Abu Dhabi to Invest $7.5 Billion in Citigroup

Boy, the equity infusion in Citi was in some ways predictable, but it happened earlier than I anticipated. Guess the bank learned from its last rescue by Prince Alwaleed not to wait until they are desperate to find a suitor. Its alternative to shore up its weakening equity base was selling assets, but with many financial firms also under stress, it isn’t the best time to be hocking businesses.

The yield on the convertible preferred, 11%, is staggering. Even Countrywide in its August bailout by Bank of America, paid only 7.25%, although the conversion was deeply in the money on that deal at the time of closing (no longer!). Based on today’s closing price of $30.70, this conversion feature is slightly out of the money, and the conversion right cannot be exercised prior to 2010, and the conversion price rises in subsequent years. Nevertheless, I would take yield over appreciation in the current environment. While the dividend yield is only slightly above the yield on Citi’s common, the common dividend will be cut before the preferred would be. Both the common dividend and terms of the Abu Dhabi deal show how much doubt there is over the bank’s prospects.

This deal will be consummated before Citi releases its audited financials for 2007. I would love to be a fly on the wall and learn what reps and warranties Abu Dhabi requires.

From the Wall Street Journal:

The investment by the Abu Dhabi Investment Authority will help rebuild Citigroup’s capital levels…

As a result of the deal, the investment authority known as ADIA will become one of Citigroup’s largest shareholders, with a stake of no more than 4.9%. The stake will exceed that of Saudi Prince Alwaleed bin Talal, long known as one of Citigroup’s largest shareholders, according to a person familiar with the situation.

“This investment, from one of the world’s leading and most sophisticated equity investors, provides further capital to allow Citi to pursue attractive opportunities to grow its business,” said Sir Win Bischoff, the bank’s acting chief executive officer, in a statement.

The investment underscores the growing role that Middle Eastern investors are taking outside their home turf. Separately yesterday, an investment company owned by Dubai’s ruler, Sheikh Mohammed bin Rashid al-Maktoum, bought a stake in Sony Corp. ADIA, which has almost $1 trillion under management, this summer bought a small stake in Apollo Management LP.

“This investment reflects our confidence in Citi’s potential to build shareholder value,” said ADIA’s Managing Director, Sheikh Ahmed Bin Zayed Al Nahayan.

In exchange for its investment, ADIA will receive convertible stock in Citigroup yielding 11% annually. The shares are required to be converted into common stock at a conversion price of between $31.83 and $37.24 a share over a period of time between March 2010 and September 2011. The investment, which came together in about a week, is expected to close within the next several days.

On Monday, shares of Citigroup fell 6.2% to $29.75 in 4 p.m. composite trading on the New York Stock Exchange.

ADIA, which is a client of Citigroup, won’t have any special ownership rights and no role in Citigroup’s management or governance. It also won’t have any right to name a member to Citigroup’s board….

The bank is at risk of more losses due to the credit-market turmoil, leading to widespread concerns that it and other financial institutions will be forced to curtail lending. Furthermore, Citigroup’s U.S. consumer business, which includes retail banking and credit cards, is trailing key rivals like Bank of America Corp. and J.P. Morgan Chase & Co.

The WSJ contained an all-too-typical illustration of Wall Street Journal’s habit of shading its reporting reporting:
nvestors have increasingly expressed concerns about Citigroup’s “tier 1” capital levels — a common measure of a bank’s capital adequacy — which for the first time in years fell below its 7.5% target in the third quarter. Although the bank is still considered to be well-capitalized, investors worried that Citigroup would be forced to cut its dividend.

Citi paid a vastly higher dividend that Countrywide did, and Countrywide was (and still is) at risk of going bankrupt. The Financial Times gave a foursquare assessment:

The impact of credit market turmoil combined with a previous string of acquisitions, including Nikko Cordial in Japan, has left Citi’s balance sheet under strain.

Its Tier One capital ratio fell to 7.3 per cent at the end of the third quarter, below Citi’s target of 7.5 per cent, and has fallen further since. The company has committed itself to returning the ratio to its target by the end of June. The issue of mandatory convertible securities to ADIA would lift that ratio by about 0.5 percentage points.

And Citi provides the usual lipstick on a pig. Again from the FT:

There have been a couple of dozen large issues of such securities in the past few years, including by companies such as Fortis and CIT. The yield premium and average conversion premium in the Citi deal are in line with the average for previous deals, according to a senior executive.

The “yield premium” being within norms nicely finesses the issue of how highs Citi’s common yield is, 7% based on today’s closing price. And I have a sneaking suspicion if I saw the terms comparison I might have more than a few quibbles with what was considered to be a comparable transaction.

Update 11/27, 10:20 PM: Andrew Clavell has decomposed the Abu Dhabi deal into its constituent parts, such as puts and calls, and concludes it isn’t bad at all (Felix Salmon translates Clavell’s analysis into lay terms). This is a very useful contribution to the discussion.

I will confess to not having realized the deal was a mandatory convert (that limits how long the 11% coupon is paid, while traditional convert preferred have a longer life and conversion is often optional, and with an 11% dividend you’d pretty much never convert unless there was considerable appreciation in the common). That does reduce the cost of this exercise somewhat.

