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.
Showing posts with label Warrants. Show all posts
Showing posts with label Warrants. Show all posts
Monday, January 10, 2011
Friday, December 24, 2010
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.
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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