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Goldman Sachs, A Great Deal for Buffet

Posted on: September 25, 2008 - Email Article - Printable Version

Steve Murray

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Warren Buffet, who has been regarded as one of the most powerful men in the world, and also one of the wealthiest, struck again to buy a stake in investment banking giant Goldman Sachs [GS: 88.78, 0.00 (0.00%)]. Buffet has steered away from many Wall Street firms in the past year, but this deal was one that he couldn’t miss. The deal, which has struck a lot of controversy from Goldman Sachs’ shareholders, is a very expensive one for Goldman to do. Lloyd Blankfein, the CEO of Goldman, was extremely worried that the markets didn’t think their balance sheet was well capitalized. After Morgan Stanley agreed to a deal with Mitsubishi UFJ [MTU: 6.27, 0.00 (0.00%)] for a 20% stake in Morgan Stanley [MS: 17.62, 0.00 (0.00%)], management at Goldman knew that something had to get done. Buffet’s investment into Goldman Sachs marks one of the biggest expressions of confidence in the today’s financial system.

According to an article in the Wall Street Journal, Buffet received a call on Tuesday while he was at Berkshire Hathaway’s [[BRK.A]] headquarters in Omaha, NB. The call came from a Goldman banker by the name of Byron Trott, who asked Buffet what type of an investment he would make in Goldman Sachs, if any. Mr. Trott, a top banker at Goldman, has had a relationship with Buffet for some time now, advising him on many deals including the investment Buffet made in Mars, Inc a few months ago. Talks escalated very quickly as Buffet has been fascinated with the business model of Goldman Sachs for some time now. The fascination started back when Buffet’s father took him to visit Goldman when he was only 10 years old. By the time Buffet was 25, he had a direct line to Sidney Weinberg, a former Goldman CEO.

The terms of the deal were very positive for Berkshire; Warren Buffet agreed to invest $5 billion in Goldman in exchange for perpetual preferred shares with a dividend yield of 10%. This will set Goldman back roughly $500 million a year, which will be taken directly off their net income in after tax dollars. This means that Berkshire will be making well over $1 million each day from this investment. It will also be extremely expensive for Goldman to redeem these shares, as they must buy them back at a 10% premium. Buffet also has the option to invest an additional $5 billion in common stock at a strike price of $115. If Buffet exercised these options today, he would make over $650 million in unrealized gains since Goldman’s stock price has jumped back over the $130 range. These warrants to purchase common stock are good for only 5 years, which may turn out to be extremely profitable for Buffet in the long-run.

Buffet protected his money by only investing in perpetual preferred stock. If he truly believed in Goldman’s operations and current valuation, he would have also purchased the equity stake in the company. This 10% dividend payment is a great deal to land, especially in these treacherous markets.

Goldman also announced on Tuesday that they will also be issuing an additional $2.5 billion of common shares. By Wednesday, Goldman said that they completed a $5 billion offering, doubling the size of their initial announcement. This equity issuance and deal with Warren Buffet means that Goldman’s shareholders’ equity could be diluted by 15-20%.

Buffet has been approached by numerous Wall Street firms in the past year. Back in March, representatives approached Buffet to invest in Bear Sterns. He considered the deal, but the deal ended up falling though since there wasn’t enough interest from other investors. Buffet was also contacted by management at Lehman to invest a chunk of money into the investment bank, but he wasn’t impressed with the assets that they had on their books.

Goldman originally looked like they were going to be able to pull out of this credit crisis, as they were respected for shorting the ABX index to hedge some of their positions. In their 3rd quarter of 2007, they announced in their earnings that their “short term hedges more than offset their mortgage related write-downs.” They were still able to weather the storm relatively well throughout 2008, until the collapse of Lehman Brothers [LEH: 0.00, N/A (N/A)]. During the same weekend of the bankruptcy of Lehman Brothers, Merrill Lynch [MER: 0.00, 0.00 (0.00%)] was acquired by Bank of America [BAC: 13.98, 0.00 (0.00%)]. John Thain tried to be proactive about the situation compared to Mr. Fuld at Lehman who was stubborn to get a deal done. American International Group [AIG: 1.66, 0.00 (0.00%)] was then forced to be bailed out by the government through a $85 billion investment from the U.S. government. The terms of this deal were extremely unfavorable to AIG, as they were charged LIBOR+8.50% on the debt, essentially implying a junk credit rating.

These developments left Morgan Stanley and Goldman Sachs as the only pure play investment banks left on Wall Street. Both Morgan Stanley and Goldman’s share price were destroyed last week amid concerns that they were not well capitalized to continue operations. Goldman’s share price fell all the way down to $85.88 during intra-day trading last week, down from their 52 week high of over $250. Rumors were also developing that Morgan Stanley was going to merge with Wachovia Corp [WB: 0.00, N/A (N/A)]. This deal would have destroyed shareholder value for Morgan Stanley, as the deal would have most likely valued them cheaper than Wachovia due to the current market conditions.

In my article I wrote in July, I outlined the problems that publicly traded investment banks were facing. My prediction ultimately came true, as I state there wouldn’t be any publicly traded investment banks by the end of the year. Now the big problem facing the commercial and investment banking industry will be the changing landscape of Wall Street and how these firms operate. Although Goldman Sachs was a best of breed in the industry even a few months ago, it will take some time to gain back that status in this challenging market as the best commercial/investment bank. The universal banking model will prevail in this market. Look towards the banks that have been able to operate efficiently in these markets like Citigroup [C: 7.08, 0.00 (0.00%)] and JP Morgan Chase [JPM: 29.25, 0.00 (0.00%)] if you are looking to diversify your portfolio with a large bank.