The Risks Inherent With Investing In Warrants

I thought I would write a quick post on the risks with investing in warrants, because the practical risks are not always discussed in finance courses or textbooks. In fairness, the thought to write a post on this topic was borne out of an article posted on The Financial Post a few days ago with respect to the Franco-Nevada Mining / Gold Wheaton acquisition that was recently announced. It provides an instructive example and lesson as to why warrants are inherently risky - especially for those deciding to go long outright.

On December 13th, it was announced that Franco-Nevada Mining would acquire Gold Wheaton by way of Plan of Arrangement for 0.0934 Franco-Nevada shares per Gold Wheaton share and $2.08 in cash consideration. In sum, the consideration would total $5.20 per GLW share, equivalent to a one day 19% premium, and a 60% / 40% split in favour of FNV shares and cash.

As an initial shareholder of GLW (which came into existence in its current form in June 2008), I would not be happy at all in the sense that the original over-subscribed equity raise was for $260mm (with green shoe) at $5.00 for subscription receipts (after a 10 for 1 share consolidation in February 2010) that included one GLW share and a 1/2 warrant struck at $10.00 for 5 years. In my estimation, the value of the 1/2 warrant was anywhere from $0.65 to $1.00 in additional consideration. This deal was well oversubscribed, and you can see the demand for this issue as the stock price tripled in value in the span of a few months (see graph below). The most startling thing is that they were able to issue the 1/2 warrants at 100% ups, which I guess is offset by the fact that each warrant had five years of time to expiration. Typically, in Canada, the strike price is about 20-40% higher than where the underlying is currently trading, and the warrants have an expiry of 18 to 24 months after the deal closes. In hindsight, I do understand why this deal was over-subscribed, and ultimately upsized, with all the brokers and management buying in as well. Any way you slice it, it was a very attractive deal for anybody that bought, which is partly why the stock rifled higher afterwards in the secondary market.





Immediately after the acquisition by FNV was announced, GLW started trading at $5.10 and GLW.WT started trading at $0.28 (see graph above). As a buyer of the sub-receipts on July 8th, 2008 for $5.00, the consideration I am getting out of this deal once it is all wrapped up is approximately $5.20 - a laughable 4% return over the span of approximately 2 years and 8 months. Note that the consideration calculation assumes the FNV portion remains constant (in reality FNV's shares will fluctuate slightly) and the public warrant holders get nothing because they are far out of the money. Moreover, as you can see from the chart below, GLW was being valued quite low by the market. The two charts below were taken from a GLW corporate presentation that was done on November 9th. Given the trading price of the stock, GLW's NAV is approximately $5.65, which means that FNV is only paying 92% of NAV - still a massive discount to where the comps are trading at. So, to clarify, GLW is being valued too low on an absolute and relative basis. Now, the original deal was well supported with players such as GMP, Paradigm, FNX, Sprott, Frank Guistra, and various other insiders buying in, so I am baffled as to how this deal got done because unless they sold when the stock was $10 or $15 (which was only a period of 5 months, under which they were mostly under lock-up), it seems to me that nobody has made any money!





From the perspective of a GLW warrant holder, I would not be happy. First, as an instructional, warrant values are driven off of three main inputs - the underlying share price, the volatility priced into the shares / market by traders, and the inherent time to maturity negotiated into the warrant indenture. Typically it is the former two that drive the pricing of the warrants on a day-to-day basis, as the latter is whittled down slowly as time passes. Let's look at what happened in the case of GLW warrants in the context of this deal.

• Stock Price - In an acquisition, the stock price rifles upwards on announcement of the deal. This is obviously positive for a warrant as part of its value is derived from the stock price. It does depend on where the stock price is in relation to the warrant's strike price. If the value of the consideration offered is less than the strike price, the warrant is basically worthless because it has no intrinsic value and limited time value. In the case of GLW, the publicly traded warrants had a strike price of $10.00, and therefore they will ultimately have zero value once the deal is completed.

