People seemed to like our post yesterday calculating a mumbo-jumbo implied equity price at which Warren Buffett invested in BAC. Particularly gratifying was that some smarter folks than us came within a few cents of my $5.28 guesstimate. You could certainly quibble with some of my assumptions - in particular Bronte Capital points out that BAC's TARP warrants imply a higher long-dated vol than I arbitrarily threw into the model, while some of their prefs imply a higher pref discount rate than the 8.25% I used - but that's why there's a spreadsheet. Quibble away.
Others used differentvaluationmethods to get different numbers, but everyone basically used the same general approach as I did. That approach is pretty intuitive: you value the preferred shares at some discount rate. Then you value the warrants based on Black-Scholes or whatever. Then you add those two numbers.
Turns out that's wrong.
The actual securities purchase agreement released yesterday afternoon includes a form of warrant with the following terms:
3. Exercise of Warrant; Term. Subject to Section 2, to the extent permitted by applicable laws and regulations, the right to purchase the Shares represented by this Warrant is exercisable, in whole or in part by the Warrantholder, at any time or from time to time after the execution and delivery of this Warrant by the Corporation on the date hereof, but in no event later than 5:00 p.m., New York City time, September 1, 2021 (the “Expiration Time”), by (A) the surrender of this Warrant and Notice of Exercise annexed hereto, duly completed and executed on behalf of the Warrantholder, at the principal executive office of the Corporation located at 100 North Tryon Street, Charlotte, North Carolina 28255 (or such other office or agency of the Corporation in the United States as it may designate by notice in writing to the Warrantholder at the address of the Warrantholder appearing on the books of the Corporation), and (B) payment of the Exercise Price for the Shares thereby purchased at the election of the Warrantholder by (i) tendering in cash, by certified or cashier’s check payable to the order of the Corporation, or by wire transfer of immediately available funds to an account designated by the Corporation and/or (ii) the surrender to the Corporation of shares of the Corporation’s 6% Cumulative Preferred Stock, Series T (“Preferred Stock”), valued for purposes of payment of the Exercise Price at the per share sum of (x) $100,000 per share of Preferred Stock and (y) the amount of any accrued and unpaid dividends on each of such surrendered shares of Preferred Stock (including all past due dividends) with such accrual computed from the last dividend payment date through the applicable exercise date of this Warrant.
Buffett's warrant to buy 700 million shares is a stock option: to get his 700 million shares, he has to pay the $7.14 exercise price, which works out to $5 billion. Where is he going to get $5 billion? He's not exactly short of cash, but coincidentally he's also got $5 billion of BAC preferred shares lying around. And the warrant agreement lets him hand in those shares to pay the $5 billion exercise price.
Does this matter? Well, it wouldn't, if he had to hand in $5 billion worth of cash or BAC preferred or gold or anything else, at fair value. Paying $5 billion is paying $5 billion. But he doesn't have $5 billion worth of BAC preferred. He has preferred shares that say "$5 billion" on them, but given their below-market coupon those shares are worth anywhere from $3.3bn (using a high-estimate 9% BAC preferred yield from before the deal was announced) to maybe $4.0bn (using a 7.4%-ish yield on BAC-I today).
In other words - if he exercised the warrant today, he could pay $5 billion in cash and get stock worth $X for some X. Or instead of doing that he could hand in $3.3-$4.0bn worth of BAC shares and still get stock worth $X. Handing in the shares saves him at least $1 billion.
Of course he doesn't need to exercise the warrants until 10 years from now, at which time the preferred shares might be worth closer to $5 billion - as rates stay low and BAC credit improves with sound management, aggressive lawsuit settlements and the continuing Buffett halo. (They might even be worth more than par, in which case he'd just pay cash.) Or, y'know, the reverse. In any case, the option to pay with shares has value.
I leave as an exercise for the reader the task of reflecting this in calculations of "implied BAC equity price." For what it's worth, on a fairly simple method of reflecting it I see a $4.64 implied stock price on the same assumptions as yesterday.