Derivatives are confusing, even pretty simple ones, which is why Goldman Sachs can describe Warren Buffett's sale of $5 billion of GS stock like this:
The Goldman Sachs Group, Inc. today announced that it has amended its warrant agreement with Berkshire Hathaway Inc., and certain of its subsidiaries (collectively, Berkshire Hathaway) from cash settlement1 to net share settlement.
"We intend to hold a significant investment in Goldman Sachs, a firm that I did my first transaction with more than 50 years ago," said Warren Buffett, Chairman and Chief Executive Officer of Berkshire Hathaway. "I have been privileged to have known and admired Goldman's executive leadership team since my first meeting with Sidney Weinberg in 1940."
"We are pleased that Berkshire Hathaway intends to remain a long-term investor in Goldman Sachs," said Lloyd C. Blankfein, Chairman and Chief Executive Officer of Goldman Sachs.
In September 2008, Buffett bought - among other things - warrants to buy 43.5mm shares of Goldman Sachs stock in October 2013 for $115 a share, for a total purchase price of $5 billion. Today he amended that to instead allow him to buy in October 2013, for a total purchase price of zero, a number of Goldman Sachs shares equal to (A) 43.5 million times (B) [the average trading price of those shares at the end of September 2013 minus $115] divided by (C) that average trading price. As of when I type this, at a price of $145.80, that works out to around 9.2 million shares. So one way to read today's agreement is that in effect Buffett is selling back 34 million (give or take) shares to Goldman for $5 billion.
There's a boring securities-law reason for doing this, which neatly explains why this happened today even though the warrants expire in October, and if you like boring securities-law puzzles you can read about it down below.2 There's an obvious more important reason for doing it, or two reasons, which are:
- Warren Buffett probably has some amount of Goldman stock that he wants to buy in October, and it's closer to $1.3bn worth for $0 than it is to $6.3bn worth for $5bn; and
- Goldman probably has some amount of stock that it wants to sell to Buffett in October, and it's closer to $1.3bn worth for $0 than it is to $6.3bn worth for $5bn.
So, Pareto optimal. Buffett doesn't have to stump up $5bn for a new investment in Goldman; Goldman doesn't have to take a dilutive new investment.
Of course you could achieve a similar result without the amendment: in October, Buffett could pay his $5bn, get his $6.3bn worth of stock, and sell $5bn worth into the market (or to Goldman); Goldman could get its $5bn, deliver its $6.3bn worth of stock, and buy $5bn back from the market (or from Buffett). That's obviously a bit messy in terms of price slippage and transaction costs,3 but more importantly: it might be a little awkward for Goldman to go buy $5bn worth of stock in the market. That's more than the $4.6 billion that it repurchased in all of 2012, and that was before it got an Incomplete on its 2013 stress test. Also before people and politicians got really into worrying about the capitalization of too-big-to-fail banks.
So you could see why Goldman and its regulators wouldn't love the optics of a much-vilified, too-big-to-whatever, stress-test-laggard bank doing an extra $5 billion of share repurchase. Even if that repurchase was intended only to reduce the dilution of the warrant exercise, and was paid for entirely out of the (equity!) proceeds of that warrant exercise.4
Of course this is basically the same thing. As Goldman, and Goldman's regulators, know perfectly well. And it's not a way around Fed approval: the warrant amendment "will become effective only if the Corporation informs the Warrantholder that the Board of Governors of the Federal Reserve System has approved or has stated that it has no objection to the net share settlement of the Warrant." But I suspect this amendment will be easier for the Fed to approve than a cash repurchase, just because it's much less transparently a share repurchase. Certainly the press release sounds better.
Goldman Sachs Amends Terms of Warrants Held by Berkshire Hathaway [GS]
Goldman 8-K and warrant amendment [EDGAR]
Goldman Sachs, Berkshire amend crisis-era warrant deal [Reuters]
1.Ooh in my day we'd have called it "physical settlement," because it is. The original warrants were physically settled (Buffett pays cash, gets shares) not cash settled (Buffett gets net in-the-money value of warrants in cash), though you can see why someone might loosely describe the former as "cash settlement." Section 3: "[T]he right to purchase the Shares represented by this Warrant is exercisable, ... by (A) the surrender of this Warrant and Notice of Exercise annexed hereto ... and (B) payment of the Exercise Price for the Shares thereby purchased at the election of the Warrantholder by 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."
2.So here's the deal. If Buffett just went and bought shares directly from Goldman, he'd have to wait six months to sell them, unless he sold them pursuant to a registration statement. Goldman can't give Buffett a registration statement on October 1, the expiration date of the warrants, because its 3Q2013 will have just ended the previous day and it will have nonpublic information about how its quarter went.
Exercising a physically settled warrant - paying cash to get the underlying shares - is just like buying shares directly from Goldman: it's a new investment decision. This is a problem because it requires Buffett to come up with the $5bn cash exercise price, buy the shares, and hold on to them for six months (or until he gets a registration statement) before he sells. I mean I'm sure he has the $5 billion, but still, awkward.
"Cashless" (net share) exercise of a warrant - just getting the in-the-money value in stock, with no payment of the exercise price - is not a new investment decision, under SEC guidance, and so allows Buffett to "tack" his holding period. As long as he's held the warrant for at least six months, he can sell shares whenever he wants. (Also, of course, he doesn't need to sell any shares to come up with the cash to exercise the warrants, since now they're cashless. But he can sell the rest of his shares, too, if he wants to.)
He's held the warrants for four and a half years, which is more than six months, but the problem is that the warrant agreement only provides for physical settlement, so he has to amend it, which is arguably its own new investment decision that requires a new six-month holding period. So they amended it yesterday. Six months from yesterday is, give or take, September 25, or a few days before the warrant expires. So he'll be free to sell as soon as he gets his shares.
Almost as soon. The warrant amendment provides "In addition, the Warrantholder agrees not to Transfer (as defined in the Purchase Agreement) the Warrant Shares until the first trading day following the Corporation’s announcement of its results of operations for the third quarter of 2013." It might look a little like cheating if Buffett sold between the end of the quarter and the 3Q earnings announcement, and the earnings turned out to be bad.
3.And securities law - as noted above, Buffett would have to wait to sell for six months or until he got a registration statement. Also GS would have to wait to buy, probably, at least until it released its 3Q results.
4.One even less dilutive approach would be for Goldman to just buy the warrants back from Buffett for cash, like they did with the TARP warrants. One might question whether Goldman once intended to do that, and, if so, whether this round of stress tests contributed to changing its mind.