• Time To Maturity - The longer the time to maturity, the greater the value of the warrant because it has more time to become "in the money". In the context of the GLW deal, the time maturity shrinks massively, thereby destroying the value of the warrant. Prior to the deal being announced, the warrant had 939 days left until expiry. After the deal was announced, the warrant had 108 days to expiry under a worst case scenario (assuming the deal is wrapped up by the end of March). In one fell swoop, 88.5% of the time that the warrant had left to expiry was eliminated because of the acquisition. This is what we call "event risk" and that is the first explanation for why the warrants dropped in price from $0.57 to $0.28 the day after the announcement, and settled in at $0.17 thereafter.

• Volatility - Prior to an acquisition, a stock price trades freely based on fundamentals and sentiment. After an acquisition, a stock trades in relation to the acquisition price and usually moves very little. If it does move, it is based on the assessment of the deal getting done. In essence, the volatility in the stock evaporates because the stock has no reason to gyrate in response to macro-economic reasons, industry changes, or even company specific developments, etc. It only moves based on news flow related to the deal and supply and demand from the arbs, which means that the stock will typically move very little. Although it would have been more prevalent in a case where the warrants were in the money, in the case of GLW warrants, volatility dropped significantly (see the post-acquisition announcement trading price graph below) and the price of the warrants in the open market cratered. In the case of an acquisition, because both time to maturity and volatility are drastically reduced, it is a little difficult to estimate what portion of the value reduction was attributable to which lever, especially because volatility is imputed from the price of the stock. However, once again, from the graph below you can visually see that volatility of the underlying GLW shares has disappeared.



Now, if you run the black-scholes model, you'll find that the theoretical price of GLW warrants is actually around 2-3 cents, yet the market has priced them anywhere from $0.15 to $0.29 post-deal announcement, and has traded them in decent volume. I'm not quite sure why anybody would pay so much over their theoretical value, but my guess is that it is simply speculators that are trading for a few pennies of profit here and there.

The other grating aspect of being long warrants of a company that is being acquired is that even if you are hedged (by shorting the stock), because volatility - the primary driver of a "warrant volatility" strategy - drops like a rock, your warrant goes down more in percentage terms than the stock you shorted.

Although this post has largely been about the negative aspects of warrants, it is important to understand the fundamentals as to how these types of securities work, and oftentimes that is best learned through losing money (such as GLW warrant holders did). On the flip side, warrants provide a significant amount of leverage and are fantastic ways to make money very rapidly, if you can navigate the minefield and buy and sell at the right time. This is especially true with warrants because time is constantly working against you when you employ such a strategy.

In Canada, there are approximately 162 public warrant issues outstanding currently, and there are probably hundreds of warrant issues that trade hands privately. In short, there are a lot of long-dated derivative ways to make money in the Canadian markets. One of my goals in the new year is to rebuild my database of warrants with updated terms. I think with the VIX currently toeing 15-16, there is a good chance to put on some attractive warrant volatility trades in the near term. It is just a matter of sorting through the rubble to find the gems. Time to add that to my New Years resolutions list.

Novartis Versus Alcon - A Win For Alcon's Minority Shareholders And Minority Shareholder Rights

As I had previously discussed the Novartis / Alcon deal in a post entitled '"Majority of the Minority": A Simple Remedy for Minority Squeeze-Outs', I thought I would give a quick update on the outcome of the deal.

On December 15th, Novartis announced that it had come to terms with the Board of Directors of Alcon, and proposed a deal to acquire the remaining 23% stake in Alcon it did not already own from minority shareholders (http://invest.alconinc.com/phoenix.zhtml?c=130946&p=irol-pressReleasesArticle&ID=1507867&highlight=). The reason why this is important is because the history of the deal extends for several years, and Novartis initially attempted to squeeze out minority shareholders for significantly less consideration than it paid for the controlling stake it acquired in Alcon from Nestle. This was a significant win for minority shareholders, as Novartis had no such obligation to give them as much consideration as Nestle under Swiss securities law. Here is a brief outline of what occurred:

• April 7th, 2008 - Novartis acquired a 25% stake in Alcon from Nestle for $143.18 in cash consideration. The deal had some interesting provisions worked in, whereby Novartis had the option to acquire Nestle's remaining 52% stake by a certain date at a certain price.

