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"If you can’t spot the sucker in your first half hour at the table, then you are the sucker."

— Rounders

At the MicroStrategy table, shareholders are the sucker 

Every pyramid scheme requires a good story, ideally one with an element of truth to it. 

Michael Saylor’s story for MicroStrategy has always been that it provides exposure to bitcoin for investors who can’t otherwise access it.

That is still a little bit true, but less so than before spot ETFs became widely available and increasingly less so with each convertible bond that MicroStrategy issues, as Mark Meldrum explains here with irrefutable logic.

The explanation begins with the fact that most buyers of convertible bonds are not seeking exposure to the bond’s underlying equity.

Contrary to the story Saylor tells, buyers of MicroStrategy bonds appear to be no exception — Bloomberg reported last week that the largest holders of MicroStrategy’s converts are hedge funds and alternative-asset managers like Calamos Partners, Linden Advisors and Millennium Management (all of whom are perfectly capable of buying exchange-listed ETFs or opening an account at Coinbase to buy spot bitcoin).

Why, then, are these funds so willing to fund Michael Saylor’s bitcoin spending spree?

Because Saylor is selling them cheap volatility.

MicroStrategy’s bonds are in high demand because 1) the stock they convert into moves around a lot (convertible bond holders are effectively short the stock on the way down and long the stock on the way up) and 2) Saylor sells those bonds cheap.

"The trade is attractive because the implied vol of the converts is way below realized vol or option-implied vol," a hedge fund holder of MicroStrategy’s bonds told Bloomberg.

MicroStrategy enthusiasts celebrate these convertible bond issues as if they are found money — an "infinite money glitch" that creates new demand for bitcoin, which creates new demand for MicroStrategy shares, which creates new demand for bitcoin.

But there is no found money in finance.

Instead, Saylor’s convertible bonds are building a pyramid of debt that becomes more precarious with every additional bond the company issues.

This debt pyramid is best imagined upside down, because for the math to work out for shareholders, each new capital raise has to be bigger than the last.

That’s how it’s gone so far and as long as that remains the case, Saylor’s new financial metric of "bitcoin yield" will continue to show that the number of bitcoin held by MicroStrategy is rising faster than the number of MicroStrategy shares.

But trees don’t grow to the sky.

Yes, newly issued equity increases MicroStrategy’s per-share net asset value because selling equity at 3x net-asset value allows the company to buy $3 of bitcoin for every $1 of stock it sells.

But "selling dollar bills for $3," as Saylor describes it, is only a benefit to pre-existing MicroStrategy shareholders, not the new shareholders he’s selling to.

For new shareholders to similarly benefit, the capital raises and bitcoin purchases have to happen in ever-larger increments, which is presumably unsustainable. 

This "bitcoin yield" strategy doesn’t make mathematical sense, according to Meldrum, "because it relies on an infinite regression into larger and larger amounts." 

The laws of financial gravity suggest that these amounts will eventually become so large that the upside-down pyramid will topple over.

When might this moment of financial reckoning happen? 

Most likely when the volatility of MicroStrategy shares starts going down.

Lower volatility will make the convertible bonds unattractive for hedge funds, who, being in the MicroStrategy game strictly for the volatility, will redeem the bonds for cash.

That is when MicroStrategy shareholders will find out what game they’ve been playing.

"If the volatility disappears," Meldrum explains, "and you have to give the money back [to bond holders], here’s what’s going to happen to the share price: It’s going to drop very quickly."

"What’s keeping the share price up is the volatility, not this magic bitcoin yield that you’re being sold. That’s just a story that’s being told to you."

It may be that the shares will drop from a much higher level than they are now and everything will be fine, I don’t know.

But shareholders should be aware of their role here: Their role is to 1) make the shares volatile and 2) pay for the collateral that backs the convertible bonds.

By paying far above NAV, shareholders provide the volatility that makes the convertible bonds valuable — and when shareholders buy newly issued shares, they finance the bitcoin that makes the convertible bonds credit-worthy.

In other words, volatility is MicroStrategy’s product and that product is being produced by MicroStrategy’s shareholders.

This makes MicroStrategy shareholders an "operational asset," in Meldrum’s framing.

Just as a widget manufacturer requires an asset like a factory to produce widgets, MicroStrategy relies on an asset — its shareholders — to generate volatility.

 As Meldrum sees it, Saylor keeps this operational asset productive with "misinformation" and "Enron-style math."

"There is a process in which you misinform the MicroStrategy shareholder," he explains, "and keep them in the game such that they will continue to produce the volatility you need to sell to the convertible bond holders, because that’s the game." 

Meldrum wants MicroStrategy shareholders to recognize that game and also their role in it: "You are an operational asset. You are the input." 

Or, in poker terms, the sucker.

Of course, the game is going well for MicroStrategy shareholders so far — the shares are up 450% this year — and I imagine it will continue to go well for some time still.

But any poker player will tell you that you can’t judge a bet by its outcome — and also that winning streaks don’t last forever. 

The risk for shareholders now is that when implied volatility falls, MicroStrategy shares are liable to fall to their net asset value "and even lower," according to Meldrum, "because you’re going to have to pay back those bonds with all that bitcoin you bought." 

With MicroStrategy’s upside-down pyramid of risk growing ever taller, a drop in volatility becomes ever more concerning.

Bondholders have first claim to MicroStrategy’s 423,650 bitcoin and if falling volatility prompts them to exercise that claim, Meldrum expects they’ll take most of them: "The residual for the shareholders is going to be rather tiny."

Are MicroStrategy shareholders aware of that risk?

I’m not sure they even know what table they’re at.

— Byron Gilliam

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