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Bill Ackman Found a Cheap Way to Buy More Valeant Stock

Matt Levine is a Bloomberg View columnist. He was an editor of Dealbreaker, an investment banker at Goldman Sachs, a mergers and acquisitions lawyer at Wachtell, Lipton, Rosen & Katz and a clerk for the U.S. Court of Appeals for the Third Circuit.
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"The biggest regret I have with Valeant is that we’re not in a position to buy more," said Bill Ackman on a conference call earlier this month, but he solved that problem just a couple weeks later. In October, when Valeant's stock first plunged on rumors about its specialty pharmacy business, Ackman had bought about 2.1 million shares for his Pershing Square funds, for a total of about $232 million.  And that was the limit: He would have liked to buy more, but he was tapped out. As he said on his four-hour call about Valeant in October:

Our only disappointment was, unfortunately we didn't have lot of money going around. We are fully invested at Pershing Square and we scraped together a couple of hundred million dollars to buy those shares.

But now his fund, Pershing Square, "has increased its stake in Valeant to 9.9 percent," making it "the second-largest shareholder in the company behind the Sequoia Fund." It revealed yesterday that it had added 12.5 million shares, or almost $1.1 billion worth at yesterday's $87.41 closing price, over the course of last Friday, November 20, and yesterday, November 23.

Where did Ackman find the extra money? Well, the answer is mostly that he didn't: He spent just $75 million to buy that $1.1 billion worth of stock.

That's because he didn't buy stock: He went to two derivatives dealers, Nomura and UBS, and bought call options on Friday that give him any gains in value of Valeant's stock above the strike price of $95. He also sold those dealers put options, which put him on the hook for any losses in the value of the stock below the strike price of $60. And he sold other call options with a strike price of $165, capping his upside: If the stock gets above $165, he gives up any further gains. Then he did the same thing again on Monday, only with strike prices of $100, $70 and $130. The options he bought cost about $235 million, plus about $9 million of hedging costs ; the options he sold brought in about $169 million. Here's the accounting:

The result of all of this is a set of payoffs that look, locally, a bit like buying stock; if the stock ends up above $95 but below $165, Ackman has more or less done the equivalent of buying $1.1 billion worth of stock, though with a bit of friction. Further away from today's price, though, it looks different: If the stock ends up below $95 -- and, again, it's below there now -- Ackman avoids some losses, though if Valeant really craters he's on the hook. And if Valeant ends up back where it was when Ackman was first buying -- that is, near $200 -- then he misses out on some of the gains. Here's a rough picture :

 

You can see the advantages of doing it this way. The big one is probably just symbolic: Ackman's trades can be characterized as "underscoring the activist investor’s commitment to the embattled drugmaker," without actually committing that much new cash. The practical maximum that an activist hedge fund can generally hold in a company is 9.9 percent, and Ackman gets to signal that he's at that maximum level of commitment. But getting the last billion dollars worth of stock -- getting from 6.3 percent to 9.9 percent -- cost him only $75 million in upfront cash, leveraging each dollar of cash to get almost $15 of stock. The way Securities Exchange Commission rules work, Ackman is obligated to disclose shares underlying any immediately exercisable options -- which these options are -- meaning that he could, and had to, file a form disclosing the new 9.9 percent ownership. You might expect that filing to be bullish, though in fact Valeant's stock has mostly shrugged.

There are other advantages. For one thing, Ackman gets exposure to 12.5 million shares of stock, more or less, without having the same market impact that he would have if he had just bought the stock. Nomura and UBS have sold Ackman exposure to 12.5 million shares of stock, but only partial exposure: The thing they've sold him looks like stock in some places on that chart but not in others, so it's not quite the equivalent of 12.5 million shares of stock. And since they've sold him a thing that looks sort of like stock, Nomura and UBS have to hedge this position by buying stock -- just, less stock than the full 12.5 million shares. The math probably comes out to the dealers buying about 7 million shares of stock as a hedge to the 12.5 million options that they sold Ackman. We talked yesterday about a paper suggesting that hedge funds' profitability is limited by the price impact of their own trading: If you have conviction about a stock, you will buy a lot of it, which will push the price up, increasing your cost of buying the stock. Getting exposure to 12.5 million shares, but with the price impact of buying only 7 million shares, might seem like a good deal.

There are also obvious disadvantages to this approach. I mean, for one thing, look at that chart: Ackman has paid that $75 million in premium, which he won't get back, so if the stock does go up modestly he will be behind where he'd be if he just bought the stock. And he has capped his upside, so if the stock gets back to $200, he doesn't see the full benefit of that. He's also time limited: Some of these options expire in February; the rest expire the following January. During his enormous late-October defense of Valeant, Ackman's team noted that it could take a long time to resolve the issues facing Valeant. But for a lot of his stake, he's now on the clock.

