Carl Icahn’s complicated (and possibly brilliant) Talisman play, explained

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Carl Icahn's investment in Talisman Energy Inc. is not as simple as it seems.

Yes, he controls 5.97 per cent of the Canadian oil and gas company. Yes, he now has the right to raise his voice. But the way he structured his investment is unconventional – to the point where some Canadian players are calling it brilliant.

In short, Mr. Icahn is throwing his weight around without throwing around too much of his money.

He gained control – but not outright ownership – of a large chunk of Talisman's stock without putting up a whack of cash. At the same time, his investment firm structured the deal in a way that allowed it to get around a regulatory hurdle that would have slowed down the pace of Mr. Icahn's plan.

Mr. Icahn's firm used put and call options to amass its stake in Talisman. The position is designed to rake in an enormous profit – larger than if he bought the shares on the market the traditional way – if the stock rallies. But if Talisman goes south, he will be out a pile of cash. It is a sophisticated bet the average investor can't pull off.

In his mandatory filings with the U.S. Securities and Exchange Commission, Mr. Icahn revealed his equity stake in Talisman is less than 1 per cent.

At least it is right now. The activist investor controls – but does not own outright – 61,554,602 shares (or 5.97 per cent) of Talisman, according to regulatory documents. This includes his equity position and the right to buy shares through call options. For this, Mr. Icahn paid about $277-million (U.S), according to regulatory documents. By way of comparison, 61.5 million shares would have cost roughly $700-million two weeks ago, before rumours about a potential activist investor snooping around Talisman got too loud.

The New York firm controls about 55.1 million of his 61.5 million shares through call options, according to the SEC documents. This gives him the right to buy the 55.1 million shares. Therefore, he only owns up to 6,456,049 shares – or 0.6 per cent – outright. In the language of the Street, he has "synthetic exposure" to Talisman.

Despite only actually owning a sliver of Talisman, Mr. Icahn on Twitter (@Carl_C_Icahn) said he "may have conversations with mgmt re strategic alternatives, board seats, etc."

He can talk with swagger and wield power because his call options are in-the-money, giving him the right, but not the obligation, to buy additional Talisman shares for $8 apiece. He paid between $3.22 and $4.64 for the calls. These call options are as powerful as shares because if Mr. Icahn wanted to vote, he could exercise the options for an additional $8. Mr. Icahn used derivatives as a low-cost way to buy influence and profit big if the stock goes up.

If Talisman's stock rallies, Mr. Icahn stands to make a pile of money. For example, if Talisman hits $18 (a speculative number for illustrative purposes), he can exercise his call options, effectively buying shares worth $18 for $8 each. He then pockets $10, less the price of what he paid for the calls.

Mr. Icahn also wrote puts, although the regulatory filing does not detail the strike price or the price at which he sold them. The puts give him another shot at making money if the stock goes up.

If the put's strike price is $8, for example, and the stock goes to $18, the put-holder will let the option expire rather than buying stock in the market for $18 and forcing Mr. Icahn to buy it for $8. That means the sale price of the puts is a tidy profit.

But if the stock price falls below $8, the put-holder will force Mr. Icahn to pay the put-holder the difference between the market price and the strike price. With as many puts outstanding as calls – 55,098,553 – this is where the New York activist could lose out. If the difference between the put's strike price and the market price is $3, Mr. Icahn has a big bill to pay.

The calls are American-style, meaning they can be exercised any time between now and March 5, 2015. The puts are European-style, so put-holders have to wait until the same day to make their move.

The deal's structure also allowed Mr. Icahn to avoid triggering the Hart-Scott-Rodino anti-trust regulation. If investors accumulate an equity position costing around $70-million, they must file documents and stop buying stock until regulators approve further purchases. Because this process takes about a month, it slows the pace of buying and forces investors to show their cards. However, if buyers use options to build their stakes in a company, they do not trigger the Hart-Scott-Rodino rules and are free to continue quietly increasing their position. Mr. Icahn, however, will need clearance under the Hart-Scott-Rodino statute to exercise his options.

Mr. Icahn's firm declined to comment.

Talisman's stock price jumped in after-market trading following Mr. Icahn's 140-character disclosure on Twitter. (He used the max amount of characters). But Talisman's stock dropped when the market opened, as investors had a chance to review Mr. Icahn's official SEC disclosure. The puts and calls position – rather than plain old shares – explain why investors backed off, market observers say.