How Hedge Funds Make Money on Warrants

I’ve been CEO of two public companies, and on the board of several other public companies. It’s always puzzled me a bit how hedge funds made money on warrants.

When a small biotech company raises money, it often has to offer warrants in order to raise capital. For example, it might sell 10 million shares of stock (usually at a discount to market, let’s say of 10%), and offer

25% warrant coverage. That means that for every 4 shares of stock, the investor receives one stock option to buy additional shares at a fixed price. This is particularly true for overnight deals, where an investment bank will raise a sub

stantial amount money–let’s say $40 million between 4 pm one day and 9 am the next day.

I’ve always heard that hedge fund make their money on the warrants, butI assumed that they made most of the money on the discount. But I’ve always been puzzled that they would almost never exercise their warrant until the very last minute, even if the stock climbed really high.

 

A guy who used to work for one of the hedge set me straight. He told me that what the hedge funds do is that they short the stock or sell options on the warrants (basically sell options with the warrants serving as the backstop), thereby extracting the full time value of the warrants. He says that it’s a relatively reliable way to make money.

This is why the hedge funds that buy into these offerings don’t really care which company is issuing the shares so long as they have enough volume and volatility, and why the banks can raise the money so quickly. The hedge funds make money whether the stock goes up or down, so long as the company doesn’t go out of business.

Just as importantly, this means that warrants can directly depress the stock price, because if they’re shorting the stock with warrants as backstop, it’s going to work as a drag on the stock price. You would normally not see warrants affecting the stock price directly, but in this case, they certainly will.

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