Here’s what I think is going on with these notes.
- They are tax advantaged.
- The Black-Scholes options pricing model has some flaws over long time periods. To some degree, Liberty is on the wrong side of it. However, the tax benefits likely outweigh the disadvantages.
- I suspect that the covenants on the debt are weak.
I believe the basic idea is this. Liberty (A) sells warrants on itself and (B) buys warrants on itself. Suppose that the two transactions cancel each other out. Suppose that Liberty’s stock compounds at a very high rate.
On (A), Liberty will lose a huge amount of money. Because it will settle the warrants in cash, it should be able to use the losses to offset its taxes. On (B), Liberty will make a huge amount of money. However, it will avoid paying taxes on the gains by settling the warrants in shares. The overall effect should be that the transaction cancels itself out but gives Liberty a huge tax loss. The value is in the tax loss.
In practice, anybody crazy enough to sell (B) will have too much counterparty risk. Instead, Liberty has bought a warrant spread on itself so the counterparty risk is limited. The net position is that Liberty has sold warrants on itself at a high strike price ($255.64). Without the warrant spread the strike price would be lower. My guess is that having to do this (compared to the cancelling warrants described earlier) waters down the attractiveness of the overall trade. Liberty is also exposed to some counterparty risk with JP Morgan, Wells Fargo, and Deutsche Bank on the warrant spread.
Secondly, the expiration dates on the various derivatives are staggered. If (A) and (B) were clearly opposites of each other, the IRS would likely disallow the tax advantages of this deal. Because the expiration dates on (A) and (B) are different, it is less likely that the IRS would disallow the tax advantages. One downside to the staggered expirations is that Liberty is exposed to some minor risk because the durations do not match. The expiration dates are also designed to let the options counterparties to unwind their hedges with less problems (the Bond Hedge Transaction warrants expire over 81 days).
In the past, convertible debt was tax disadvantaged because it pays little or no cash interest that could reduce taxes in the short-term. Normal debt would have greater tax deductions in the short term because the cash interest qualifies for tax deductions. The IRS “fixed” this disparity with new rules. Then Liberty and other parties issued convertible debt that gamed the new rules. So the IRS introduced a new set of rules to try to prevent the system from being gamed. I believe this is why the notes pay cash interest.
The people trading with Liberty will likely base their pricing on a modified version of the Black-Scholes formula. I think that the Black-Scholes formula will underestimate the value of long-term call options on LMCA.
- Malone will likely compound LMCA at a very high rate.
- Malone likes to use leverage. This will increase volatility. Charter, one of LMCA’s major assets, is currently in the process of increasing its leverage.
LMCA is selling warrants on itself to parties which will underpay for them. I presume that the tax advantages of the debt outweigh the disadvantages of selling warrants too cheap.
I am skeptical of the risk management of Deutsche Bank, JP Morgan, and Wells Fargo. I feel like they are on the wrong side of Black-Scholes mispricings in this situation. They probably won’t lose much money but this doesn’t feel like a smart trade.
Liberty has announced its intention of a major spin-off of assets in Liberty Broadband. This usually hurts noteholders because there will be less assets to back up the debt. When Liberty spun off LINTA, bondholders sued the company for this reason. Smart debtholders will ensure that there are strong covenants in place to protect them against shenanigans.
While I did not manage to find much information on the covenants of the 1.375% cash covertible notes, the proposed spin-off suggests that they are weak because they presumably allow the spin-off to happen.
Advantages of the overall transactions:
- Tax advantaged.
- Possibility of profiting from the debtholders due to weak covenants. (I don’t see Malone ever explaining this game to others.)
- The cost of long-term borrowing is currently very low.
- Warrants (may) have been sold too cheap.
- IRS may disallow the tax advantages.
- Limited counterparty risk.
- Duration risk.
- Risks that come with any form of debt (e.g. leverage can get you into trouble).
I believe that the reason Liberty has structured the debt this way is to game the tax system. Otherwise they would definitely avoid the value destruction going on with #1, #3, and #4.
Perhaps a smart move would be to talk to the noteholders and try to buy 2023 LMCA warrants from them. The noteholders may sell the warrants too cheap if they are pricing the warrants based on Black-Scholes.
*Disclosure: I am long LMCA common stock.