Citadel comes to the defense of E*Trade

Fri Jun 26, 2009


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By Pete Gallo

There is often a thin line between prudence in preserving wealth and the act of throwing more money at a bad investment out of engulfing denial. Only hindsight will show which is the case regarding a June decision by Ken Griffin's Citadel Investment Group to deepen its financial exposure to embattled online retail brokerage firm E*Trade Financial.

Citadel is a long-term investor and the largest shareholder in E*Trade, a company whose stock price fell from $3.70 one year ago to a low of roughly 60 cents late in the first quarter of this year. The good news is that the stock has rebounded somewhat, hitting $1.65 on June 16.

But that's about the only good news. Severe recessions aren't the best times for retail brokers like E*Trade, as its client base - the herd of semiprofessional day traders - inevitably thins.

Still, all indications are that Citadel is far from abandoning the company. On June 9, Griffin put himself in a hands-on position by joining the board, giving the stock a notable 3% gain in a single trading session.

Griffin is clearly determined to protect Citadel's investment in E*Trade, which was initiated in 2007, when the hedge fund took an approximately 18% stake in the company along with some $3 billion in asset-backed debt, according to regulatory filings with the U.S. Securities and Exchange Commission. That's no pocket change, even to a hedge fund giant like Chicago-based Citadel, which has shrunk significantly after experiencing losses last year.

And Griffin apparently isn't playing his new board role as a passive consultant. Two weeks after the hedge fund chief joined the board, E*Trade disclosed in SEC filings that Citadel had taken an additional 90.9 million shares in the company (at a price of $1.10) as part of a larger offering that raised $435 million. E*Trade also said that it planned to exchange debt for stock later in the month to further a planned $1.2 billion recapitalization.

The E*Trade recapitalization was ordered by the U.S. Office of Thrift Supervision in April. Citadel's most recent cash infusion, combined with a forthcoming debt-for-equity swap, will satisfy the conditions set by regulators.

But Citadel itself has to be careful of the regulators. The rules of the road say Griffin's investment shop cannot take on unlimited exposure to the financial company without risking coming under the same OTS oversight as E*Trade, making the latter's restructuring a delicate, though clearly manageable, balancing act.

Surely, the homegrown expertise on Citadel's equity and debt desks will prove a valuable asset in E*Trade's restructuring. Citadel's involvment may also hint at a larger role for hedge funds in the financial sector, filling some of the gaps left by the decimation of investment banks.

And Citadel's strength in execution and systems may help E*Trade as well once it gets back on track. Although Citadel is clearly not an activist investor per se, one has to wonder why the firm didn't take a more hands-on role with E*Trade years ago, considering the good fit and Citadel's massive equity and bond investment.

Citadel has sold some shares since its initial 2007 investment. The most recent purchase raised the hedge fund's stake from 15.6% to 17%, according to SEC filings.

Citadel is the force of private enterprise in the tale of E*Trade's retrenchment. The company has also applied for roughly $800 million in bailout money under the federal government's Troubled Asset Relief Program. E*Trade asked for federal relief roughly nine months ago, but as of June 19 had yet to receive an answer.

Without the recent capital raising (with the help of Citadel), E*Trade would have faced a cease-and-desist order from the OTS, according to SEC filings by the retail brokerage. In that light, Citadel simply couldn't risk losing its entire investment in E*Trade, making a defensive restructuring and a board role for Griffin the smart and only play for the hedge fund.

E*Trade is on anything but sure ground. On June 19, Standard & Poor's downgraded the retail brokerage group's long-term rating from double C to triple-C minus. The view from S&P was that restructuring "will modestly improve the foundation, lengthen the maturity structure of the holding company's long-term debt, and materially lower interest servicing requirements. But we view these transactions as a short-term fix to a long-term problem."

Citadel's efforts have thrown E*Trade a lifeline. But it's very hard to conceive of a winning exit strategy, short of a sustained upturn in the market. Unless, that is, the hedge fund firm wants to enter the retail market.

ISSN: 2151-1845 / CDC10004H