However, my quibble isn’t with Clavell’s analysis, but the way he frames his conclusions. At a 7+% yield, issuing common, or any security priced in relationship to common, is an expensive exercise for Citi. With that rich a yield, it’s a guarantee that the yield is propping up the price (I know of at least two people who hazarded to buy the stock recently based on its yield). Similarly, the bank is committing itself to an 11% cash outlay, even with the tax deductions. If Citi continues to be stressed financially (a near certainty), being committed to high (relative to the amount raised) outflows is not a pretty position to be in. The overall economics may appear attractive, but that calculus misses the risks implicit for Citi of having fixed commitments. To put it in economic terms, Citi has a strong liquidity preference, and this deal makes demands on liquidity. That works against economic considerations that might otherwise be favorable.

Common dividends, on the other hand, can be cut, but one can only guess how hard it would have been for Citi to sell this much in straight common (as in how much would it have depressed the price). (An aside: Salmon argues that cutting the dividend might increase the stock price. Huh? A dividend reduction would tank the common).

The other consideration is that one use of cash, at least according to Bloomberg, was to preserve the common dividend. Yikes. Now cynically, Rubin had to say that Cit was going to maintain its dividend. The firm wasn’t going to have much success selling a security with a forced conversion to equity if it did’t act as if it intended to maintain a dividend that keeps the stock from plummeting.

But you don’t use a financing to pay the outflow on another financing (it’s another matter if you use one financing to retire another). A new financing should be used to shore up the balance sheet, but Citi’s high dividend stock puts it in a very difficult position. Any equity-like instrument is likely to have a high cash outlay attached. So Clavell is no doubt right that this is a relatively attractive option for Citi, but keep in mind that Citi doesn’t have good options.

We’ll see if Citi cuts the dividend after a long enough interval that they can tell Abu Dhabi that circumstances had changed. If things continue to deteriorate at the bank, that could take as little as six months.

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  1. Anonymous

    The world is unfolding as it should. Investment of current account surpluses is shifting from low risk to high risk assets when it is most advantageous to do so.

  2. Anonymous

    can you explain why in the current environment you prefer yield to appreciation i didnt follow sorry to be an idiot

  3. Genesis

    On why yield – you can short the common to hedge off the risk.

    You now have all your cash back and are delta neutral, but they have to pay you the coupon!

    This is a zero-risk trade for the guy writing the check. Nice deal eh?

    (Yeah, yeah, I know there are usually supposed prohibitions against this. Yeah, ok. And these investment pools have no affiliates who can do the other side of it, right? Pull the other one.)

    If the company goes boom, you lose nothing (your convert is worthless but the short profit offsets it; no change) while if the stock rises your short goes the wrong way but the convert appreciates – again, no net change.

    Basically, its a way to park $8 billion and get paid 11% on it, risk free.

    Now tell me where you find that sort of deal – other than from someone who REALLY needs the money!

    The CFC deal at 7% was Guido financing. This deal is Guido-squared.

    I guess its fitting, given all the CDO-squareds that these clowns (plural, not just “C”) have been putting out over the last few years…..

  4. Yves Smith

    Anon of 12:18 PM,

    It’s not a dumb question at all. In the last ten+ years there has been a pronounced bias towards valuing stocks based on appreciation potential rather than dividends and dividend growth. Yet the traditional way of valuing stocks was a dividend discount model.

    The more immediate answer is that appreciation is a less certain source of return than dividends. And while dividends can be cut, a preferred dividend is given preference over common, so it would not be cut if at all possible.

    I see considerable downside risk in the stock market generally and Citi in particular. Tony Jackson in today’s Financial Times drew parallels between our stock market and that of 1973. Stock averages fell 70% in the following 2-3 years and did not return to 1973 levels for more than a decade. And that was with a period of high inflation in between, so it took longer to regain 1973 prices on a real basis. In inflationary times, you want to accelerate the receipt of cash, since cash now is worth considerably more than cash later. While all stocks suffer when inflation increases, growth stocks are affected more than high dividend stocks.

    I expect Citi to underperform, but a minority thinks it is a buy. I believe they will be found to have even more losses. Even with the investment, I think they could still be seen as being undercapitalized, even fragile.

  5. Anonymous

    “The yield on the convertible preferred, 11%, is staggering.”

    To quote the immortal Hunter S. Thompson, Citi these days sounds like a farmer with terminal cancer trying to borrow against next year’s crop. So what kind of rate would you expect it to get?

    The trick now, I guess, will be to cut the jobs to free up the cash flow to cover the vig.

  6. Anonymous

    “I believe Citi issued a denial.”

    Actually, it was a non-denial denial of Nixonian proportions:

    Ms. Pretto said in the statement that “any reports on specific numbers [of layoffs] are not factual.”

    Got that? Not factual. So if the job cuts come in at 44,999 they can honestly argue that the 45,000 figure was “not factual.” That’s why they pay the PR guys the big bucks.

    Actually, my other pet theory about the layoff leak is that it was specifically designed to prep the ground for the Abu Dhabi deal (Abu Dhabi Doo!) — to try to keep it from becoming another fiasco like the Dubai ports deal.

    If so, then the next message leaked out of C should be that the massive layoffs won’t be necessary after all — as long as the deal goes through quickly.

    The message to the Arabphobes: Make a move and the 45,000 employees (many of them residents of Greater New York)get it.

    Somewhat like the scene from Blazing Saddles, except with a tall white guy wearing an expensive Italian suit.

  7. Anonymous

    genesis said above:

    “On why yield – you can short the common to hedge off the risk.

    You now have all your cash back and are delta neutral, but they have to pay you the coupon!”

    However, if you are short the stock, don’t you have to pay the dividend? 7% yield on Citi currently.

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