Citadel’s Bond Financing: We’re Going Public, Baby
Citadel’s recent announcement that it plans to issue up to $2 billion in bonds has caused quite a ruckus among those in the hedge fund-watcher community. The general theme: securing long-term leverage that is fundamentally more stable than bank-based financing. Jenny Anderson over at the New York Times wrote a nice piece on this yesterday.
Citadel Finance, a unit of the Citadel Investment Group, a $12 billion hedge fund, disclosed on Monday that it intended to raise as much as $2 billion in bonds — a first in the industry. It follows the announcement that the Fortress Investment Group, a giant alternative investment group with billions in hedge funds, private equity and loans, is going public, another first for the United States markets. Both announcements suggest that hedge funds, at least a handful of them, are giving up some of their coveted privacy in exchange for more stable capital.
These funds are growing up.
Fortress was clear why it wanted to go public: it gets permanent capital, a currency — the stock — to do deals and pay employees and a sense, however ethereal, of physical permanence.
The reasoning behind Citadel’s effort to raise debt is more subtle, but equally significant: liquidity management. When the financial world implodes, as it inevitably does, Citadel does not want to be at the mercy of its banks, who at those moments of crisis are likely to be less generous with financing.
Liquidity management is not insignificant for hedge funds. Investors give a hedge fund money to manage. But they can redeem that money, depending on the terms of the fund, if the investments go bad. A fund can collapse when bad investments lead to investor redemptions, which in turn force managers to sell positions, often into deteriorating markets, to meet those redemptions. The banks, which manage funds’ accounts, see the deterioration and force tougher financing conditions or call in the loans. Death comes quickly in such cases.
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Citadel’s bonds will allow it more flexibility in times of crisis. This is particularly important considering one of Citadel’s main strategies: capitalize on moments of crisis in the market. When Enron collapsed, Citadel jumped into energy trading. When Amaranth was in a lurch, Citadel and J. P. Morgan bought the energy trades. But being opportunistic when banks are being cautious is a bad mix. Longer-term funding is a first step to mitigate that.
Expect more hedge funds to follow suit. To raise the money, Citadel had to do what hedge funds in general and Citadel in particular are loath to do: open the vault and tell the world how much money it makes (a lot) and how much it charges its investors (also a lot). As more institutions invest in hedge funds and regulatory scrutiny increases, such transparency will come. Selling bonds is a way for hedge funds to benefit from that.
I find this to be a very interesting, but less generalizable development than it has been portrayed by many in mainstream media. Citadel is, if not an anomaly, certainly one of a rare breed of hedge funds dotting the 9,000-strong global landscape. It has availed itself of a financing technique that is simply not available to many, regardless of its inherent logic. Why? The very nature of hedge fund risks and returns themselves. But more importantly, I think the stories miss the fundamental driver behind the MTN issuance: Citadel is preparing to go public, both getting investors familiar with its financial profile as well as getting its internal house in order for the kind of reporting that being a public company will require. But hey, this is just one man’s opinion.
That said, let’s first analyze the MTN deal in a vacuum. Let’s review the purpose and properties of conventional hedge fund leverage in order to create a basic frame of reference. How can leverage be achieved?
- Use of asset-based credit to buy long positions in stocks and/or bonds
- Use of derivatives to create synthetic long and short positions in stocks and/or bonds
- Use of the cash proceeds of a short sale to invest in stocks and/or bonds
This contrasts with the use of unsecured credit to buy long positions in stock and/or bonds, which is what Citadel is doing. The degree of leverage that is generally provided by banks is a function of factors such as net exposure, the liqudity of assets being bought/sold, and the degrees of diversification (asset type, geography, specific instrument, etc.) across the portfolio being financed. Also, it should be noted that there are margin requirements for the various securities, listed and over-the-counter instruments used by hedge funds.
A key point raised by many of the analyses of the Citadel financing are right on: bank-based financing for almost all hedge funds are subject to strict repayment requirements should collateral values erode. This situation certainly does not arise if one has issued unsecured debt. However, based upon its recent SEC filing it should also be noted that Citadel has total leverage of 7.8 times its ($13 billion) in assets, implying approximately $90 billion in credit, so that a $2 billion MTN program, in and of itself, is not going to forestall a meltdown. But who knows - maybe this is just Citadel dipping its toe in the water to see the market reaction, and if it responds well it will seek to issue more unsecured paper. We’ll see.
