medium-term confusion
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…