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REV: NOVEMBER 7, 2013

VICTORIA IVASHINA

DAVID SCHARFSTEIN

Blackstone and the Sale of Citigroup’s Loan

Portfolio

At the end of March 2008, Bennett J. Goodman (HBS’84), a Senior Managing Director at

Blackstone, one of the world’s largest private equity firms, was reviewing materials for the potential

purchase of a $6.11 billion pool of leveraged loans from Citigroup, one of the world’s largest banking

entities. Most of these loans were used to finance large leveraged buyouts (LBOs) that had been

announced in late 2006 and early 2007. In a number of cases, Blackstone had considered making an

equity investment. The research and due diligence that Blackstone had performed in the process gave

Goodman some degree of confidence that he understood the risks in the loan portfolio. TPG, another

large private equity firm that was considering partnering with Blackstone in purchasing the loan

pool, had also researched and even participated in many of the LBOs.

Leveraged loans, including those in the loan pool, were generally trading well below par. The

subprime mortgage crisis, which erupted in 2007, had led to a re-pricing of a wide range of debt

instruments. Some of this re-pricing came from the recognition that risk had been underestimated in

the credit boom of the mid-2000s. But Goodman thought that some of the re-pricing—perhaps even

most of it—was driven by investors’ excessive risk aversion and retrenchment from risky assets, fire

sales, and general lack of liquidity in financial markets. This appeared to create an opportunity to

generate superior risk-adjusted returns by investing in a large portfolio of credits priced below their

fundamental value. The investment would require Blackstone to value and manage a set of opaque

and highly illiquid fixed income assets. It would also require large amounts of funding, and the

capacity to hold their position for an extended period until debt values recovered.

Citigroup would facilitate the transaction by providing debt financing for the purchase of the loan

pool. Blackstone would provide the rest of the funds, and would stand in the first loss position. As

protection for Citigroup, the debt was secured by the loan pool. Citigroup required that the loan pool

be marked to market and, in the event the value of the loan pool fell below a certain threshold,

Citigroup had the right to request additional collateral.

Blackstone Capital Partners V closed in 2006 $21.7 billion ($13.5 billion target). As a point of reference, fund raised in 2003

was $6.5 billion.

________________________________________________________________________________________________________________

Professors Victoria Ivashina and David Scharfstein prepared the original version of this case, “The Sale of Citigroup's Leveraged Loan Portfolio,”

HBS No. 209-080. This version was prepared by the same authors. It was reviewed and approved before publication by a company designate.

Funding for the development of this case was provided by Harvard Business School, and not by the company. HBS cases are developed solely as

the basis for class discussion. Cases are not intended to serve as endorsements, sources of primary data, or illustrations of effective or ineffective

management.

write Harvard Business School Publishing, Boston, MA 02163, or go to www.hbsp.harvard.edu/educators. This publication may not be digitized,

photocopied, or otherwise reproduced, posted, or transmitted, without the permission of Harvard Business School.

214-037

Blackstone and the Sale of Citigroup’s Loan Portfolio

Goodman, along with Tripp Smith and Doug Ostrover, had just earlier that month closed the sale

of their firm, GSO Capital Partners, to Blackstone for approximately $1.0 billion. GSO became the

credit and distressed debt division of Blackstone alongside the firm’s Private Equity, Real Estate and

Fund of Funds businesses.

While the investment opportunity seemed attractive, and had the support of a number of GSO’s

general partners, the very dislocations in the market that gave rise to the opportunity also brought

substantial risk. In recent months, financial markets had witnessed a set of events that would have

been hard to imagine a year earlier. Just a few days prior, Bear Stearns—one of the most prominent

global investment banks—had collapsed, leading JPMorgan Chase to buy the bank for a small

fraction of its value a year earlier, and then only with assistance from the Federal Reserve. And the

economy had moved into a deep recession. Goodman questioned whether anyone could predict how

markets would evolve over the next year. He wondered how Steve Schwarzman (CEO) and Tony

James (President) would react to such a high profile transaction in the face of such uncertainty. Was

the loan pool a great buying opportunity or a great opportunity to remain on the sidelines?

Citigroup’s Leveraged Loan Exposure

In the second half of 2007, the banking industry and financial markets began to show signs of

considerable stress brought on, in large part, by rising default rates on residential mortgages and the

decline in the value of residential mortgage-backed securities. On November 4, 2007, Citigroup

announced that the decline in the fair value of its $55 billion in U.S. sub-prime related direct

exposures could be as much as 20%.

By the end of 2007, Citigroup’s financial results were

significantly affected by write-downs related to subprime exposures, leveraged lending, a slowdown

in investment banking activities, and the collapse of the private label securitization market. Net

income was down 83%, and the stock price was down 47% relative to 2006. While Citigroup still

appeared to be “well capitalized” from a regulatory capital perspective, its capitalization ratios had

declined despite efforts to bolster them.

With the prospect that it would incur further losses in the

months to come, Citigroup was focused on ensuring that it would continue to meet regulatory capital

requirements.

