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 -
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
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,
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
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
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.