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.
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