One particular source of concern was Citigroup’s portfolio of leveraged loans, which at the end of

2007 stood at $22 billion. Most of Citigroup’s leveraged loan exposure was for LBOs that had been

announced in late 2006 and early 2007, including Alltel, First Data, TXU, and Harrah’s Entertainment.

Exhibit 1

lists the largest LBO loans arranged by Citigroup.

Exhibit 2

shows the total volume of

leveraged loan issuance through the first quarter of 2008.

As the lead underwriter of a loan, Citigroup’s goal was to profit from underwriting fees and sell

the bulk of the loans to a syndicate of investors, including other banks, mutual funds, hedge funds,

insurance companies and sponsors of collateralized loan obligations (CLOs) and collateralized debt

obligations (CDOs). As part of the underwriting process, Citigroup would have to commit to fund

the buyout even if it was unable to place the loans with other banks and institutional investors.

The information in this section is drawn from Citigroup’s Securities and Exchange Commission filings covering firm’s

activity in the second half of 2007.

At the moment, the minimum total capital requirement for banks was set at 8% of risk-weighted assets. To be considered

well-capitalized under the Federal Reserve Board Prompt Corrective Actions a bank would have to hold 10% of its risk-

weighted assets. As of December 31, 2007 Citigroup’s total capital ratio was at 10.7%, down from 11.7% a year before.

LBO debt financing was typically committed at the time of the LBO bid. This so called “staple financing” was especially

common for large LBOs. Yet often there would be a substantial delay between the financing commitment and the deal closing.

Blackstone and the Sale of Citigroup’s Loan Portfolio

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large LBO typically used senior unsecured notes in addition to loans. Notes also promised lucrative

underwriting fees and Citigroup was willing to fully guarantee funding by committing to issue a

bridge loan to make up any shortfall in financing. Providing such a funding guarantee facilitated the

transaction, but posed risks to Citigroup in the event it could not place the debt. This risk was

realized in the fall of 2007 when securitization markets shut down and institutional investors were

reluctant to invest in leveraged loans and notes. As a result, Citigroup’s leveraged loan portfolio

ballooned to $22 billion. Several of these positions were leftovers from failed syndicated efforts.

Further, Citigroup had committed to another $21 billion of leveraged loans.

Citigroup’s leveraged loan exposure posed two main challenges for the bank. First, leveraged

loans were costly from a regulatory capital perspective since they received a 100% risk weight. By

contrast, real estate loans only received a 50% risk weight, and highly rated securities only a 20%

weight. With a capital requirement of 8%, this would mean that Citigroup would need $80 million of

capital for every billion dollars of leveraged loans. Reducing its leveraged loan portfolio would ease

Citigroup’s capital requirements, but might entail selling the loans below their fundamental value,

possibly at fire sale prices. The second challenge posed by holding these loans was posed by their

accounting treatment. Since a substantial fraction of these loans was intended to be sold and as such

would be classified as “held-for-sale” under accounting requirements, their value was marked-to-

market. With the leveraged-loan index (LCDX) dropping to 97 cents on the dollar in the fall of 2007

(from par level in summer of the same year), Citigroup had to recognize $1.5 billion losses on its

leveraged loan portfolio for the fiscal year ending on December 31, 2007. By March of 2008, the LCDX

index dropped to 92 cents on the dollar, and analysts estimated that write-downs on the leveraged

loan portfolio for the first quarter of 2008 could be as high as the total leveraged loans related losses

for 2007. Volatility in the pricing of leveraged loans would add further volatility into Citigroup’s

earnings and its stock price.

The Loan Portfolio Transaction

With these concerns in mind, Citigroup approached several large investors, including private

equity firms and hedge funds, about purchasing leveraged loans from its portfolio.

Blackstone, along with its partner, TPG, expressed interest in a portfolio that contained sixteen

different issuers with total face value of $6.11 billion from the total $22 billion portfolio. (See

Exhibit

3.)

Most of the portfolio was comprised of debt used to fund deals reviewed by Blackstone and/or

led by TPG. The largest exposure, accounting for 25% of the portfolio, was debt used to fund the 2007

buyout of Alltel sponsored by TPG and Goldman Sachs Capital. The riskiest debt instrument in the

portfolio was Harrah’s senior unsecured notes used to fund the 2008 LBO sponsored by TPG and

Apollo. These notes comprised 3% of the portfolio.

Overall, roughly 75% of the portfolio was comprised of senior secured debt holding first-lien

claim on borrowers’ fixed and intangible assets. The remaining 25% comprised of unsecured bonds.

For example, Harrah’s buyout was announced on October 2, 2008 and approved by shareholders on December 19, 2006. At that

point, the transaction included commitments of $5.9 billion of equity and $15.8 billion of new debt. Harrah’s was the world’s

largest gaming and lodging company. However, for the transaction to be closed, the buyers had to go through a long and

arduous process of obtaining casino licenses in every state where Harrah’s operated. The necessary regulatory approvals for

Harrah’s were finalized on December 24, 2007, two month ahead of the expected date. The financing of the acquisition was

closed on January 28, 2008.

