Warren Buffett Takes a Goldman Stake

Buffett's Berkshire Hathaway will provide the giant investment bank with a $5 billion cash infusion in exchange for preferred shares

Warren Buffett, riding to the rescue at Goldman Sachs (GS) with a $5 billion cash infusion announced Sept. 23, has long used the services of the giant investment bank, though sometimes grudgingly so. When the Oracle of Omaha cut a deal with the Pritzker family last year to buy a $7 billion-a-year crazy-quilt of businesses called Marmon Holdings, Buffett proudly said that he and the wealthy Chicago family arrived at a price without the help of advisers, a style that let them avoid "nit-picking."

Buffett agreed to shell out an initial $4.5 billion for a 60% stake in Marmon that is expected to grow over time. But Berkshire Hathaway (BRKA), Buffett's investment company, did have to use Goldman to do some of the heavy lifting to finalize the deal. And the outfit did such a good job of it that in his annual letter to shareholders last year Buffett singled out a banker there, Byron Trott, as "the rare investment banker who puts himself in his client's shoes." Buffett added that he and his partner at Berkshire, Charlie Munger, "trust him completely."

It's not clear whether Trott, who is still associated with Goldman, had anything to do with the deal Buffett just struck to take a big chunk of Goldman. But there's no doubt that Buffett thinks highly of the outfit and that the partners there return the favor. Lloyd Blankfein, Goldman Sachs' chief executive, was effusive in announcing the deal: "We are pleased that given our longstanding relationship, Warren Buffett, arguably the world's most admired and successful investor, has decided to make such a significant investment in Goldman Sachs."

Private Preferred Offering

Through Berkshire, Buffett is taking $5 billion worth of perpetual preferred stock in Goldman in a private offering. For that, he'll get a 10% dividend and warrants to buy $5 billion of common stock with a strike price of $115 a share. He'll be able to exercise the warrants at any time over five years. Goldman's stock closed Sept. 23 at 125.05, up 3.5%, and it was climbing past 133 a share in after-hours trading after news of the deal broke. The firm's stock last fall was worth about 248 a share, but has plunged with the fortunes of Wall Street generally. Like the wily Nebraskan, the market seems to believe Goldman's pummeling has been overdone.

Goldman and the other big free-standing investment bank left on Wall Street, Morgan Stanley (MS), on Sept. 21 agreed to convert themselves (BusinessWeek.com, 9/22/08) to commercial banks to avoid the fate that befell three other giants on the Street. Bear Stearns collapsed earlier this year and was sold to JPMorgan Chase (JPM) in a fire sale, while Lehman Brothers filed for bankruptcy protection, and Merrill Lynch (MER) rushed into a sale to Bank of America (BAC). Still needing capital, Morgan Stanley arranged this week to sell 20% of itself to Japanese banking titan Mitsubishi UFJ (MTU) for more than $8 billion. To fill its capital needs, Goldman will have Buffett's $5 billion and supplement that with at least $2.5 billion that the bank plans to raise in a public offering.

Calling the move by Buffett "a strong validation of our client franchise and future prospects," Blankfein added that the investment "will further bolster our strong capitalization and liquidity position." For his part, Buffett called Goldman an "exceptional institution." He added, "It has an unrivaled global franchise, a proven and deep management team, and the intellectual and financial capital to continue its track record of outperformance."

Lower Margins as Commercial Banks

Just how much both Goldman and Morgan will be hampered by their commercial-bank status is arguable, however. Analysts have said their profitability is bound to shrink as they have to move away from some of the risk-taking proprietary trading they have done in the past, which has goosed their results. The banks will be overseen by a coterie of regulators, including the Federal Reserve, the Treasury Dept., and the Federal Deposit Insurance Corp., which are sure to rein in some of their more aggressive activities. Some analysts have said that return on equity, which averaged 22.1% at Goldman and 19.5% at Morgan since 1999, could drop to as little as 13%, closer to those of conventional bank holding companies.

Still the banks could wind up keeping some of the business operations they have had that are outside of conventional banking and that gin up returns. Both Goldman and Morgan won exemptions that allow them to take possession of oil as part of their commodities trading operations, for instance, and they could seek to make the exemptions permanent. Normally, commercial banks don't buy and keep oil or other physical assets. Other outfits have won such exemptions in the past.

Certainly, Buffett expects Goldman to continue showing top-drawer returns, though his backhanded compliments may well continue. In his 2003 letter to Berkshire shareholders, the billionaire saluted Goldman banker Trott for helping arrange a deal for Berkshire to buy a subsidiary of Wal-Mart (WMT). While arguing that he and Berkshire officials did no "due-diligence" review of the deal, instead trusting in Wal-Mart's representations after a two-hour meeting, Buffett did say that Trott was instrumental in the deal and in two other Berkshire purchases. "He understands Berkshire far better than any investment banker with whom we have talked and—it hurts me to say this—earns his fee."

It remains to be seen whether Buffett will get a great deal on this investment, but it's certainly welcome at Goldman Sachs.