FOOL ON THE HILL
Berkshire's Unusual Security

Berkshire Hathaway last week sold an unusual new security that has generated a great deal of interest and publicity, which is exactly what Warren Buffett intended.

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By Whitney Tilson
May 29, 2002

Berkshire Hathaway last week created a frenzy among its many faithful shareholders and followers when it sold in a private placement to institutional buyers $400 million (plus a possible $100 million over-allotment) of an unusual new type of security called SQUARZ (Goldman Sachs, the underwriter, didn't reveal what that stands for). SQUARZ pay a mere 3% interest -- low even by today's standards -- plus buyers are required to pay 3.75% annual interest, for an effective interest rate of minus 0.75%. Berkshire's press release boasted that SQUARZ are "believed to be the first security to carry a negative coupon."

Warren Buffett may be beloved by investors, but would anyone pay for the privilege of lending him money? Of course not. The kicker on this deal is that each $10,000 SQUARZ -- which was actually sold for $10,339.63 because buyers had to pay the negative coupon in advance -- comes with (quoting from Goldman's prospectus) "a warrant to purchase, on or prior to May 15, 2007, 0.1116 shares of [Berkshire Hathaway's] class A common stock or 3.3480 shares of class B common stock... at an exercise price of $10,000."

The math on the warrants
Here's the math on the warrants: Multiply $77,900, Berkshire's closing price on the day before the deal was announced, by 0.1116, which is equal to $8,694. Thus, for the warrants to be in the money, Berkshire stock will have to appreciate by 15.0% in the next five years (to reach the exercise price of $10,000) -- and by 18.9% before the buyers actually begin to make a profit (at $10,339.63).

The likely buyers
There has been speculation that the primary buyers of SQUARZ were hedge funds that focus on the convertible market, but I'm skeptical of this theory. These funds rely on stock volatility to profit from trading securities like SQUARZ and the spread with underlying stock, but Berkshire is significantly less volatile than the market (its beta is 0.70). It's more likely, I think, that bond funds prevented from buying common stocks, but seeking the potential upside of a stock with the downside protection of a triple-A credit like Berkshire, bought the offering, intending to hold it for many years.

Does the deal make sense?
Does this deal make sense to such buyers? Let's assume that a bond investor seeks 4.58% annual returns on a five-year corporate bond issued by a triple-A credit (this figure is taken from the Yahoo! Finance Bond Center). Someone paying $10,339.63 today for one SQUARZ seeks to have at least $12,934 in five years -- 4.58% compounded over five years is 25.1%. To reach this amount, therefore, Berkshire stock worth $8,694 would have to appreciate 48.8%, or 8.3% compounded annually.

Given that Buffett has publicly said that he expects overall stock market returns to be in the neighborhood of 8% over the next decade or two, and separately I've heard him comment that he believes Berkshire Hathaway stock will do at least a few percentage points better than the market over time, 8.3% sounds like a low figure. Perhaps Buffett's apparent bearishness explains why the stock fell $2,000 the day the deal was announced (hedging by some SQUARZ buyers could also have contributed to the decline). I have a different interpretation, however.

Why SQUARZ?
The most important thing to understand about this deal is that $400 million to $500 million is insignificant in the context of Berkshire Hathaway's enormous balance sheet. Buffett is drowning in cash -- for example, last quarter the company's float grew by $1.8 billion to $37.3 billion -- and his biggest problem is finding attractive places to invest it, so why would he raise more? And to the extent he wanted to raise more, why not just issue a regular bond rather than creating a funky new security with a weird name?

Buffett answered these questions on a conference call he had last week with institutional investors that were considering buying SQUARZ (to my regret, I missed the call and have been unable to find a recording or a transcript -- please email me if you can help -- but I've spoken with two listeners). On the call, Buffett lamented that every year he hears from business owners who tell him they wish they'd sold their company to Berkshire, but didn't because neither they nor their advisors had thought to contact Buffett. Thus, Buffett said the primary reason for doing the SQUARZ offering was to increase Berkshire's profile as a buyer of private companies, both by attracting general publicity and also by generating fees for Wall Street (many private business owners hire a Wall Street firm to help them sell their business). According to a Dow Jones story (paid subscription required), Buffett said during the call:

We're hopeful that...our appetite for reasonably priced acquisitions gets even better known around the world.... If doing this deal causes one or two more people, perhaps outside this country, to think of Berkshire when it comes time to sell their business [the offering] will have more than accomplished its purpose.... If we get the phone call from the right sort of person, ...the odds are reasonably good we're going to make a deal.