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Blackstone and the Sale of Citigroup’s Loan Portfolio

The weighted average coupon of the portfolio was LIBOR+309 basis points (bps).

(See

Exhibit 4

for

information on the forward LIBOR.) The weighted average coupon for the senior secured loans in the

portfolio was LIBOR+277 bps. On average, the loans in the portfolio were rated “B”/”B-”.

Financing

After some period of negotiation, Blackstone, TPG and Citigroup set the purchase price for the

$6.11 billion loan portfolio at 83 cents on the dollar.

Citigroup offered to provide 80% leverage for

senior secured loans and 60% leverage for senior unsecured notes. Overall, Citigroup offered non-

recourse debt financing for 75% of the purchase price. According to the deal terms, Blackstone and

TPG would contribute a total of $1.26 billion of equity.

Figure A

Transaction Structure

LIBOR + 309 bps

$6.11 billion

(face value)

loan portfolio

Debt: $3.81 billion

Equity: $1.26 billion

Transaction value: $5.07

billion

LIBOR + 100 bps

Margin calls

Source:

Casewriters.

Citigroup

Buyers

(Blackstone and TPG)

The cost of the Citigroup financing was LIBOR+100 bps. The financing had a tenor that matched

the average maturity of the loans in the portfolio with the interest payment not due until after the

coupon interest was received from the instruments in the portfolio. Moreover, the financing included

a “recycling provision,” which gave Blackstone the ability to use the same financing terms for

reinvestment in any assets as long as the total credit did not exceed $3.81 billion. This meant that

Blackstone could at, any point, further diversify its portfolio by selling some of their positions and

reinvesting the proceeds in other loans. The recycling provision would be available for four years

from the loan closing.

The underlying loan portfolio would be used as collateral on the $3.81 billion financing. If the total

value of the loans fell below 66.4% of its face value (80% of the purchase price), Blackstone and TPG

would have to post additional collateral. (See

Figure A.)

LIBOR is the London Interbank Offer Rate, determined on a daily basis, and based on estimates by a panel of banks of the

rate at which they can borrow on an unsecured basis. Typically, the LIBOR used to calculate the interest rate on the notes and

loan reset on a quarterly basis.

The portfolio valuation was a collaboration between Blackstone private equity arm (Blackstone Capital Partners), its credit

arm (Blackstone Debt Advisors) and recently acquired GSO Capital Partners, a credit-oriented alternative asset manager

focused on the leveraged finance marketplace.

Blackstone and the Sale of Citigroup’s Loan Portfolio

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Assessing the Deal

A key to the investment from Blackstone’s perspective was that the loan portfolio was

substantially undervalued. In its view, Blackstone had carefully selected the portfolio so that the

expected default rates would be smaller than those for average “B”-rated securities, which

historically were estimated at 5.91% for the first year (Exhibit

5).

The default probabilities implied by

credit default swaps (CDS) were substantially higher. For example, the CDS for Harrah’s

Entertainment notes implied a default probability in the subsequent year of 20.82% (=1147.35 bps/(1-

0.449), where 0.449 is the historical recovery rate on defaulted senior unsecured notes).

(Historical

recovery rates are reported in

Exhibit 6. Exhibit 7

provides data on credit default swaps spreads for

the senior unsecured debt of the issuers in the Citigroup loan portfolio.)

Even if the market was indeed wrong, there were several risk factors to consider. Although

Blackstone tried to assemble a diverse portfolio, a default for any individual credit would adversely

impact returns. Blackstone was also not a financial sponsor in the underlying buyouts. If

fundamentals of the underlying issuers were to deteriorate, as a holder of debt, Blackstone would not

have control over managerial and operational decisions.

If the market was mispricing the loans, Blackstone and TPG could just wait for loans to mature.

However, their investment would be subject to quarterly mark-to-market risk. If the market values

continued to drop they could be subject to a margin call, requiring Blackstone to post collateral. This

would adversely impact the equity returns. While the cushion against a margin call seemed

reasonably large, the economic conditions and, specifically, the conditions of the leveraged loan

market had been deteriorating for over half a year. When the market would hit the bottom and when

it would start to recover was hard to say even for a debt market veteran like Goodman. (See

Exhibit 8

for Bennett J. Goodman’s biography).

A CDS is a contract that promises a payoff to the buyer in the event a particular loan or bond defaults (such as failing to make

interest payments or filing for bankruptcy protection). Should a default occur, the buyer of a CDS is paid par value in exchange

for the underlying debt instrument, or is paid the difference between par value and the market value of the debt instrument. In

exchange for this insurance, the buyer makes quarterly payments to the seller. These payments are referred to as the CDS spread

and are quoted in basis points per year. Thus, a loan with a CDS spread of 500 basis points requires the buyer to pay 5% of the

par value to the seller on an yearly basis or 1.25% per quarter. Higher spreads correspond either to a higher default probability,

a lower recovery rate, or both. Here, the recovery rate is assumed fixed. To estimate default probability implied by CDS spreads,

one could use the following formula:

Probability of default in a given year

CDS spread

(1-Recovery rate).

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