* Knauf discloses offer to buy USG for $42/shr
* USG says proposal is "wholly inadequate"
* Berkshire offers 6-month option to sell USG shares to Knauf
* USG jumps as much as 20 pct (Adds analyst's comment, updates shares)
By Arunima Banerjee and Ankit Ajmera
March 26 (Reuters) - U.S. building products maker USG Corp , backed by Warren Buffett, rejected an unsolicited buyout offer from its second-biggest shareholder, Germany's Gebr Knauf KG, saying the offer substantially undervalued the company.
Gebr Knauf disclosed on Monday it had offered to buy the maker of gypsum wallboards earlier this month for $42 per share, a premium of 25 percent to the stock's Friday closing, valuing the company at about $6 billion.
In response to the offer, Buffett's Berkshire Hathaway Inc , had offered an option to sell its 31 percent stake in the company as long as Knauf's offered at least $42 a share for USG. Berkshire also proposed an option purchase price of $2 per share.
The option provides a sweetener for Buffett to shed a profitable investment that originated at the height of the housing crisis in late 2008, when Berkshire and Canada's Fairfax Financial Holdings Ltd bought $400 million of USG's debt.
The $2 per share cost of the option would provide Berkshire about $86.8 million upfront, based on its 43.39 million share USG stake. Berkshire would keep that money even if Knauf is unable to buy USG.
"This (USG's rejection) is ultimately a negotiating tactic and Knauf will increase its purchase price to at least about $44 per share," Instinet analyst Michael Wood wrote in a client note.
"While we expected neither USG's board of directors nor top shareholders to be eager to sell at the proposed valuation... Berkshire's option proposal implies it felt the $42 offer was a suitable starting point in the price negotiation," Wood wrote.
USG's stock rose as much as about 20 percent to $40.20 on Monday. They have fallen about 13 percent this year.
"Knauf's opportunistically timed proposal is wholly inadequate," USG's non-executive chairman Steven Leer said.
The company reported a 6.8 percent decline in its 2017 operating profit, hurt by higher costs of raw materials such as gypsum and steel. At the same time, it also benefited from robust demand for housing in the United States.
Morgan Stanley is the financial adviser to Knauf. J.P. Morgan Securities and Goldman Sachs and Co were the financial advisers to USG. (Reporting by Arunima Banerjee and Ankit Ajmera in Bengaluru; Additional reporting by Jonathan Stempel; Editing by Anil D'Silva, Saumyadeb Chakrabarty and Arun Koyyur)