Another Analysis of the Citi-Abu Dhabi Deal

Ah, someone, namely jck at Alea, finally nailed the economics of the Abu Dhabi investment in Citigroup. I have to confess that when I read Andrew Clavell’s analysis, I was sufficiently chastened so as not to think about it further. But jck points out the obvious flaw: Clavell decomposed the deal in to put and call options when there is not much optional about this deal. The Abu Dhabi Investment Authority is required to convert its preferred into common in 2010-2011 within a pre-set range of conversion prices.

So the advantage to Citi is that this preferred dividend is tax deductible, while common dividends aren’t, so the cash flow impact is more or less a wash (assuming the common dividend doesn’t get cut, which in my view is optimistic). And because the share issuance is deferred, it doesn’t depress the price of the common short-term (indeed, the information content of the investment perked up not only the stock but the entire market).

However, I keep coming back to the fact that this is a good deal for Citi only under the circumstances. Selling stock at a 7% yield is a very steep price and reflects the climate of doubt around financial companies in general and Citi in particular. The real reason that this is good for Citi is that the odds are high that the credit markets will deteriorate further, and any funding down the road would be on considerably worse terms.

ADIA was encouraged to do the deal because Prince Alwaleed earned a juicy return on his purchase of a 20% stake in Citi in the early 1990s. But then the stock was trading at under $10 and many believed it was on its way to zero. The time to buy into troubled companies is when there is blood on the streets. ADIA’s investment is likely to be premature.

From Alea:

They are called “Upper DECS Equity Units“, not that it will stop the blogosphere from promptly analysing the deal as if it was a bond actually a “reverse convertible” no less…

No, ’tis not a reverse convertible, if it was, given the current volatility, it would be the steal of the century from Citi’s point of view.With a reverse convertible you are long a bond and short a put. The coupon is the maximum return you can hope for.If the stock price is below the strike price of the put at expiration you get the stock otherwise you get your cash back.
Clearly not the case here.ADIA is just plain long $7.5 billion of Citi equity.No put option, no call option.The trust preferred equity has tax advantages for Citi so the real cost is 11%*0.615 = 6.76% , pretty much in line or even slightly lower than the current [uncertain] dividend yield. For ADIA, the uncertainty over the actual number of shares they will get upon the mandatory conversion above current market prices gets compensated by some extra guaranteed yield unlike plain equity where the dividend may be impaired in the future.But at the end of the day they are long equity, period.

Let’s get some authority in here, John Bilson, a finance professor at the Illinois Institute of Technology’s Stuart School of Business in Chicago said to Bloomberg:

“Abu Dhabi is on the hook to buy Citigroup stock. This thing does not have any option attached. This is more like a forward contract to purchase the stock.”

Exactly…great and clever deal for both sides, given the current market state.

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  1. Anonymous

    Re: trust preferred equity has tax advantages for Citi so the real cost is 11%*0.615 = 6.76% , pretty much in line or even slightly lower than the current [uncertain] dividend yield.

    Last time I checked rates were falling and there was talk of a liquidity trap. guess the subprime thing is over; so whats next, Orange County-like defaults from coast-to-coast?

  2. Yves Smith

    Anon of 1:00 AM,

    Agreed. In my earlier post on this topic, I grumbled that everyone who said that this deal was good for Citi ignored Citi’s liquidity needs. They’d be better off cutting the dividend and hoarding cash, but you can’t do that if you need to sell equity to shore up your balance sheet. (Actually, they could if they were willing to sell assets instead, which in a less troubled market would have been a better option).

  3. Peatey

    yves, I think you misunderstand Clavell’s breakdown of cashflows. Mandatories like DECS can be broken into cashflows that would result from having the 4 components as laid out. There is no optionality about the transaction, just that the cash-flows to the holder of the DECS are exactly modeled with the constructed portfolio (in fact, this is how many analysts value a DECS, by adding up the stock and option prices with the dividend).

    Keep up the great work.

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