Buffett Buys A Piece of Goldman

It's a good time to be teaching Corporate Finance. Buffett's latest move (making a substantial investment in Goldman Sachs) is bound to make it into a lot of class discussions. The Wall Street Journal's take (at least, as expressed by Georgetown finance professor James Angel) is

Berkshire's plan "is a sign of confidence from one of the nation's most respected investors," said James Angel, a finance professor at Georgetown University, who added that "sharp investors" now are "sniffing around the wreckage of the credit crunch to pick up good assets on the cheap."

I think the second part of the statement is closer to the truth than the first. Here's what the Sage of Omaha gets for his money

The deal is structured in two parts, giving Berkshire a stream of cash and potential ownership of roughly 10% of Goldman. Berkshire will spend $5 billion on "perpetual" preferred shares of Goldman. These are not convertible into equity but pay a fat 10% dividend.

Berkshire also will get warrants granting it the right to buy $5 billion of Goldman common stock at $115 a share, which is 8% below the 4 p.m. closing share price Tuesday of $125.05. At Goldman's roughly $50 billion market value, based on that closing price, exercising those warrants would give Berkshire about a 10% stake in Goldman.

So, while the preferred isn't convertible, he gets what is essentially "synthetic convertible preferred". In essence, he gets his preferred payouts if the stock price doesn't rise, and the option to buy stock at a discount if the price is above $115. So, in effect he has a combination of preferred stock and an in-the-money call option. Barry Ritholtz prices the warrants at approximately $1.5 Billion, giving Buffett an effective yield of 14%, and cites another source who estimates their worth at $3.5B, and a yield of 17%.

Once again, Buffett has been able to make an investment at a very attractive price. In times where there's a lot of turmoil, having cash on hand makes it easy to buy companies (or parts of them) at a bargain, and according to Berkshire's first quarter, they had $31 Billion on hand. So, Buffett had cash at a time when Goldman desperately needed it. As a result, he got a great deal.

Just Damn. That guy is smart.

What to Use as the Equity Risk Premium?

I'm teaching Corporate Finance again this semester. In the class, we spend a fair bit of time on the CAPM (yes, I know - it's not perfect. But it is a still pretty good). One of the big issues is what to use as the Market Risk Premium (or, as it's sometimes called, the "Equity Risk Premium). Looks like I'll be using this piece as background: The Equity Risk Premium in 100 Textbooks by Pablo Fernandez of the University of Navarra. Here's the abstract:

I review 100 finance and valuation textbooks published between 1979 and 2008 (Brealey, Myers, Copeland, Damodaran, Merton, Ross, Bruner, Bodie, Penman, Weston, Arzac...) and find that their recommendations regarding the equity premium range from 3% to 10%, and that several books use different equity premia in different pages.

Some confusion arises from not distinguishing among the four concepts that the word equity premium designates: Historical equity premium, Expected equity premium, Required equity premium and Implied equity premium.

Finance professors should clarify the different concepts of equity premium and convey a clearer message about their sensible magnitudes.

It's worthwhile reading - you can download the full version on SSRN here.

HT: Jim Mahar at FinanceProfessor.com

Capital Structure, Buybacks, and Free Cash Flow

I'm in the process of putting together material for my Advanced Corporate Finance class. Of course, it has a module on capital structure and payout policy. One of concepts we'll get across is that holding extra cash often gives managers incentives to invest in negative NPV projects (the old "free cash flow" problem). So, according to agency theory, managers should lever up and pay out the excess cash to shareholders in the form of buybacks and/or dividends. Unfortunately, higher leverage and lower cash holdings exposes the firm to increased risk of financial distress.

Along those lines, I was going through my "clippings file" and came across this piece in the Economist. It discusses some of the costs of excess debt during recessions. Of course, it's always easy to look back after the fact and say that firms shouldn't have levered up so much, since it means they'll face distress costs during a recession (hindsight's always 20/20, after all).

In a related piece David Merkel id a piece a while back on financial slack and how he uses it in evaluating cyclical companies in Real Money. He illustrates his approach using the steel industry. When identifying good companies in the steel industries he looks for several things:

...With a cyclical company, watching the pricing trends of the commodity produced is the most critical factor in short-run stock performance. Longer term, it comes down to finding companies that have these four characteristics:

1. They're industry leaders with impeccable balance sheets.

2. They have reasonable operating leverage; they should be profitable at the cycle trough.

3. Their industry is hated, so their stocks can be bought at a cheap price.

4. They use free cash flow at a cycle peak in a way that prepares for the trough.

...Points 2 and 4 suggest a corporate humility that arises from restraining the increase of productive capacity when times are good, and a willingness to invest when times are bad.

Point 4 is the most relevant to the whole leverage/payout discussion: what's the best use of free cash flow? Should it be invested, used to pay down debt, or be distributed to shareholders? If good time are expected to continue, the company is best off investing the excess in positive NPV projects and then paying out excess free cash in the form of dividends and buybacks (and buybacks result in increased leverage). However, if troble is expected ahead, they're better off paying down debt or holding more cash in reserve.

I think it'll make for a good discussion in class.

Larry The Liquidator

I've started putting together my syllabus for the spring semester. I'll be teaching the advanced corporate finance class. I haven't taught this particular class for a couple of years, so I thought I'd change things around a bit this time. It's about 50/50 between lectures and cases, and this time around I think I'll play this clip from Other People's Money. It's the speech by Larry The Liquidator at the shareholders' meeting, and it's a pretty good representation of the PE/buyout/corporate selloff world's approach to things. It's also one of the best finance clips you'll find in any movie anywhere. .

Enjoy.

Cost of Corporate Borrowing is Up

Because corporate borrowing costs were low in recent years, many companies loaded up on debt. Now, much of that debt is coming due at a time when companies have experienced slowdowns. Here's a recent article from the NYTimes Online, titled "Cost of Borrowing Zooms up For Corporations":

Like consumers and homeowners, America’s corporations binged on easy credit when times were flush, racking up huge debts. Now the bills are due, and paying them back will not be easy, or cheap.

This year alone, more than $700 billion in corporate loans will come due, according to Standard & Poor’s. That is the size of the federal bailout of the financial sector. Many companies were counting on being able to borrow more money to meet those obligations and kick their debt farther down the road.

But with the credit markets still tight, corporations are being forced to pay much higher interest rates than they did a few years ago, putting more strain on balance sheets already hammered by falling profits and a grinding recession.

Read the whole thing here