Yesterday, Goldman Sachs (NYSE:GS) announced that it had come to a new deal with Berkshire Hathaway (NYSE:BRK-A) (NYSE:BRK-B) under which Berkshire will take a big stake in Goldman shares as soon as Berkshire's warrants on the Wall Street investment company expire this fall. Yet while many analysts have marveled at the vote of confidence that CEO Warren Buffett's move represents in Goldman's future, the real surprise is that Berkshire gave up the chance to take a much larger position in Goldman.
The original deal
To understand the implications of the modification that Goldman and Berkshire agreed to, you first have to look at the history of how the two companies got together in the first place. During the financial crisis, Goldman was among many banks facing a major capital crunch. But rather than doing a massively dilutive offering of shares at just about the worst possible time, Goldman instead turned to the Oracle of Omaha for financing. Berkshire and Goldman agreed to terms under which Berkshire gave the Wall Street giant $5 billion in exchange for two things: preferred stock paying dividends of 10%, and warrants to purchase $5 billion in common stock at the then prevailing price of $115.
Once Goldman had recovered, it quickly redeemed the preferred stock, paying a premium of $500 million above the $5 billion face value in order to avoid having to continue to pay exorbitant financing costs of 10%. But the warrants remained outstanding, and with their having a five-year term, October 2013 loomed large as the date on which those warrants would come due. As Goldman's share price rose ever higher, the odds of those warrants getting exercised grew to a near-certainty.
What could have been
If Berkshire had stuck with the original deal, then it could have picked up roughly 43.5 million shares of Goldman, worth almost $6.4 billion today, for the bargain price of an additional $5 billion. Given how much cash Berkshire has in its coffers, that deal could easily have qualified as one of Buffett's famed "elephant" investments, giving the insurance giant a stake of about 9% in Goldman.
That position may sound huge, but it's definitely not unprecedented, especially for a portfolio the size of Berkshire's. Buffett's company already holds roughly 9% stakes in Wells Fargo and Coca-Cola, as well as nearly 14% of the outstanding shares of American Express. Moreover, a $6.4 billion investment in Goldman would fall far short of the 10-figure sums that Berkshire owns in each of those three companies.
But under the new agreement, Berkshire agreed to what's known as a cashless exercise of its warrants. Rather than paying the $115 per share under the terms of the warrant, Berkshire will receive whatever number of shares corresponds to the paper profits of its warrant position as of late September. At the current price for Goldman shares, that would be about $31 per share, and Berkshire would end up with about 9.2 million shares -- barely a fifth of what its position would be in a full exercise.
A sign of things to come?
The big question that the Goldman deal leaves for Berkshire shareholders is whether Buffett will use a similar exit strategy in exercising the warrants Berkshire obtained in its 2011 deal with Bank of America (NYSE:BAC). The 700 million shares of B of A that Berkshire could receive if it exercises all of its warrants would represent an equally impressive 6% stake in the bank, and B of A might have the same concerns about potential dilution that reportedly motivated Goldman to make its modification. Given that those warrants don't expire until 2021, B of A will have plenty of time to think about how it wants to approach Berkshire when the time comes.
Even after the modification, Berkshire's stake in Goldman will still be significant, at roughly 2%. But with its cash stash untapped, Berkshire still has its elephant gun loaded for potential prey beyond the financial sector.