Citi and Sovereign Funds: A Post-Mortem
But a few queries encouraged me to finish and post it – so here it is… mostly written February 27/28 at the time of conversion. There has been a lot of talk about whether the U.S. government’s attempts to shore up the capital base of banks like Citigroup were being complicated by the stakes that sovereign funds and other ‘private’ investors took in the bank. Sovereign funds of Abu Dhabi, Kuwait and Singapore were among those that provided capital to the bank holding company back in November 2007 and January 2008, in exchange for fairly high interest payments.These deals varied in structure. GIC and likely Kuwait (along with others that co-invested with them like Saudi Prince Alwaleed bin Talal and Sandy Weill) have reportedly agreed to convert their shares. ADIA’s investment, structured as debt, continues unaffected. See the press release for details on the conversions. Now most of the “private” holders of preferred shares have been encouraged to convert their preferred shares to common stock to boost the company’s tangible common equity. “Encouraged” may be an interesting term given the carrot and stick approach. The stick of course was the loss of dividends paid to preferred shareholders. The carrot was getting a larger share of Citi than previously negotiated. Based on details relating to Singapore’s investment, the new shares seem to covert at around 3x the amount of equity from the initial deal, ie diluting common stock holders by 74-75%. It is not clear if the other preferred stock holders (those that trade freely) will convert on the same terms.
Citi officials have been trying to convince these investors to convert their shares to common stock, thus increasing the holdings of common stock and reducing the need to pay out the large dividends. Those to Singapore’s GIC were over 7% (see here for a consolidated chart of the structure of SWF investment in financial institutions in 2007/08). The holders of these preferred shares (both sovereign and non-sovereign) were perhaps understandably reluctant given the potential of further dilution if the government injects even more capital and the loss of the dividends, however, it was only a matter of time given the pressure on the equity price and need of Citi to reallocate the capital it has received. And no matter how much the funds might have been reluctant to lose the dividend payments, having the company falter further would clearly not be in their interest.
The U.S. government will also raise its stake from about 8% to about 36% – having already agreed to match the preferred share conversion of ‘private’ holders of common stock.
Citigroup’s exchange offer enables GIC to exchange its convertible preferred notes to common stock at an exchange price of US$3.25 a share, compared with the conversion price of US$26.35 under the original terms of the investment. As a result, GIC’s equity ownership of Citigroup will rise to an estimated 11.1%, without any injection of additional funds
The other investors that were part of their $12.5b capital injection in January 2008 also seem to have accepted these terms. These include Saudi Prince Alwaleed, who famously took a stake of just under 5% in the 1980s. It seems notable to me that there has been no mention or confirmation from Kuwait whose Investment Authority invested around $2b at the same time, but I can’t imagine they would be a standout. So why the push to common equity?
It seems two-fold. One -the US government in its stress test is emphasizing tangible common equity (TCE) as its unit of a banks assets. Financial institutions cannot use the equity of preferred share holders as part of loan-loss provisions, so boosting capital helps the institution to prove sufficient capital to offset future losses (more on that in a moment)
The NYT’s dealbook noted
Citi’s T.C.E. ratio had dropped precipitously to as low as 1.87 percent before Friday’s conversion, from its historical average of around 5 percent in the years leading up to the subprime mortgage debacle, mostly because of losses it has occurred from the fallout from the financial crisis.
The second is likely a reduction of dividend payments. Citi previously cut its payments to common stockholders and cutting that to preferred stock holders would help some of its cash flow issues. Of course it also reduces the cash flow accruing to these sovereign funds.
A quick estimate suggests that if Singapore will receive 11% of Citi common stock, then Kuwait might receive around 5-6%, this implies that foreign government investors will hold over 15% of Citi. A year ago, this might have posed significant political questions – and might still trigger regulatory concerns. Yet, the fact that the US government will control twice that stake, may lessen concerns even if it poses other thorny challenges about the role of governments as controlling stakeholders.
Furthermore depending on the results of the stress tests, there could be additional capital injections to Citi, which might not only dilute previous common share holders who were diluted by 74 or so percent in this deal but also these newly converted investors. Given the potential losses that my colleagues Nouriel Roubini and Elisa Parisi-Capone project may be ahead for the US financial system, more recapitalization seems likely.
So… will other banks follow Citi’s lead? perhaps not. Before being bought by Banc of America, Merrill already had to pay compensation to Temasek, the Korean investment corporation and Kuwait Investment authority when it issued new capital. They received a greater number of shares in compensation and now hold shares in the combined firm though the total stake is not clear to me. Voting rights?
A big question is how these investors will exercise the voting rights that as common stock holders they are surely be entitled. Usually an over 10% stake would imply the right to pick board directors. These investors, who hope to make good on their investment, are likely to be supportive of the US governments approach and anything that would bring the institution back to profitability. But it does pose some corporate governance challenges.
I have argued in the past that asking for sovereign investors passivity poses as great risks as their active role since it might result in either actual leverage over the company in question or the perception of it. More transparency about the action of shareholders is in the interest of all parties. In fact, the active participation of sovereign investors who tend to have longer investment horizons could be beneficial.
Finally… What about Abu Dhabi
The structure of the capital injections by which Singapore, Kuwait and others invested in January 2008 was different from that of Abu Dhabi which bought DECS equity units in November 2008 (see the details from Citi). Abu Dhabi’s securities are hybrids – convertible bonds that would convert to equity starting next year. Because of this structure, they are treated as debt and payments are not affected.
At the time of purchase Andrew Clavell noted that “Citi has raised tax ded
uctible, upper tier capital funds for 4 years at a cost equivalent to another financing source of Libor+150.” This could change of course should the US government take a larger stake in Citi. But the ramifications of taking actions that would affect the bondholders in aggregate would have major effects on a range of institutional investors and is a big can of worms. Yet the 11% interest and dividend payments to ADIA, paid out quarterly, must not be too popular in some quarters. To be continued… I’m sure. For those that are interested, check out this reuters clip of my thoughts on the role of SWFs in the recapitalizations.