North America Equity House

IFR Review of the Year 2012
9 min read
Owen Wild, Robert Sherwood

Rumble in the ECM jungle: An explosion in overnight risk trades in the US has broken the cosy cartel that saw US ECM teams for years earn huge fees. For applying the lessons from its European experience and aggressively promoting the profit-share approach to blocks – for the benefit of clients – Citigroup is IFR’s North America Equity House of the Year.

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The method with which Citigroup has rebuilt its equity capital markets business in the US is, without doubt, controversial. The bank upset the US ECM apple cart – and rival bankers – by opening its chequebook to buy block transactions.

Doing so led to Citigroup ending IFR’s 2012 awards year in top spot for US ECM with league table credit of US$25.5bn across 182 deals. The bank’s 12.5% market share was comfortably ahead of the 11.2% earned by both Bank of America Merrill Lynch and Barclays.

But it is the trajectory of the past three years that truly marks out the bank. In 2010, the bank’s market share was just 4.9% (if its self-led US$17.6bn follow-on is excluded) while in 2011 it was 8.6%.

The 2010 performance was perhaps artificially low as the institution was still rebuilding and some of the gains in the past two years represent reversion to the mean. But there is no doubt that Citigroup’s ECM team is now batting well above average.

Breaking the cartel

The bank reached this level by aggressively committing capital to purchase blocks of stock from corporations and financial sponsors.

Block trades are now an established part of the ECM landscape in the US, as they have been for many years in Europe and Asia. Many ECM bankers do not like the practice but it is here to stay.

That ECM pros dislike blocks is not surprising, as such deals often result in lower fees for taking more risk.

Standard marketed selldowns typically pay bankers around 4% (a bit less for small deals, a bit more for large deals). Citigroup’s aggressive encouragement of risk trades undoubtedly undermines that – to the benefit of clients. Sellers of stock, after all, love exactly what bankers hate – they get risk-free solutions and pay less for the privilege.

“There is no need for a company that is highly liquid and can access the capital markets very efficiently to pay a 5% gross spread across multiple bookrunners,” said Phil Drury, who runs ECM for the Americas at Citi with Doug Adams.

And clearly if Citigroup can earn more than 1% on a sole-led risk transaction the rewards are greater than a 5% spread split five ways (even if the risks are increased).

Competitors decry the practice as unsophisticated and little more than an attempt to purchase league table credit, going so far as to point out the irony that an institution that breached on risk would make risk the foundation of its ECM business.

Another reason rivals hate Citigroup’s focus on blocks is that it has allowed it to tempt away hitherto loyal clients.

“Defending your clients is part of capital markets. If you leave them open, then we are going to come in and take them,” said John Chirico, Citigroup’s head of capital markets origination for the Americas.

It is also a fact (one that some don’t like to acknowledge) that block trades require something which should be fundamental to a good ECM operation: an accurate read on where demand lies for a particular stock and at what price it clears.

Whatever the rights and wrongs, though, the growing demand from corporations and sponsors is indisputable.

A total of US$76.1bn in stock sales was conducted on a capital-committed basis during the awards year, nearly half of overall follow-on volumes (US$160.8bn) and by far the highest figure in history – the previous high watermark of US$18.5bn occurred in 2004, according to Thomson Reuters.

The art of the block

Of course, not all blocks are the same. The trick is to avoid where possible the “dumb risk” of bidding wildly in an auction in favour of backstopping deals following exclusive negotiations with a seller. Citigroup claims plausibly to have achieved a sensible balance between the two.

Citigroup’s US$1.13bn purchase of Ventas shares on January 4 sent shockwaves through the ECM community, but validates the bank’s claim. The commitment, the largest ever for a REIT stock sale and the fifth-largest purchase of stock in any sector, was all-secondary, in a stock that paid a yield. Most importantly, the purchase price was negotiated prior to launch.

“Heading out of the gate, we knew that investors would be giant buyers of equity, especially equity with a yield component,” said Chirico. “We called it early with Ventas, and that set things off and running.”

Key to the negotiations with Lazard Real Estate Partners, the selling stockholder, was an agreement that provided a guaranteed price but included a profit share between bank and seller if the stock was placed above that level. Upside participation aligned the seller’s and bank’s interests far more effectively than a pure agency trade with the bank earning a flat 5%.

Overnight marketing of the 21m share block culminated in pricing at US$53.65, locking in a US$4.2m profit for the parties. That the stock traded up, closing the following day at US$53.80, proved a vindication of unmet investor appetite for yield-oriented investments.

Citigroup has extensive experience from the other regions of how risky the block business can be, including its own share of expensive failures. The approach in the US has been to use the profits of each trade to back the next. If they were wiped out on any trade then it might be game over for the year.

Citigroup rolled over profits, that started with Ventas, into two transactions in February, six in March, two more in April, and six each in May and June. In total, the bank committed US$12.4bn across 40 transactions.

Some of those resulted from auctions, but crucially two-thirds were a result of negotiations with a profit share, including a US$3bn monetisation of Capital One by ING in September. Citigroup lost money on just two situations, by the bank’s own reckoning.

Signs of weakness?

IPOs, an enduring measure of ongoing business, were a weak spot within the Citigroup platform as the bank underwrote US$3.9bn of business for 35 clients, giving it 9.1% market share and seventh place in the US league table. However, the large syndicates are shown by market leader Bank of America Merrill Lynch claiming top spot with an 11.1% share on apportioned volume of US$4.7bn across 42 transactions.

Citigroup had a hand in six of the 10 largest IPOs of year, including key appointments on influential transactions such as LinnCo, Carlyle Group, and Allison Transmission. The bank’s resume includes a coveted spot as stabilisation agent on Berry Plastics’ US$470m IPO in October that was mandated by Apollo Group long after the private equity firm filed initial documents on the transaction.

It was also involved on the controversial Facebook listing, but was not an influential player in the decisions around that deal, which were driven by Morgan Stanley and (to a lesser extent) Goldman Sachs.

“The strength of a bank’s IPO franchise is not in the number of deals in a given year,” said Clayton Hale, head of strategic equity solutions. “It is in the sorts of deals you are mandated on, how you get them done and why you are chosen.”

All of this activity was overseen by a team with decades’ worth of ECM experience. Tyler Dickson, now head of global capital markets origination, but previously global head of ECM at the bank during the explosion in risk trades in Europe in the mid-noughties, summed it up. “Citigroup was able to drive our number one volume position because of our ability to read markets; come in aggressively early in the year in educated risk in the block trade market, to identify unique windows for best-in-class IPOs and a number of sponsor monetisations,” he said.

Rumble in the ECM jungle