• January 4th, 2010 - Novartis exercised its call option to acquire Nestle's remaining 52% stake for $180 in cash consideration. Simultaneously, Novartis made an offer to minority shareholders for $153 in the form of an all-share offer of 2.8 Novartis shares. The first issue was that the offer was lower in monetary terms. The second issue was that it was in shares, which although technically fungible with cash, are worth less than an all-cash offer because they created uncertainty of what a minority shareholder would receive in the end. Moreover, the deal was further complicated because Novartis shares are priced in Swiss Francs, which introduced exchange rate risk for a minority shareholder. In short, the offer was inadequate any way you looked at it. Luckily, the three independent directors of Alcon formed a committee to review the transaction.

• January 20th, 2010 - Alcon's independent committee determined that the deal was "grossly" inadequate.

• February 17th, 2010 - RiskMetrics publicly stated that the Novartis deal was prejudicial to Alcon minority shareholders.

• July 8th, 2010 - Alcon's independent committee created a $50mm "litigation trust" that allowed them to continue to legally protect minority shareholder rights upon the acquisition of Nestle's 52% stake by Novartis.

• December 15th, 2010 - After a little over 11 months, Novartis folded their hand and agreed to acquire the remaining 23% in Alcon for a price of $168 per share. This is payable with 2.8 Novartis shares, and if the value of the share consideration falls short at closing, then it will be topped up to $168 with cash. The $168 consideration is basically the blended price that Nestle received for its two blocks of shares.

As always, there is some commentary that I would like to make. First and foremost, I find this deal to be bittersweet for minority shareholders. It is a positive outcome to this deal in the sense that the deal is finally getting done. It is negative in the sense that it has been a long time between the initial offer in January and the closing of the deal will be over a year, and closer to a year and a half once the legalities are wrapped up. Alcon shareholders have been in limbo, and will continue to be this way for the next few months.

Secondly, the bump in consideration from $153 to $168 is also positive. However, the consideration is in shares, which any appraiser can tell you are less valuable than cash. It is true that it will be a "tax free" rollover for shareholders, so they have the option of holding onto their stake without tax consequences. However, cash is a certainty and should always be valued higher than shares. Share values are transient. They are typically supported by fundamentals in the long-term, but can deviate significantly in the short-term. The other aspect of this transaction is that if the value of the offer comes in at more than $168 at closing, the share ratio will be reduced to ensure consideration remains at $168. Although I am skeptical of Novartis' share price rallying much higher prior to deal closing (due to hedging), the attractiveness of the consideration received will only be certain on the closing date. At current prices, Novartis is trading at 14x earnings, which is at the higher range of comparables, although not outrageous on an absolute basis. What I would be worried about as a potential Novartis shareholder is multiple compression, and more importantly, fund managers selling their newly acquired Novartis shares on the open market after the closing date, thereby depressing the price. In short, the consideration received is uncertain, and there is some probability of it being less than $168.

Third, the $168 is a blended price that Nestle received in total. It is a combination of an initial $143.18 on the 25% stake sold in 2008 and $180 on the 52% stake sold in 2010. I maintain that the $143.18 price was a trade done in the context of a different market and at a different time. As such, it is irrelevant to the pricing of any stake being sold in 2010. Moreover, the value of the Alcon business was different in 2008 than in 2010. I believe that the minority shareholders should have argued for $180, as they should receive the same consideration that Nestle received in 2010. At the very least they should have argued for an interest adjustment on the $143.18 portion, as Nestle effectively had access to that cash two years prior. My solution would have been to apply some sort of risk-free interest rate (t-bill or short-dated treasuries) to the $143.18 portion of the consideration calculation to bring the value of the cash to present value. Using one month US t-bills as the proxy, the additional consideration would amount to about $0.31 or 20 basis points more than what Novartis offered, primarily because rates cratered over the 2 year time frame. Although the methodology is more fair and correct (in my view), this option was probably not considered due to the minor amounts involved and the relative negotiating positions of Novartis and Alcon. On the flip side, I do understand that there is a control premium ascribed to Nestle's 52% block of shares, which minority shareholders cannot take part in. This is the main "bitter" aspect of the deal. The shares are probably worth $180, but minority shareholders have no legal way to force a bump. Nor can they argue that they deserve the price ascribed to a control block. Given that the independent committee has recommended that shareholders approve the deal, I believe it will go through as planned.

