Monday, December 11, 2006

Viewing Citadel

Guambat rather reckons that the view from a citadel is somewhat different than the view of a citadel, and that the difference in perceptions would make for somewhat differing assessments of the world at large.

Guambat has also taken note that there have been numerous hits to his recent post about Citadel, the hedge fund, from the Citadel, if Guambat's StatCounter hit-ometer is to be trusted. With that kind of scrutiny, Guambat edges deeper into his burrow to try to see just how it might have been that he may have disturbed some hornets in the ramparts of the Citadel.

So, with that in mind, Guambat passes along more information that you probably don't want to know anything about if "you" are not of the Citadel, gleaned from other online accounts.

First, lest Guambat offended anyone with his wild conjecture (this IS a public coffee house type of forum and opinions can be expected to run to fantasy, after all) that there may have been some sort of prearranged put deal, and without directly addressing or answering that conjecture, note this from another blogger:

JPMorgan Flipped Amaranth Positions To Citadel
[T]here is clear evidence that JP Morgan and Citadel entered the transaction as partners. Previous reports had left it unclear whether each had bought off separate pieces of the portfolio or entered under some mutual arrangement. The memo refers to a “risk-sharing agreement” between the bank and the hedge fund, implying the institutions partnered on the deal.

And to correct any misunderstaning from Guambat's conjecture that the pricing paid for the debt issuance might be suggestive of desperation (Guambat was only reacting to what he read elsewhere about the points they reportedly paid and noticing the significant premium over reported "average" costs for similar debt), there is this more detailed story on the Citadel debt arrangement from the Financial News Online,

Citadel leads the way in financial self-sufficiency by William Hutchings
Could Citadel founder Ken Griffin be the most feared man on Wall Street? His plan to issue $500m (€385m) in bonds, which will make his $13bn hedge fund less reliant on Wall Street for financing, last week had investment bankers questioning how long it will be until they lose influence over some of their most lucrative clients. Wall Street makes billions of dollars each year from hedge funds.

Citadel is one of the most self-sufficient hedge funds in the world. It has secured its capital by locking investors into its funds for three years, while its focus on investment automation has helped free it from dependence on investment staff. It conducts marketmaking in options and last week tried to buy a licence to a hedge fund database to give it insight into rivals’ trading strategies.

The $500m in bonds Citadel plans to issue will cut its reliance on banks for financing and reduce margin call risk, which brought down Amaranth Advisors in September and Long-Term Capital Management in 1998.

Citadel’s 363-page memorandum, obtained by Financial News, provides a rare glimpse of how the hedge fund operates.

Citadel was set up by Griffin in 1990, soon after he graduated from Harvard University. Griffin, 38, has preferred investment systems to human judgment since he was a first-year student at the US university where, in 1987, he wrote a computer programme that made money arbitraging between convertible bonds and their issuers’ equities.

Griffin stepped back from trading long ago but remains president and chief executive, with responsibility for investment and risk management, and leads the 11-member management committee that runs Citadel.

Citadel’s technology budget runs into hundreds of millions of dollars a year, according to bankers. Costs are paid directly by investors in its funds, instead of a 2% management fee. Last year, Citadel’s operating expenses, including performance-related staff compensation, amounted to $1.2bn, comprising 8.75% of its offshore fund and 7.66% of its onshore fund. In addition, Citadel takes 20% of any positive investment performance.

Investors in Citadel’s funds have had to agree to lock in their capital for longer than usual in the hedge fund industry. About half have agreed to three-year lock-ins and the rest have accepted Citadel’s right to restrict quarterly redemptions to 3% of the fund. Citadel can deny redemptions completely if it believes meeting them would hurt the funds’ returns.

These stringent terms date from 1994, when heavy redemptions forced Citadel to sell bonds into a falling market and realise its only loss-making year, dropping 4.3%.

The performance spurred Citadel to diversify from its reliance on the convertible arbitrage strategy, although arbitrage has remained at the heart of its investment approach, as has an extensive use of quantitative models.

The firm has been trying to free itself from dependence on bankers since 1998 when John Dirocco, former chief investment officer, was hired to create a securities lending operation, a role normally filled by prime brokers. Citadel has developed a substantial electronic trading operation so that it can handle its own trades, and last year used this to set up an equities broking business to compete with Wall Street’s biggest retail brokers.

The bond launched last week is the latest in this series of moves. The proceeds will allow Citadel’s funds to leverage some of their positions, without the need for funding from banks.

Citadel has focused on arbitrage, or relative, value strategies. Arbitrageurs find pairs of investments whose prices they expect to converge and buy one while selling the other.

Arbitrage can cut out risk but practitioners often raise their risks by using leverage, borrowed money, to magnify the potential returns. Citadel said at August 31 its net leverage ratio overall was 7.8, higher than the average hedge fund but not unusual for an arbitrageur.

In 1994, Citadel built on its expertise in convertible bond arbitrage by introducing merger arbitrage, taking a long position in shares of a target company while short-selling shares in its would-be bidder; and statistical arbitrage, which might buy the shares or bonds of one company while short-selling them in another in the same industry.

By 1999, it had broadened into more directional strategies, taking outright long or short bets, and the event-driven approach that may invest in distressed debt or the shares of a demerging company. In 2001, Citadel moved into reinsurance and long/short equity investment. The following year it began trading energy derivatives.

It estimates about half its assets at any time are invested in primarily equities-related strategies, comprising long/short global equities, statistical arbitrage, merger arbitrage, event-driven strategies and convertible arbitrage.

About 15% of its assets are invested in global credit, trading in corporate bonds, while another 15% is in global energy, trading in natural gas and other energy derivatives.

About 10% of Citadel’s portfolio is in global rates, trading in currencies as well as government bonds and mortgage-backed securities, while the final 10% is in reinsurance, conducted through Bermuda-based companies in which the funds have invested. Citadel has not engaged in global macro trading, a strategy that would be hard to replicate.

Another blogger (well to compare the quality of Guambat's blog and the other blogger with the simple "another blogger" is even more self-delusional that usual for Guambat; the other blogger seems to actually know that of which he blogs) did a take and a re-take on the Citadel financing, too:

Citadel's Bond Financing: We're Going Public, Baby
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.


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.

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....

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.

Citadel is paying what is akin to an insurance premium for initiating this ground-breaking strategy.


A really smart friend of mine sent me a note about this post.

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.

Reading and wondering, out loud as it were. That's what we do here in the blogoshpere. Let all who enter here Caveat emptor.


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