In any event, there are certain pros to bank-provided, asset-based financing: it’s cheap. It will always be cheaper to lever against assets then to borrow unsecured. It may even be that top hedge funds could negotiate term financing provisions with their banks on a portion of their borrowings if they are willing to pay out the yield curve. This will still be cheaper than unsecured debt though certainly at a premium to overnight rates. Also, my sense is that this type of financing is not made available to most hedge fund clients of prime brokers, but only the top clients that run large, diversified portfolios. But again, I am confident that banks are very innovative via their prime brokerage operations to provide flexible, creative financing solutions to their top clients. But what about the rest of the non-Citadels of the hedge fund universe? Another benefit to bank-based financing is that there aren’t the disclosure requirements of a public MTN program. This is huge issue for some. For some this feature alone would be a deal-breaker.
But regardless of desire, this type of issuance simply isn’t available to most hedge funds. They lack the necessary scale, diversification of instruments and strategies, risk management infrastructure, track record and management depth to get institutional investors comfortable with unsecured debt securities. This is just a fact. So Citadel is paying what is akin to an insurance premium for initiating this ground-breaking strategy.
So why would Citadel do this deal?
- Show itself as an innovator in the hedge fund field - this is important to Ken Griffin
- Secure stable, term financing for a portion of its borrowing needs
- Do a “small” issue as a ground-breaker for subsequent financings
- Get its organization prepared for the kind of disclosures necessary for going public - which I believe it will try and do after Fortress tests the waters - this is also important to Ken Griffin
Time will tell if I’m right. But I do find this recent development most interesting.
ADDENDUM
A really smart friend of mine sent me a note about this post. He happens to run a sizable fund-of-funds, and is quite simply one of the brightest people I know. Notwithstanding the fact that he went to Caltech (ha). My friend posited that there may be a purely economic reason behind this issuance, which I wanted to share with my readers. While I continue to believe that my over-arching explanation is still valid, I would be remiss in my goal as a blogger to increase the level of intelligent debate to not share his observations with you. The precise text from his email is provided here.
Your comment in your Dec 02 piece on Citadel that “it will always be cheaper to lever against assets than to borrow unsecured” got my attention…. I think it may actually be possible to explain Citadel’s bond issue by looking closely at the economics. Maybe I’m wrong, but I have difficulty imagining a prime broker extending three- or five-year asset-based financing to a hedge fund client at competitive rates, especially when that client is already levered 7x to 8x as Citadel appears to be. A friend in the prome brokerage industry concurs that term financing of such lengths is virtually, or perhaps completely, nonexistent. Thus, Citadel probably cannot capitalize on the strong inversion of the yield curve by resorting to traditional channels hedge fund leverage.
You see where this is heading. If unsecured financing allows Citadel to reach a point out on the (inverted) yield curve that would otherwise be beyond their grasp, it actually just might make economic sense to do it. At today’s rates, three-year BBB+ paper is cheaper than 6-month LIBOR and not far off 6-month T-bills… and that’s before we bake in the PB’s spread on whatever financing they provide. Citadel may not be making much money after taking the underwriting fees into account, but I’ll bet they’re not “paying up” nearly as much as you think.
But here’s the real magic: If Citadel has been able to convince its auditor that this debt issuance is bona fide balance sheet financing and not securities available for trade, it can carry the debt at par on its balance sheet until either it matures or they buy it back. If BBB+ spreads widen or the yield curve gets less inverted, Citadel has a free call option to buy back the debt into treasury and book a profit. If not, they carry it at par and pay it off at maturity with (then cheaper) overnight asset-based financing, avoiding the need to ever book a mark-to-market loss. Voila, a $2 billion financing arbitrage.
Maybe I’m wrong on all this, but it does make you wonder. After all, Ken Griffin doesn’t like to lose money.
This is an interesting analysis and certainly worthy of consideration. Thanks to my friend Jeff for doing some independent homework and adding to the discourse. And for keeping me honest.