What Buffett is implying about Berkshire's stock price
If we take Buffett at his word -- and I do -- then we can see that his primary motivation was to make absolutely certain that the offering was a big success -- in other words, oversubscribed. (Imagine the bad publicity if buyers couldn't be found.) To ensure that such a novel, complex offering was oversubscribed, he had to offer an attractively low implied breakeven stock price to SQUARZ investors (e.g., 8.3% annual growth in Berkshire's stock). 

I'm not arguing that Buffett deliberately did a bad deal -- just that I believe it would be incorrect to jump to the conclusion that he only expects his stock to compound at a 8.3% rate for the next five years. I believe it will do substantially better than that (which is why I own the stock), and I think Buffett believes so as well, based on comments I've heard him make.

Tax benefits
According to a Washington Post article, the SQUARZ structure may also offer significant tax benefits to Berkshire:

As with any corporate debt service, Berkshire Hathaway gets a tax deduction for the 3 percent interest it pays to bondholders. The 3.75 percent income the company collects, however, is not taxable, said Robert Willens, a managing director of Lehman Brothers and the firm's expert on taxes.... And there could be an even bigger tax advantage, theorizes Willens, who stresses that he has not seen the documents involved but is evaluating the deal based on his long experience on tax issues.

It looks as if the bonds fall into a special category of 'contingent payment debt instruments,' because in addition to the regular 3 percent interest they collect, bondholders can make money by using the warrants to buy Berkshire Hathaway stock. When 'contingent' interest costs are involved, the issuer gets to claim much bigger deductions. Instead of deducting 3 percent interest, Berkshire Hathaway might be able to deduct 6 percent or 7 percent.

Signal the market
Finally, this is pure speculation, but I suspect that one of Buffett's motivations behind the SQUARZ offering may have been to take investors' expectations down a notch and perhaps flush out investors that he didn't want to own his stock. In less than a month, Berkshire had risen from just under $70,000 to nearly $80,000 -- a level not seen in more than three years. Obviously, Berkshire's intrinsic value did not increase this quickly, and Buffett has stated many times that he wants his stock to closely track the company's intrinsic value.

In addition, with the stock appearing on 52-week-high lists nearly every day, I think a number of traders and momentum players were drawn into the stock -- precisely the type of investors that Buffett disdains. By setting a relatively low stock growth rate at which the SQUARZ would be a breakeven proposition to buyers, Buffett appeared to indicate that Berkshire was fully valued, which would lower investors' expectations and likely scare out undesirable short-term investors. As argued above, I question whether Buffett was indicating any such thing, but if this was what he wanted to signal, it had the desired effect as the stock dropped by $2,000 the next day (it has since bounced back $1,000).

Conclusion
Buffett has once again demonstrated his genius. Via the SQUARZ offering, he has:

  • Attracted widespread attention -- this story has been featured prominently in many major business publications;

  • Generated meaningful fees for one of Wall Street's most prominent investment banks -- consequently, you can bet that Berkshire is now on Wall Street's radar screens to a much greater degree than before;

  • Raised money at low cost -- the only cost, a non-cash one, would be minor dilution if Berkshire stock compounds at a reasonable rate; and

  • Reduced investors' expectations and possibly chased away some undesirable investors.

Of course, it remains to be seen whether the SQUARZ offering leads to new business acquisitions for Berkshire, its most important aim, but I'm optimistic that it help.

-- Whitney Tilson

[Still confused or have a comment about Buffett's SQUARZ gambit? Take it to the Berkshire Hathaway discussion board. Only on Fool.com.]

Guest columnist Whitney Tilson is Managing Partner of Tilson Capital Partners, LLC, a New York City-based money management firm. He owned shares of Berkshire Hathaway at the time of publication. Mr. Tilson appreciates your feedback at Tilson@Tilsonfunds.com. To read his previous columns for The Motley Fool and other writings, visit http://www.tilsonfunds.com/.