On Home Capital, Buffett will double money

Equity stake at discount to market price

TORONTO • Warren Buffett is no stranger to taking advantage of dark times to turn a much-needed investment to his advantage.

The Oracle of Omaha, whose Berkshire Hathaway emerged late Wednesday as a major owner of shares in Home Capital Group Inc., as well as a primary lender, famously invested $5 billion in Goldman Sachs right after the 2008 collapse of Lehman Brothers. At that time, the world’s largest financial institutions were facing their own liquidity crisis and a very uncertain future.

Berkshire Hathaway’s five-year investment was a gamble of sorts that everything would work out, and it paid off handsomely. It provided stability to the teetering sector and, at the same time, netted Buffett an eye-popping 62 per cent return.

Though the terms of the Home Capital deal are different, there’s hope some of the hallmarks of the Goldman Sachs case — stability, market confidence, and a path forward — can be replicated, even if it comes at an upfront cost to the company.

Alan Hibben, a veteran investment banker brought in as a director of Torontobased Home Capital in its darkest days, recognizes the power of the Buffett brand. In an interview with the Financial Post, he said the company’s board backed the Berkshire Hathaway transaction because — even above financial considerations — the mortgage lender needed a “sponsor” to take it through good times and bad.

Hibben acknowledged that securing Buffett’s participation came with a price for the Canadian company, including giving Berkshire Hathaway a stake in Home Capital of almost 20 per cent at a steep discount to a recent trading average.

The deal won’t close for a few days, but based on the $9.55 a share purchase price and Thursday’s closing share price of $19, Berkshire would already have nearly doubled its $153 million investment in Home Capital’s equity, on paper.

And there’s a pledge on the table to issue a second tranche of equity subject to shareholder approval at a vote to be held in September. It would give Berkshire Hathaway a further 24 million shares at $10.30 each, for a combined investment of around $400 million in exchange for a 38.4 per cent stake in Home Capital.

There’s no way to know where the stock will be trading in September, but, at Thursday’s close, the second tranche would net Berkshire Hathaway a further gain of more than $200 million, and a total gain of about $350 million on its $400-million investment.

Acknowledging the optics of the discount, Hibben told the Financial Post the transaction was undertaken “because the board unanimously agreed that this company needed sponsorship.”

He said it was imperative to building trust back among depositors who fled when Home Capital was hit with a regulator’s allegations of misleading disclosure. The company also needed a sponsor to backstop liquidity and capital and “just to make sure that if things all go to hell in the next couple of years that there’s someone along with us that would be helpful,” Hibben said.

The transaction does not compel Berkshire to remain invested beyond a fourmonth hold required by regulators for private placements, Hibben said. But he thinks the Omaha-based investment firm will remain on board based on Home Capital’s stronger outlook.

“I suspect that they’re going to be a rational economic actor. As long as the company, and the board, is doing the sort of things you need to do to build value, they will be shareholders,” he said.

Hugo Chan, chief investment officer of Kingsferry Capital Management Group Ltd., a Home Capital shareholder, said the terms of the deal are more favourable for equity holders than some of Buffett’s past investments in troubled firms, including Goldman Sachs.

“Berkshire Hathaway is investing in straight equity as opposed to very costly preferred shares with expensive preferred dividends that are bad for common equity shareholders in the longrun,” Chan said in an email, adding that he is supportive of the Omaha-based investment firm increasing its stake in Home Capital in the fall.

But other observers questioned whether other shareholders will approve the steep discount. They say the deal is vintage Buffett, who penned an op-ed in the New York Times nearly a decade ago that read, in part: “Be fearful when others are greedy, and be greedy when others are fearful.”

Not only is Berkshire Hathaway getting all the stock at a double-digit discount, its credit facility comes with an interest rate of nine per cent. That is only slightly cheaper than the previous emergency credit facility provided by the Healthcare of Ontario Pension Plan, which HOOPP’s chief executive Jim Keohane characterized as akin to distressed debtor-inpossession financing during a television interview.

What’s more, analysts say Berkshire Hathaway’s $2 billion investment is secured by more than $4 billion in collateral in the form of Home Capital mortgages.

“Clearly Buffet made the deal of the century,” said a veteran lawyer and mergers and acquisitions specialist based in Toronto.

“All you need to understand to evaluate Buffett’s play is that the company was never as unsound as the stories painted it.

“They have an important market share in an industry that will never go away,” he said, adding that Buffett is poised to profit in legendary fashion when conditions stabilize and markets calm down.