Inside the DuPont Buyback

DuPontDD gave its shareholders some instant gratification last week, setting a $3 billion buyback whose impact was juiced up by a semi-exotic trading arrangement with Goldman SachsGS.

Shares of the chemical manufacturing giant are up 6% since the news, a gain that also reflects investment upgrades at banks including Goldman and the adoption of a more conventional $2 billion repurchase program over two years. They closed Tuesday at $41.73.

But what really lit the fire was DuPont's $3 billion "accelerated share repurchase" plan, in which Goldman was hired to help retire 8% of DuPont's outstanding stock over nine months. Unlike typical buybacks, which might never be consummated, DuPont's deal created an immediate improvement in the supply/demand profile of its stock while lowering the denominator in the company's earnings-per-share calculation.

While the agreement helped revive a flagging stock, Goldman Sachs hardly goes hungry in the deal. Not only does the powerhouse investment bank rake in a fee for structuring the transaction, it also gets a chance do some trading arbitrage in shares of DuPont.

In the deal, DuPont pays Goldman Sachs for 75.7 million shares at their price the day before the agreement was announced: $39.62 apiece. Over the next nine months, the investment bank will make open-market purchases of DuPont shares to close out the position. The transaction is similar to a short sale in which a trader sells borrowed shares and must replace them later.

On the surface, the deal might seem risky for Goldman Sachs -- couldn't it lose money if it's forced to repurchase the DuPont shares at inflated prices? The answer is no. The way accelerated buybacks -- which have been around for a little over a decade -- are structured, Goldman has an insurance policy against any such swing.

Roughly speaking, if DuPont's stock rises, the company will pay Goldman Sachs the difference between the initial buyback price and the "volume-weighted average price" of the stock over the period when Goldman does its buying. Conversely, if the stock declines in price over time, Goldman Sachs will credit the difference back to DuPont.