lehman is not too important to fail. It is GS fodder and not at such a reduced price as BSC was given.

But it would be a steal and hurt a lot of people who have worked hard and are innocent. People are going to save LEH, no reason to hear more stories about how XYZ spent 20 years productively at ABC bank and lost his retirement because it was all tied up in (sometimes restricted) stock.

Ultimately, the government will step in and support FRE/FNM, real estate will find a bottom, and things will swing back the other way again. The banks will follow, and our next bubble will be forming in some asset class.

Luckily this time, our currency is cheap so our import costs will slow consumer spending, to spur savings, while exports will pick up and currency conversion will make the US institutional money wealthy. It is two years out, but at least the rumors of its death have been greatly exaggerated. This time the banks won't create the recovery, it instead return to a more true equilibrium that works, but where everyone has less.

So if LEH can hang on somehow hang on, be it through a transaction that could hurt if things don't turn out well, shouldn't we be supportive of their actions. I would buy shares of the described transaction if given the opportunity, would you?

Obama 08

13

Posted by DrederickTatum, Aug 20, 2008 1:33AM

Question for those more learned than I:

If LEH issues a warrant on 25% of its outstanding shares, doesn't it massively increase the cost of raising additional revenue?

A hypothetical: LEH issues the warrant. Six months from now, with the credit crisis still roaring, LEH is forced to take even greater write-downs. LEH is forced into issuing new stock to [insert emerging-country wealth fund here]. However, LEH would have a pre-existing duty under the warrant to provide the investor with a 25% stake. Consequently, LEH would take a superflous 25% charge on any new shares issued to cover the rights of the warrant-holder...

So is this a poison-pill type situation? If someone buys the warrant, won't LEH's hands be tied in the long-run?

If I were an investor in this warrant, I'd never let LEH dilute me out of my investment. There could be a profit opportunity here... but there could be a wee bit more danger than I originally thought.

I'd appreciate any insight.

14

Posted by guest, Aug 20, 2008 3:23AM

insight #1: you're a moron. "If LEH issues a warrant on 25% of its outstanding shares, doesn't it massively increase the cost of raising additional revenue?"

retake basic accounting and then ask questions that sense.

insight #2: "If I were an investor in this warrant, I'd never let LEH dilute me out of my investment. " Its called an equity claw back, Merrill already went through the exact scenario you describe. the warrant probably specifies a fixed price for 25% of the total shares outstanding.

Lehman is not in a position to worry about the dilution of its equity holders. That's like a cancer patient refusing to take Chemo cause his hair might fall out in six months. If you're still alive in six months, you can worry about that shit then.

15

Posted by guest, Aug 20, 2008 4:07AM

#5

1) LEH is in no position to negotiate. The buyer dictate the terms. When you smell blood, you go for the kill.

2) No. They have to sell Neuberger. You must be dreaming if you think they have other better options.

3) 33% IRR is pretty good, if you work for IndyMac.

4) Nobody's asking you to buy all of the options at one strike date and all at one go. Are you so fixated with Jan 10 12.5 that you have to have only that? There are ways to create synthetic options payoff with different options you moron.

The supposed benefits of this proposed LEH deal can be recreated by the buyer's own desk. There's no need to give up control of Neu to reap these benefits. Like what #10 said, since lehman has an option on the neuberger asset, the "buyer" doesn't even really get control of the asset unless lehman decides not to buy it back.

16

Posted by guest, Aug 20, 2008 6:47AM

Who is Lehman?

17

Posted by guest, Aug 20, 2008 7:58AM

Too long...

18

Posted by guest, Aug 20, 2008 9:18AM

hey, these comments are great, and I really think there are some smart people posting here now.

But lay off all the insults, its just not needed

19

Posted by guest, Aug 20, 2008 10:15AM

@ 18 - Agreed.

@ 14 - Don't be such a douche.

20

Posted by guest, Aug 20, 2008 10:24AM

#15

Give up. You're wrong and have obviously never done any sort of PE transaction in your life. If you had, you would know that an unlevered return of 33% is pretty good base case. If they can finance 50% of PP at 10%, it jumps to 56%.

With billions needing to go to work, the large PEs would be thrilled to do this deal.

21

Posted by guest, Aug 20, 2008 10:59AM

@20 Never done a PE transaction but the large PEs' public shareholders probably would not be 'thrilled' to say their already declining investments dumped into Lehman right about now... .

22

Posted by guest, Aug 20, 2008 12:12PM

So your opinions are based on knowledge you acquired (and I'm only guessing based on your IndyMac "quip") from business headlines in the Post?

I'm not sure that is going to classify you as an expert on this or any other serious business topic...

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