pure arb

and now, a deceptively simple titled gem from de shaw - is it better yet?

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from the magicians of de shaw, we bring you time portals and other illusions

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courtesy of de shaw, we bring you the basis monster that ate wall street

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…van winkle.  pure arb, now back in session.

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a little too long coming, but which one is unlike the others?

BX: $32b / $78b AUM (41%)
FIG: $9.4 / $36b AUM (26%)
GLG: $3.4b / $20b AUM (17%)

perhaps the right conclusion here is that PE dominates hedge funds.  or that GLG just sucks…

verdict when OZM prices (GSTrUE don’t count)

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in a surprising turn of events that calls to mind a litany of foolish japanese acquisitions overseas, nomura is taking down 15% of fortress for $888mm (or a $5.9b valuation). the number 8 is auspicious to the japanese, and one can’t help but wonder how much its use actually cost. or who actually foots the bill for that matter; after all, the implied valuation is lower than the $7.5b originally contemplated for an IPO.

is this a strategic move aimed at bolstering the asset management franchise?

bloomberg experts think so:

“I can understand the logic, especially after the investment in Instinet,” said Elizabeth Rudman, a Tokyo-based credit analyst at Moody’s Investors Service. “Japanese financial firms have had difficulties managing overseas investments in the past. It will be important for Nomura to demonstrate that they can generate substantial returns.”

and what better way is there to demonstrate investing competency than acquiring minority stakes in non-transparent, private companies?

of course, an IPO may still be coming. so perhaps we all miss the point, and this is actually intended to be nomura’s ICBC…

when in doubt, i defer to the experts:

Taking a stake in Fortress gives the firm a foothold to win more business servicing hedge funds and buyout firms on a worldwide basis, says Angus McKinnon, a Tokyo-based senior partner at Trident Pacific Capital, which manages $65 million of Japanese equities.

clearly a size player who knows what he’s talking about.

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the secret behind hedge fund wealth is not investing prowess as commonly believed. nor is it superior risk management, (sometimes too) timely access to information, broker relationships, not even institutionalization. all of the above helps, but one needs to give credit where due. hedge fund wealth is primarily the result of an uncanny ability to take advantage of “other people’s money”. the performance fee structure already smacks of free leverage: you bear the risk, but 20% of any upside is mine to keep. this much is well known.

but citadel, perennially an innovator, takes free leverage one step further. as i briefly discussed in a prior post:

citadel has the right to defer fees so that they are invested alongside investor capital. not only this, but citadel gets, at its option, up to 3x leverage on the deferred amounts! investors foot the bill through reduced returns. as of august ‘06, deferred amounts totaled close to $2b. the actual amount of leverage employed was not disclosed, but the ken griffin in me still cackles with joy.

this bears further examination. to that end, a quick perusal of kensington’s ytd financials. on the revenues side:

• $1.75b in investment gains
• $3.75b in investment income

and expenses:

• $3.6b of investment expenses (primarily interest)
• $600mm of operating expenses (mostly compensation, up to $550k for each of 1100 employees)

all in, $1.3b of income to be divvied up. ken gets first dibs:

• $300mm to returns on deferred fees (18.5% on $1.65b)
• $200mm in performance fees (20% of $1b)

and leaves $800mm for investors (13% on $6.2b of capital).  in case the significance of this hasn’t yet set in, let me repeat. investment returns were 20% of $6.2b in investor capital (or 17% of $7.85b if one includes deferred fees). yet citadel earned 18.5% on deferred fees, while investors collected only 13% on invested capital. of $1.3b in income, citadel took $500mm while investors kept just $800mm.

if that’s not pure arb, i don’t know what is.

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courtesy of the financial times:

The importance to Wall Street of a handful of large hedge funds was starkly illustrated by the disclosure that Citadel Investment Group paid more than $5.5bn in interest, fees and other investment costs last year.

More than 90 per cent of the investment expenses represent interests payments, including the cost of the roughly $100bn of net debt provided by investment and commercial banks. Citadel had gross assets at the end of August of $166bn, representing leverage of 12.5 times.

