Re: MSTR-More Real Options Thoughts.

After reading my original thread, a friend asked me an interesting question that inspired this thread (see previous thread explaining how accounting identity A-L=E creates “real optionality”).

Here is the question: If the bond investor is “short a put” and the equity investor is “long a call," isn’t the company/issuer “long a put” and “short the call"?

Technically, the answer is “Yes,” but practically speaking, the company is 99.9% incentivized the same way as investors.

Why “Technically Yes”? Because from a narrow, zero-sum perspective, the bond issuer “wins” if bond investors “lose” and the real put gets exercised. In the same way, the equity issuer “loses” if equity investors “win” and the real call goes ITM.

But in the end, this is just semantics. I don’t know of any company that issues bonds and then roots for a default simply because they’re “long the put.” Similarly, I don’t know of any company that issues stock hoping for a stock collapse simply because they’re “short the call.”

This is because companies typically incentivize management teams to think like shareholders. If anything, this incentive is so powerful that it induces managements to do reckless things (like perhaps swapping zero-vol cash for 100% vol BTC?) and swing for the fences.

A “real option” framework gives a powerful explanation of management incentives. Since companies grant equity compensation to managements to align them with shareholder interests, managements are naturally looking to maximize the value of the “real call” represented by Equity.

One way of maximizing the value of an option is to increase the volatility of the underlying. If Equity E is a call option on the firm’s Assets A, then taking more risk with A and making outcomes more volatile gives the call option E a higher probability of winding up deep ITM.

Incidentally, this is EXACTLY what Saylor did. He swapped a zero volatility asset with a 100% volatility asset. Mind you, we are talking about Asset volatility now, since Equity E is a “real call” on the firm’s Assets which also comprise his underlying software business.

But remember, higher volatility is a sword that swings both ways. Higher vol benefits long option positions but it hurts short option positions.

By issuing so much debt and embedding “short puts” into his capital structure and simultaneously jacking up his Asset volatility, it also increases probability of that put getting exercised – euphemism for “default/bankruptcy.”

In the world of distressed, there is a notion of “zone of insolvency” when it comes to fiduciary duty of management. This doctrine stipulates that when a company becomes distressed and enters the “zone of insolvency,” management must also consider the interests of creditors.

In other words, management must not just maximize Asset vol by “swinging for the fences”; it must also consider its creditors who are “short that put” and would be hurt by that same Asset vol maximization and elevated risk-taking.

The MSTR case study is obviously not (yet) a distressed situation, but the underlying incentives are exactly the same and explainable by a “real options” framework.

Someone asked a question that spurred another thought: Don’t confuse a financial option (the embedded call in the convert whose underlying is equity E) with the real option that debt represents (the short put on Assets A).

In the same vein, there is a difference between Asset volatility and Equity volatility — that difference is capital structure. In an unlevered company (which MSTR was before all this), Va (Asset Vol) is typically far less than Ve (Equity Vol).

After all, a company’s enterprise value/asset vol doesn’t fluctuate with Mr. Market, right? Without leverage, Ve won’t even be that high. But add in leverage (L), and Ve becomes magnified.

What’s interesting in MSTR is that not only did he heap on a ton of leverage (L), but he used it to purchase a highly volatile asset that potentially swamps the mitigating vol effects of his basic software enterprise.

So he massively jacked up Va. And since the debt (as long as it’s OTM and not converted) represents a short put on A, the volatility of A (Va) can really bend him over at an inopportune time (like debt maturity) and put him at the mercy of exogenous events.