Monday, September 5, 2011

Warren Buffett's Investment in BofA - And what is doesn't tell us

A hot topic of discussion lately has been Warren Buffet’s (dba Berkshire Hathaway) investment in Bank of America and the either – good, or great terms, he was able to get on his $5 billion investment.  In investment that BofA said it didn’t need and/or didn’t want.   A lot of the attention has been paid to the implied profitability of the structure of the transaction, and I have read some good analysis of the implicit discount he received (this is from Slate).  There has even been some talk about the implicit wager on the willingness/ability of the federal government to provide a “backstop” by refusing to let another major financial institution fail (a real, and probably accurate market perception).

But for me it boils down to something a lot simpler – size.  By investing $5 billion in BofA, Berkshire became one of the largest shareholders, and if you include the options would be able to control something in the order of 50,000 preferred shares and 700,000 common shares (at an exercise price of about $5 billion).  But even at that level of investment it represents just 14% of BofA’s total market cap as of today, which is down 80% from 2007.  So he got a good return (6%) and liquidity on $5 billion, which is something that is hard to do.  Consider that Berkshire had $47 billion in cash as of 6/30/11, mainly in Treasuries, so the ability to put $5 billion to work at a yield 3x what Treasuries are paying with an equity upside in the form of “at-the-money” warrants is a huge win.  There are only so many places one can put $5 billion without fully taking over a company.  As a matter of fact, there are only 36 companies (including BofA) in the US with a market cap above $70 billion (BofA’s is $77 billion as of 9/1/11).  Investing $5 billion in a company smaller than that would run the risk of having to consolidate their operations in Berkshire’s financial reporting and effectively exercising control over the company, or being stuck with a position they could not hope to get out of efficiently.

Buffett said he was hunting with an elephant gun these days and there are only so many elephants roaming the financial landscape, and you really can’t shoot too many other animals with elephant guns and not completely blow them up.

So at the end of the day I think size – sheer, unadulterated size, explains a lot of the investment in BofA.  And I think going forward Berkshire will probably do a more of what is effectively PIPE (Private Investment in Public Entity) type investing.  Elephant guns aren’t very effective on rabbits, so when he sees elephants out there I’m not going to be surprised when he pulls the trigger.