…

Senior Wall Street executives on Friday expressed surprise at the high interest costs and Citadel’s willingness to reveal the leverage of its funds.

tomorrow the nytimes will regurgitate this story with the headline: “citadel interest expense rivals goldman’s net income”. no doubt the nypost will retaliate with an article comparing the magnitude of citadel’s “debt load” with that of general motors (indulge me and pretend cerberus/GMAC never closed). and somehow someone somewhere will tie it all into the necessity of hedge fund regulation. $100b! these hedgies are out of control! ssdd, indeed.

truthfully, i cringe only because the $5.5b figure is altogether meaningless. the financial times itself hints at the answer:

Citadel also has huge interest income which in the current year is running slightly ahead of payments.

most of the expense number is just a passthrough of interest income. consider my (sadly hypothetical) hedge fund. armed with $10b in investor capital but no real ideas of my own, i invest $100b into floating rate bonds that pay a coupon of LIBOR+100. my PB (goldman) finances this and charges me LIBOR+50 on the $100b of principal, while paying me LIBOR on my $10b of margin. assume a LIBOR rate of 5%.

over the course of a year, i receive $6b in interest income on the bonds, and $500mm interest on my margin. of that, i pay $5.5b in interest to goldman. voila! we’ve recreated part of citadel’s income statement. so far so good…

and now to complete the picture: my PB also has a cost of capital; goldman would never condemn $100b of partner (shareholder, if you must) capital to LIBOR+50 hell. so that money is borrowed, at somewhere in the ballpark of LIBOR. goldman pays out $5b in interest, and keeps $500mm for itself.

$500mm is a hefty sum, no doubt. but it’s also an order of magnitude smaller than $5.5b. moral of the story? headline numbers are deceptive.

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so the identity of our mystery investment grade issuer has been revealed to be none other than citadel. unsurprisingly, the media is agog with pseudo-intellectual analysis of the issue and its implications.

in particular, the assertion has been made by bloomberg, breakingviews, dealbreaker and others that, with this sort of stable funding base, citadel has begun to and will eventually insulate itself substantially from mark to market risk.

from dealbreaker:

With the medium-erm (sic) debt issuance announced yesterday, Citadel may be on it’s (sic) way to becoming the anti-Long Term Capital Management—a hedge fund that can increase its leverage without incurring margin call risk if it’s (sic) investments go south.

and breakingviews:

The citadel of Wall Street is under attack - by its customers. That’s one way to interpret Chicago hedge fund Citadel’s plans to raise up to $2bn through the sale of investment grade bonds. The reason: a pool of cheap capital could allow the hedge fund to bypass the prime brokerage arms of investment banks in leveraging up its $13bn of investments.

nevermind that the MTN program is for an aggregate $2b of issuance, or that citadel’s book really is on the order of $165b ($1b and $25b in the two feeder funds kensington and wellington respectively, plus $70b in each of the trading affiliates CEFL and fairfax). prime brokers around the world are no doubt quivering at the thought of losing a debilitating 1.2% of citadel’s business to bond investors…

the reality is this. until citadel is able to issue double digit billions of investment grade debt, PB relationships aren’t going anywhere. if anything the MTN proceeds should be used to finance illiquid investments that the PBs won’t touch. in turn, that frees up cash to post as margin, effectively allowing even more leverage…but leverage that is still subject to NAV triggers and margin calls.

i also take issue with the claim that this leverage is obviously cheap. breakingviews again:

Thanks to the investment grade rating, Citadel should be able to borrow money at less than 6% - or about a 125 basis point spread over US Treasuries. The advantages of this are manifold. For one, it’s cheaper than the rates prime brokers charge to lend money or structure leverage in Citadel’s many trading strategies.

for starts, citadel’s financing spread is most likely in the low double digits (over LIBOR). therefore 6% is certainly not “cheaper than the rates prime brokers charge to lend money”. some adjustment must be made for the duration difference though; PB financing is overnight while the inaugural MTN issue will be 5 years. on that basis, perhaps one might consider the bond financing cheap. semantics maybe, but worth keeping in mind.

the biggest discrepancy between traditional PB financing and this bond issue, however is seniority. while the bonds are senior unsecured and pari with all other senior unsecured debt ($2.5b worth, in fact), the issuer is a financing sub of the feeder funds. most of the assets however reside in the trading affiliates. hence despite feeder level guarantees, the MTNs are structurally subordinated to the PBs. in an LTCM style blowup where posted margin is wholly insufficient, bondholders are fucked.

one might argue that there is a $13b equity cushion of investor capital. yet investors will retain their usual ability to redeem investments (in accordance with normal restrictions and penalties). granted, the covenants do deny citadel the ability to waive those restrictions and penalties, and citadel’s gate and lockup are very restrictive. but the fact remains that the equity cushion is fluid and can be withdrawn…

how does this all shake out? perhaps it’s too early to tell. i for one is still waiting for some enterprising journalist to explain it all to me..

