Berkshire Hathaway paid $5 billion for 10% cumulative perpetual preferred stock and warrants to buy 43.5 million shares of Goldman Sachs at $115 a share.
Before I explain how much Berkshire Hathaway is likely to make on the combined deal, let’s breakdown the pieces.
There are two pieces to the deal.
The value of the first piece – the preferred stock – will probably come in two parts. The first part is the dividend. Berkshire Hathaway gets $500 million a year in dividends from Goldman Sachs. The second part is the redemption premium. Although you hear a lot about the possibility of Goldman Sachs “repaying” Berkshire, Goldman Sachs can’t just pay off 100% of Berkshire’s original investment. Goldman has to pay back 110% of what it borrowed. That’s $5.5 billion.
Now, technically, Goldman Sachs doesn’t have to pay anything back. It could leave the preferred stock out forever – that’s why it’s called perpetual preferred stock – and just keeping paying what’s effectively a 10% interest rate to borrow $5 billion. Goldman isn’t going to do that. There were reports last fall that Goldman would have already repaid the preferred stock if it wasn’t for the Federal Reserve. Apparently, the Fed told Goldman to wait a couple quarters.
So what if Goldman Sachs repaid Berkshire Hathaway today?
Well, let’s stick with just the preferred stock for now. And let’s see how much Berkshire would make. The preferred stock was issued in October 2008. Two years have passed since then, so that’s $1 billion in preferred dividends. On top of that, Goldman would have to pay an additional $500 million. So, overall – even if Goldman repaid Berkshire today – they’d still end up paying $6.5 billion to get out from under a $5 billion loan. From Berkshire’s perspective, that means $1.5 billion in gains on a $5 billion investment.
However, the only way to judge Berkshire’s return on its Goldman Sachs investment is to lump the preferred stock and the options together. After all, Buffett bought them as a package deal.
As part of the October 2008 deal, Berkshire got the option to buy 43,478,260 shares of Goldman Sachs common stock for another $5 billion. That works out to $115 a share. Which explains the weird number of shares. ($5 billion / 43,478,260 = $115/share).
Berkshire has the right to buy Goldman Sachs stock at any time until October 2013 for $115 a share.
Let’s pretend Warren Buffett exercises that right today.
He won’t. Buffett has said he’s not going to exercise the options until 2013.
Just humor me…
Goldman Sachs closed at $161.31 on Wednesday. Berkshire Hathaway has the right to buy Goldman Sachs stock at a price of $115 a share. If Berkshire exercised that right today, it would make $46.31 a share. And Berkshire has the right to buy over 43 million shares at that price. So that’s $46.31 a share times 43,478,260 shares.
Which equals $2.013 billion.
Now, we can put the gains together and calculate Berkshire’s annual return on its investment in Goldman Sachs.
Personally – and some people may disagree with me – I think the best way to estimate Berkshire’s return is to separate the dividend payments from the capital gains.
Berkshire invested $5 billion in October 2008. If Goldman Sachs redeemed the preferred stock and Berkshire Hathaway exercised its common stock options today, Berkshire Hathaway would have received a total of $8.513 billion over 28 months in exchange for its original $5 billion investment.
If all of that money had been received today, Berkshire would have a compound annual return of 25%.
But, Berkshire didn’t receive all the money today. It got the dividend payments earlier.
You can estimate Berkshire’s return on its investment by just taking the yield on Berkshire’s cost ($500 million / $5 billion = 10%) and then adding the compound annual growth rate in the value of the remaining investment to the annual dividend yield on Berkshire’s cost.
The capital gain portion – separate from dividends – is currently a 19% annual return.
Obviously, Berkshire capital gains will rise and fall along with Goldman’s stock price. And the annual rate of return will also change depending on exactly how long it takes Goldman to pay off the preferred stock.
Berkshire’s capital gain comes from a combination of $2.013 billion in option gains and $500 million in preferred gains. This $500 million is just the redemption premium. It’s separate from any dividends.
So, that’s $7.513 billion in capital Berkshire would take out of the investment versus the $5 billion it put into Goldman.
The growth in capital from $5 billion to $7.513 billion over 28 months is equal to a 19% annual growth rate.
Then, there’s the 10% a year in dividends.
So, that’s 19% plus 10%. Which gives Berkshire an estimated 29% annual return.
In reality, Berkshire earned less than 29% compounded, because it couldn’t reinvest the preferred dividends it got from Goldman in investments of equal quality.
Still, we’re talking about a 25% to 30% annual return on Berkshire Hathaway’s investment in Goldman Sachs.
An investment in the S&P 500 made on the same day would have returned about 10% a year.
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