Fourth, I must applaud the independent board of directors for taking the steps necessary to fight for minority shareholder rights. The $15 increase in consideration for the 69mm shares held by minority shareholders translates into a little over $1bn in additional value that is rightfully theirs. That is the product of three individuals fighting for minority shareholders, but a slew of other parties as well. Both proxy advisory firms, Glass Lewis and RiskMetrics were instrumental in guiding the market to refuse Novartis' "grossly inadequate" initial offer.

Fifth, as indicated by market folly's recent post, this deal will get done because of the fact that the arbs are now deep into this trade and will vote in favour. I wanted to point out visually how the market responded to this deal throughout time.


The graph shown above displays the spread value on a relative basis. What I mean by this is the spread value of the deal originally announced (the value of 2.8 NVS shares minus the value of 1 ACL share). As you can see, the market immediately priced a negative spread on the deal, as it believed that minority shareholders should get closer to $180 for their shares. Three things are playing out here. First, the ACL shares are initially being hedged with NVS shares as arbs have to short 2.8 NVS for each 1 ACL they own. That put tremendous pressure on the price of NVS in the market, thus lowering the value of the share consideration immediately. This is in addition to the share dilution concern by NVS shareholders who would have sold NVS for that reason alone. Second, as markets began to tumble in the summer, NVS shares had more pressure on them which pushed the value of the share consideration down even further and the expectation of a bump in the share exchange ratio up. Hedgies would look at the value of the share consideration at $135 and say that it is too low relative to the already low absolute valuation of $153 that was set by NVS only 6 months prior (keeping in mind there is relatively little change in the fundamental value of the business). They would also assume that they are getting a free option on a bump in the share exchange ratio, and would thus put on the spread at +$5 all the way up to $20. Third, as market participants talk and determine what the real value of the minority stake is and the likelihood of a bump, their expectations for a bump increase simultaneously (along with the risk trade being put back on in August) and they begin to push the value of ACL shares from the $150's into the $160's. The interesting aspect of this is two-fold. First, given what market folly indicated in his post, the hedgies could have been colluding to go long at the same time and thus affect the status of the deal (a form of quasi-activism). The second interesting aspect is that as soon as the stock continues to hang at the $160 level for an extended amount of time, it is clear to any market participant that NVS will be forced to offer more consideration if it wants to close the deal - in essence, the bump is a self-fulfilling prophecy. You can see this in the chart below. From August onwards, the deal traded at a negative spread (assuming a $153 payout), with ACL rallying all the way to $170, presumably under the assumption by some poor-sap that a deal would get done at $180. It promptly sold off to a more reasonable level in the low 160's when NVS decided to bump to $168 to get the deal done.


Sixth, strategic deals like this always get done in the end. Novartis is primarily concerned with acquiring and running the business for fundamental / strategic reasons. They could not continue to fight to oppress minority shareholders because they have the business to run as control investors. I understand that they tried to take advantage of minority shareholders, however, I am just baffled at how long it took for them to work out the deal. You can clearly see them integrating the business as time goes on (appointment of Novartis CFO to oversee Alcon, appointment of Novartis CEO to chair Alcon, etc), so you can see their thought process playing out in the press releases, and it was apparent to me that they were going to do the deal at some point in time. Why did it take eleven months? I guess we'll never know.

Seven, it took NVS approximately 8 months to acquire Nestle's 52% stake, and my assumption is that it will take a shorter time frame to acquire the minority stake held by the public. The company has guided to "the first half of 2011" in terms of closing, which makes it a 6 month long wait until consideration is paid out, assuming a worst case scenario. I think there is a chance it could get done sooner. From a risk-arb perspective, that is a long time to have your capital at risk, which will not be attractive to all arbs. The share price of ACL should stay within hailing distance of $168. At the current price of $161.70, the annualized return is roughly 8%, which is about right for this type of trade. I think ACL has to trade down to $157 or $158 to make it attractive currently. With that said, I think there will be an opportunity at some point in time to go long ACL at an attractive annualized return (+15%). Given the volatility in the markets and the skittishness of arbs, there is a good chance of ACL being sold off in the coming months due to the risk trade being taken off by funds. As it stands right now, I'm a buyer at $158.