More generally, by buying this stake via options, Ackman is locked into pretty specific views about where the share price will go, and when, as opposed to the more general-purpose Valeant exposure that he'd get by buying stock directly. Of course, that's just true of the shares underlying these new options; Ackman still has full exposure to the other 21.6 million shares that he's bought, leading to this rather gruesome approximate picture of his total position :

 

Based on that chart, and on Ackman's previous statements and occasional lengthy conference calls, it would be reasonable to assume that Pershing Square is pretty committed to Valeant. Buying a lot of stock through options turns out to be a convenient way to signal that commitment. 

  1. He also spent about $1.7 million on extremely short-dated call options, expiring just two days after he bought them. Those did not work out. These numbers come from Ackman's Schedule 13D/A and Exhibit 99.5 filed yesterday, though the purchase of about 2 million shares was reported at the time

  2. The numbers here, and in the chart below, come from Exhibit 99.5 to Ackman's Schedule 13D/A. Math is mine.

    I should say, I don't know anything about Ackman's collateral terms with his option dealers, and it's possible that he has to post additional cash collateral beyond the $75 million. But his disclosed outlays for those new shares come to about $75 million.

  3. That is sort of a shorthand way to describe what pseudonymous financial blogger Kid Dynamite discusses in this post. Basically, Ackman did something that looks like buying stock. He did this by buying options from dealers. To hedge those options, the dealers had to buy stock, because they did something that looks like selling stock to Ackman. 

    On one of these trades -- the Friday one -- the dealers seem to have bought stock over the course of the day to hedge their trades, pushing the stock up (and making Ackman's options more expensive). But on the Monday trade, it seems, Ackman just bought the dealers' hedges for them, and took the stock-price risk. That went against him: He bought 1.6 million shares at about $93.83 apiece, and sold them to the dealers at $88.25 apiece, though presumably he got some of those losses back in the form of cheaper option prices. But that $9 million of slippage is part of his overall cost.

  4. Some notes on this picture:

    1. I ignore the difference in expiration dates and just say "Final stock price." This is of course not right; the smaller set of options expire in February 2016, only a few months from now, while the larger set have more than a year to run. 
    2. The "just buy stock" comparison is to buying 12.5 million shares at an average price of $89.97, the volume-weighted average price of Valeant's stock over Friday and Monday (according to Bloomberg). That comes to $1,124.6 million, a bit more than the $1,092.6 million you get based on yesterday's close.
    3. I ignore the financing/opportunity costs of buying the stock. Ackman keeps an extra billion dollars by buying options instead of shares, which is valuable to him.
  5. That's mainly because of Section 16(b) short-swing profit rules, which limit a 10 percent stockholder's ability to buy and sell stock. A 10 percent holder who buys and then sells within six months has to give up any profits on the trade, which most hedge funds, for obvious reasons, don't like to do. So most activists try to stay below 10 percent, though there are occasional exceptions. (Carl Icahn, at least, has gone over 10 percent in Herbalife.)

  6. It seems likely that Ackman bought 1.6 million shares for his dealers to hedge the second set of options; see footnote 3, above. That represents about a 47 percent delta. I see (VRX <equity> OV on the Bloomberg terminal) about a 58 percent delta, or around 5.3 million shares, for the first set of options, for a total of around 6.9 million shares, which I rounded to 7 million because I am not doing particularly precise math here.

  7. Of course, you have to compare it to the price of the options. Also, it is not entirely a bad thing for Ackman to push Valeant's stock price up, since he already owned so much of it. But better to push it up after his buying than before it.

  8. Here, for instance, is how Pershing Square lawyer Jenna Dabbs described typical drug-industry investigations, from the transcript of that call:

    I think it's helpful to note in this context, there is often a lot of coverage when these investigations are first made public, there's a lot of discussion about them. But what happens after that we talked about the timeline of these investigations sometimes being quite lengthy. What happens after that is everybody gets down to work. The government will do its investigation. The company that is involved will take steps to modify their practices as necessary. They will cooperate in the investigation and is always an evolving situation as the facts develop. Ultimately any wrong doing is identified has to be taken seriously and it has to be fixed. We're confident that serious engagement and that thoughtful consideration of business practices is exactly what's going to happen here. 

  9. This assumes that he bought his initial slug of 19.5 million shares at an average price of around $200, which is what press reports have implied. You can get a more accurate picture from his original Schedule 13D and trading exhibit, but it won't change much. The second slug of 2.1 million shares came at $108.13.

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

To contact the author of this story:
Matt Levine at mlevine51@bloomberg.net

To contact the editor responsible for this story:
Zara Kessler at zkessler@bloomberg.net