Citigroup Alternative Investments last month launched a pioneering structured investment vehicle. It boosts leverage to the subordinated noteholder without really increasing the risk and will widen the potential investor base. Edward Russell-Walling talks to the team.
Within the careful world of structured investment vehicles (SIVs), evolution has generally taken its time. But Citigroup’s latest vehicle – launched 16 years after its pioneering prototype – represents a remarkable leap forward. The team that designed it hopes it will provide a significant boost to the SIV sector, by changing the nature of the product and widening the potential investor base.
Citi’s new SIV is called Sedna, after the Inuit goddess of the sea. She was a girl who had some very nasty experiences before attaining divinity – read into that what you will. Last year, however, her name was also given to a newly discovered planetoid. Lying far beyond Pluto, Sedna is the remotest body yet sighted in our own solar system.
In that spirit, Sedna Finance Corporation dares to boldly go into what, for SIVs, is uncharted space. In September, it raised $80.5m in the first tranches of its revolutionary two-tier capital structure, which should enable it to buy some $2bn of assets. But then Citigroup has always been a trailblazer in this market, having created the first SIV, called Alpha, in 1988.
Alpha matured 10 years later, but four of its successors (Beta, Centauri, Dorada and Five) operate to this day. Together they hold some $42bn of assets – about 40% of the total SIV market, Citigroup estimates. All four vehicles are managed by London Credit Structures, which sits inside the Global Credit Structures unit of Citigroup Alternative Investments.
Alongside London Credit Structures, Citigroup has now established a new business, SIV Strategies, responsible for the creation and management of Sedna. SIV Strategies is headed by group managing director Tim Greatorex, who co-led the Centauri project in 1996. He says that present market conditions are not unlike those that prompted the creation of Alpha.
“The first SIV was designed in response to a spread environment much like today’s,” explains Mr Greatorex. “Spreads to high quality borrowers were compressed and, if you were looking to achieve much more yield, you had to go down the credit spectrum or take other forms of risk.”
Alpha used highly rated paper to borrow at the best rates and invested the proceeds very safely in what was ultimately a mix of credit arbitrage and maturity transformation strategies, but without taking any market risk. Alpha and other traditional SIVs have had a two-tier funding structure, consisting of top-rated senior debt and a smaller piece of privately placed subordinated capital notes that did not carry a public rating. By investing in the highest quality securities and hedging currency and interest rate risk, the leverage provided by the cheap finance at the top of the structure has enabled SIVs to produce attractive and stable returns for investors.
While SIV formation surged through the 1990s and the early part of the new millennium, it has since slowed considerably, as managers have found it increasingly hard to place the subordinated capital notes. Indeed, no new SIV has launched since the end of 2002.
Mr Greatorex maintains that Citigroup’s reputation and placing power have enabled it to avoid these problems, but agrees that Sedna was designed within this context.
Leverage boost
The new vehicle’s most dramatic feature is the way in which it boosts leverage to the subordinated noteholder, but arguably without increasing the key risks. Alpha’s leverage ratio was around five times. “Later, it was possible to raise the ratio by managing and measuring risks more effectively,” says Mr Greatorex. “With Centauri and Dorada, the maximum leverage went up to around 20 times, but that was about as far as it would go using the existing structure. Sedna’s big innovation has been to change the liability structure.”
In the fullness of time, Sedna hopes to issue $15bn of top-rated debt (first priority senior notes, or FPS) and to raise a further $1bn in sub-triple A financing. The major difference is that this element will itself be split into two: single A-rated second priority senior notes (SPS), and un-rated subordinated notes.
The SPS tranche should attract a broader range of investors and be cheaper and simpler to sell. “This is a tradeable, rated debt instrument with a defined coupon, just like any other Eurobond,” explains Richard Burrows, SIV Strategies’ head of funding. “As such, it will allow us to tap into a wider investor base.”
The subordinated notes will continue to be placed in the time-honoured, rather painstaking, way, but they will now offer a degree of leverage previously unheard of – over 100 times.
Sedna has been two years in the making, and one of the principal challenges was how to balance risk appropriately between these three tranches of capital. “Achieving the right risk/reward ratio was difficult,” admits Paul Goody, product development chief at SIV Strategies and one of Sedna’s key architects. “Ultimately, we had to provide sufficient protection to achieve a solid single A rating on the SPS notes, while at the same time ensuring that the real rewards of the structure flowed through to the subordinated note investors.”
Key to sustaining the high leverage is the process of achieving and maintaining the FPS and (particularly) SPS credit ratings. Part of the price to be paid for this is a reduction of risk on the asset side, and Sedna’s portfolio limits are stricter than usual. While traditional SIVs can invest in triple B rated paper, Sedna may not buy anything below single A.
“Sedna will invest in very high quality debt securities,” says Stuart Crouch, Sedna’s head of investments. “Typically at least half of the portfolio will be triple A, with the rest split between double A and single A.”
Sedna can only lend to obligors rated A-/A3 or higher and its investments will be confined almost exclusively to banking and financial paper, and asset-backed securities. “The focus is very much on stability, and that pushes you towards these two sectors,” Mr Crouch explains.
More unusually, Sedna will also use synthetic credit exposure to account for up to 20% of its balance sheet. As Mr Greatorex points out, writing single name default swaps reduces liquidity and liquidation risk compared to funded investments.
He suspects that the new vehicle will be something of a pioneer in writing credit protection. “I don’t know if Sedna will be the first SIV to be active in credit derivatives,” he says, “but I expect it to play a more significant role in that market than other SIVs.”
To justify its ratings, Sedna will run a proprietary capital adequacy model on a weekly basis. “We run a million simulations each week for each rating agency,” says Mr Goody. “Each simulation covers up to 10 years in real time, which makes 10 million years of activity.”
So how will the investors react? “The subordinated notes are very interesting. They are one of the more highly leveraged instruments in the capital markets, but leveraged in a very safe way,” says Mr Greatorex. “When you are lending to safe counterparties, leverage is not, in itself, a bad thing – it just provides more return. Yes, there is more credit risk than with a traditional structure, but taking leveraged credit risk is actually the whole point of a SIV. The other risks, liquidity or liquidation, are actually reduced by the higher asset quality and slightly lower ratio of triple A debt to the remainder of the liability structure.”
The result is that, instead of customary SIV capital returns of Libor plus, say, 250bps, Sedna is looking at a spread of 10% or more in the medium term.
In this climate, those are very attractive rewards but, as Mr Greatorex acknowledges, three-figure multiples of leverage take a little getting used to. “The challenge is to persuade investors to buy the subordinated notes,” he says. While the analysts think the returns are wonderful, the investment committee and the CIO need to be persuaded that leverage at this level can still represent safe credit risk.
Investor interest
There is, nonetheless, a strong pipeline of interest, Mr Greatorex says. The bank has now successfully placed $13.5m in subordinated notes and another $67m in SPS paper, with further issuance expected shortly. Since the company began operations on September 16, it has issued more than $300m of FPS notes, and is building its asset book.
The aim is to grow the asset base to more than $15bn over a five to seven-year period, with new tranches of subordinated notes being issued once or twice a year. “It’s important to grow in phases; if you had $100m in subordinated notes all at once, you couldn’t do anything with it,” Mr Greatorex says.
Beyond its own growth prospects, Sedna has a wider strategic role to play – as a pathfinder in Citigroup’s mission to expand its total SIV universe. “Our aim is to grow Global Credit Structures’ assets to $100bn in the next five to 10 years,” Mr Greatorex maintains. “We hope Sedna will help to give us momentum for that growth.”