on that note, three noteworthy pieces of disclosure in the citadel red:

• citadel passes through most if not all operating expenses, including compensation, to its investors. in the past three years this came to 4.7%, 5.2%, and 8.8% of assets. fortress, eat your heart out. citadel’s performance fee drops straight to the bottom line.
• citadel has the right to defer fees so that they are invested alongside investor capital. not only this, but citadel gets, at its option, up to 3x leverage on the deferred amounts! investors foot the bill through reduced returns. as of august ‘06, deferred amounts totaled close to $2b. the actual amount of leverage employed was not disclosed, but the ken griffin in me still cackles with joy. this hit to investors is somewhat offset by a $600mm loan from merrill lynch.
• HSBC wrote citadel’s domestic feeder wellington a $400mm total return swap on CEFL. the hedge for the swap is shares of CEFL itself. the transaction apparently was structured to lever up domestic returns to offshore levels and minimize return disparity between the two feeder funds. which begs the question: if stakes in a hedge fund can be swapped up, who needs a MTN program?

lamentably, there is no mention of VaR, which, while flawed and meaningless a risk measure, would nonetheless allow all sorts of titillating comparisons with goldman and other hedge funds thinly disguised as banks…

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hot on the heels of the fortress s-1, rumor has another high profile hedge fund ready to tap the public markets, this time incredibly in the form of investment grade debt.

any copies of the offering memo floating around out there?  do float one my way..

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fortress filed an s-1 on wednesday for what is being hailed as the first hedge fund IPO, a groundbreaking event worthy of frenzied discussion. the idea conveniently overlooks the bloodbath at the formerly NYSE listed but now defunct BKF, instigated by icahn and the idiots at steel partners.

the ny times published a piece on the fortress IPO, as did breakingviews. neither seem to have actually read or understood the filing…

the nyt, for example, thinks fortress runs on a 10% net margin:

For the first half of this year, Fortress, which has 500 employees, earned $88 million on revenue of $877.5 million. Fees from its funds totaled $185.8 million.

and breakingviews guesses futilely at the fee mix:

Assume that 70% of Fortress’s net income comes from performance fees and only 30% from management fees and that implies a blended multiple of about 13 times 2007 earnings.

given the relative dearth of effort by those that usually think for me, i took a quick and dirty stab at the s-1. some thoughts, subject to mistake and revision:

the corporate structure is hopelessly convoluted, so the financials are misleading - some of the managed PE funds are actually consolidated. hence the naive reading has revenue way overstated. though it sounds a little low, ‘05 revenues are likely on the order of $510mm, composed of:

• $170mm in reported mgmt fees (or 1.5% on c. $11b)
• $240mm in reported incentive fees
• $40mm in gains on direct investment in managed funds
• $60mm in fees on PE gains subject to clawback (and hence not recognized as revenue)

comp takes out $235mm and g&a another $30mm for a net of $245mm, and an average payout ratio to staffers of about 48% of revenues. note that the filing assumes at one point a 38% payout on PE revenues; perhaps traders are more loved? (as it should be.) with a blended headcount of 330, average comp comes to $745k - just slightly better than goldman.

for the first half of ‘06, adjusted revenues come to $351mm, based on:

• $145mm in reported mgmt fees (or 1.5% on c. $19b)
• $80mm in incentive fees (returns must have sucked)
• $16mm in earnings on direct investments
• $110mm in PE fees subject to clawback

subtract comp of $170mm and $18mm in g&a for a net of $163mm, which annualizes, sans growth, to net income of $326mm.

onto the balance sheet. on the asset side, fortress holds:

• $340mm in direct investments in their own funds, from providing seed capital for new ones
• $70mm in options on their own funds, no doubt a trick picked up from the BDC scam that is NCT
• $890mm in unrealized performance fees (net of 38% to comp) on $7.1b of unrealized gains on listed portfolio cos

add in $670mm of debt (to fund distributions to the partners) and the implied EV of the business comes to $6.87b, or an amazing 21x ‘06 earnings and 9.8x revs.

no surprise, then, that fortress is going public. the partners took out cash of $160mm in ‘05, $310mm in the first half, and will take out another $400mm before the IPO. that will leave fortress with a $485mm hole in members’ equity (deficit), to be filled by IPO proceeds.

without an IPO their normalized take would have been more like $400mm this year. between piddling $400mm annual payouts and 90% of $7.5b upfront, what is the discerning trader to do but accept the free money?

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and yet here we are…

pure arb. dedicated to the pursuit of free money.

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