Thursday, November 29, 2007

Private placements

Another financial instiitution that had had major writedowns gets a cash infusion. Worldwide: "-- E*Trade Financial Corp., the U.S. discount broker grappling with mortgage losses, will get a $2.55 billion cash infusion from a group led by hedge-fund manager Citadel Investment Group LLC."

This is on the heels of Citi getting $7.5 Billion from Abu Dhabi.
"Investors seem delighted that Abu Dhabi is injecting $7.5 billion into Citigroup, bidding up stocks in general on new confidence that the mortgage solvency crisis might ease. "
Several items of note (BTW these are great for class! Hint hint ;) ).

1. Originally (with the writedowns) leverage ratios had gone up dramatically. Assets had been slashed while debt was largely the same. As this happened, financial distress costs rose.

I have talked to a few investors who had taken that portion of their portfolio above the SIPC's insured $500,000 out of E-trade.
E-trade CEO even acknowledged this in his released statement:
" `This capital infusion will restore investor and customer confidence in the company...' ''
Note to my classes, why? What could this have done to E-Trade? Since it is almost December I will give you a bonus hint: think It's a Wonderful Life!

2. The stock market reaction to these private placements is generally positive at least in the short run. . That much is well known. What is less understood is the "Why". Some of it of course is the reduction of these agency costs, but not all private placements take place in this crisis environment and they are still met with positive (albeit less positive) reactions.

My favorite explanation is that when people who have better information do something, I would be smart to follow their lead. This information hypothesis story goes back at least as far as Wruck's 1989 paper (he also mentions monitoring) and has received quite a bit of support--e.g. this 1999 paper by Goh, Gombolo, Lee, and Liu).

There is another version however. For at least some private placements, the new investors are more apt to be active in monitoring management. This version is consistent with much of what we see in private equity firms as well.

It is undoubtedly true that in some cases monitoring improves, but it often is troubling since a private placement is usually done by management (and not always in a time of need). Why would management actively seek out investors to make their lives miserable.

A recent paper by the late Michael Barclay with Cliff Holderness and Dennis Sheehan (three professors who I owe a great deal of my financial learning both at Penn State and Rochester) further questions this monitoring hypothesis and shows that it can be overstated since often the new investors are passive.

Further antecodal support for the information explanation is that (at least in the resolution of these major financial events) there appears to be a fairly strong industry effect at times when things look bad. The intuition is that these private investors are not just buying the firm, they are also buying into the industry.
(a fascinating version of this is by Besley, Kohers, and Steigner) who actually find a negative reaction in good times (the monitoring may make firm X a stronger competitor) but a positive reaction when in a bear market.

4. Firms do try to get back to their target debt levels. Publicly issuing equity can take months and is generally associated with a stock price decline, so privately placing equity is often a faster (and more positive!) event.

5. And finally, Ben Franklin had it right when he said "Necessity never made a good bargain." The new investors (especially at Citi) seemingly got a pretty good deal. From the
"In general, Wall Street was relieved to hear about the Abu Dhabi Investment Company's infusion, which will boost Citi's ratio of cash to debt and, in turn, make Citi stronger financially. Once the equity units Abu Dhabi bought are converted into stock in 2010 and 2011, Abu Dhabi will hold a 4.9 percent stake in Citi. Until those units get converted, Citi will pay Abu Dhabi a yield, or essentially an interest rate, of 11 percent."

From the NY Times's Dealbook on the ETrade deal:
"Citadel is getting E*Trade’s portfolio for a cut-rate price: It is paying $800 million for assets that had a book value of $3 billion. E*Trade said Thursday it is taking a $2.2 billion haircut on the transaction."

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