The Risks Inherent With Investing In Warrants - Part 2

So, apparently the security holders of GLW were sufficiently irate enough to launch a formal complaint against the previously announced FNV / GLW deal. As I profiled in my initial blog post, "The Risks Inherent With Investing In Warrants", my analysis indicated that both shareholders and warrant-holders should be unhappy with the deal.:

• Shareholders would be unhappy because they basically received no return on their investment since the IPO (albeit a good premium to recent trading prices). Regardless of my valuation concerns, with the proposed consideration, it would be an incredibly mediocre deal because the split between cash and shares would be exactly 60% / 40% (0.0934 FNV shares and C$2.08 in cash), which means that shareholders that wanted either consideration would only get that specific mix. In short, shareholders that wanted all FNV shares would receive only 60% of their consideration in that form and shareholders that wanted all cash would receive only 40% of their consideration in that form. Most investors would have a preference one way or another, which virtually ensures that all parties would be unhappy with the structure, let alone the valuation.

• Warrant-holders would be unhappy because they were being robbed of their optionality. Given that the consideration to be paid was 40% in cash, the warrants would lose a significant portion of their optionality as they could no longer be exercised into a full FNV share, but rather into the consideration only (cash has no optionality, which is really the only reason one would hold a warrant). Note that this is precisely why GLW warrants dropped so rapidly on December 13th, the day of the acquisition announcement.

On January 6th, 2011, a new deal with revised terms was announced:

• GLW shareholders can elect to receive a) C$5.20 per share in cash or b) 0.1556 FNV common shares, subject to the limitations of a cap on both forms of consideration as well as pro-ration. Total cash available is C$215mm and total shares available are 9.66mm.

• GLW warrants can be exercised for 0.1556 FNV shares or C$5.20 in cash. In essence, the warrant-holders are now not forced to swallow a 60% / 40% split, but are allowed to choose what form of consideration they want. As cash has zero optionality, in this situation, all warrant-holders would choose FNV shares.

What the revised offer does is it gives security-holders the option to select a form of consideration that is consistent with their individual needs and desires. In a situation like this, typically all shareholders would opt for the all-cash portion, thereby attaining a fixed price and real and immediate liquidity. Whether or not shareholders choose cash or FNV shares is dependent on their perception of the valuation of FNV (whether it is cheap or dear) and the opportunity costs to each individual investor. Moreover, the new option allows those that wanted to hold onto their GLW shares roll-over their ownership into FNV, whereas those that want to cash out can do so without having to rely on market prices and without causing market impact (which can be an issue for large shareholders trying to move blocks in an illiquid name). With all shareholders electing the all-cash option, this would cause the cash portion of the collar to be breached and all security-holders would receive a pro-rata share of both considerations, equivalent to the original 60% / 40% split. The same result would occur if all shareholders chose the FNV share option. It remains to be seen what GLW shareholders ultimately elect, and I will report on this once the election results are announced. It will be interesting to see what the results are, but like with most deals, I imagine that shareholders will gravitate towards the cash option. In my view, this is especially so because GLW is being valued at around 90% of NAV, whereas FNV is being valued in the market at around 150% of NAV. Moreover, FNV is not a pure-play on gold, but rather a conglomeration of royalty interests in gold, platinum, copper, nickel, oil, and gas. Unless I'm missing something, no rationale investor would agree to trade a position in a discounted pure-play into a position in a relatively over-priced conglomerate. My guess is that shareholders will get a pro-rata share of both considerations as a result of everybody clamoring for the cash option.

To me, what is very interesting is that most deals have to be renegotiated because the valuation is too low. Either shareholders negotiate a bump, force a bump through appraisal rights, or a new bid from another party comes forth. In this case, GLW shareholders were apparently happy with the valuation of the firm. However, warrant-holders (and probably shareholders) were unhappy in terms of the type consideration that would be paid. That is not the fault of the security-holders, but rather it is the fault of management. In essence, the forced re-jigging of this deal was really because of poor security-holder communication on behalf of management. It appears that GLW completed the deal in a hasty fashion, and did not fully consider its security-holders wants or needs, nor fully understand the market micro-structure of its securities. Luckily for warrant-holders, GLW management was smart enough to renegotiate the deal, and hopefully all parties can walk away from this averted debacle satisfied.