Citigroup needed to sell off its large loan exposure in 2007, but struggled to find investors willing to buy its leveraged loans and were willing to deeply discount the price received. The private equity firms took it as a great opportunity to earn equity-type returns from the leveraged loan industry’s difficulties.
From private equity firm’s perspective, the Citigroup loan portfolio transaction allowed diversification, better financial performance, and higher lending volumes without any extra operational support. Private equity firms could earn 10% discount on the purchase of the loan portfolio from Citigroup at an attractive price of 90 cents on the dollar. The potential return should be higher than 10% since the loan prices would definitely increase given that large-scale buyers were stepping in. Private equity firms would gain profit if demand for the loans pushes prices above Citigroup’s discounted sale price. This transaction also enabled them to utilize capital levels that might otherwise be too high given the refinancing situation at that time.
After the transaction, Citigroup would no longer have to mark down the original leveraged loans if their value fell further. From Citigroup’s perspective, it would also send a positive signal to the market that it confirmed the recorded values of other leveraged loans in its portfolio and turned over the shrinking situation of its balance sheet. It helped Citigroup not only remove or at least greatly reduce the risks that Citi might not wish to retain, but also to avoid having too little capital by transferring the loans off the balance sheet through the ownership shift. In other words, the sale of Citigroup’s leveraged loan portfolio allowed its balance sheet to maintain its full capacity. In addition, Citigroup expected coupon payments on the $7.8 billion debt from the private equity firms regardless of the leveraged loan default and could obtain a protection to claim the private equity funds’ assets if the funds failed to pay Citigroup additional collateral for the decrease of the value of leveraged loans.
The present value of loan portfolio less the acquisition costs will provide the PE firms with an understanding of their gain on this sale. Multiple assumptions were necessary to determine the calculation, each varying in impact on the eventual valuation. Taking all assumptions and various sensitivity analyses into consideration, the deal does make sense relative to the assumptions listed. The net present value for private equity firms is slightly below $2 billion; the present value of the loan is slightly below $5 billion (see Appendix A). Given the worst case scenarios and variability, we still feel that this is a great investment due to the investment generating positive NPV given most scenarios.
The assumptions used to calculate NPV and PV of the loan are as follows. * BB Credit Rating: We have determined that a BB credit rating was best for this loan. Based on the B- rating of Harrah’s entertainment, their riskiest loan with the highest credit spread, we felt that a BB rating would be best based on the weights of the portfolio. This rating provided us an estimate of the yearly default probability: 1.2% (based on info provided). * Tenor: We assumed that the remainder of the whole portfolio would last 5 years, and cash flows were discounted back on an annual basis. We used five years because we felt that the market would be unwilling to accept a long tenor during such an illiquid time. * Incremental Cash Flows: The cash flows calculated on annual basis were based on the floating rates received from the $12.5 billion loan as well as the rates paid to Citibank from the $7.8 billion loan. Calculating the cash flows together instead of separately makes the project riskier due to it being highly levered. This is why we needed a slightly higher re-levered beta. *