A recent transaction between Blackstone Group LP (“Blackstone”) and Citigroup may well signal future opportunities for capital providers including private equity firms. While that particular transaction appears most appropriate for diversified asset management firms, it may suggest ways for private equity firms to utilize committed capital to provide targeted credit support. It also is another variation of the type of derisking transaction we discuss on page 5 of this issue in the article “Pension Derisking: New Ways to Manage Old Pension Liabilities.” We discuss the transaction and its implications for private equity firms below.
According to public reports, Citigroup transferred a portion of the credit risk relating to a $1.2 billion pool of shipping loans on its balance sheet to an affiliate of Blackstone through an insurance arrangement. Blackstone provided this insurance through a synthetic securitization structure: Citigroup entered into a credit default swap (“CDS”) with a separately capitalized Blackstone entity as counterparty, with the CDS insuring a portion of the credit risk of the loan pool. Under its regulatory capital rules, Citigroup used the CDS to reduce the amount of capital it was required to hold against the loan pool, thereby allowing it to deploy existing capital more efficiently.
Implications and Future Opportunities
The key motivator for Citigroup was its desire to secure capital relief under the so-called “Basel III” capital rules, which will be phased in over a multi-year period and are expected to substantially increase regulatory capital requirements for U.S. banking organizations, particularly those with significant trading activities.1 Given the sizeable costs associated with these increased capital requirements, U.S. banking organizations must consider not only whether transaction structures achieve underlying economic and tax objectives, but also whether they are capital efficient under Basel III. It is, therefore, not surprising that other U.S. banking organizations are actively considering these types of transactions: indeed, other major U.S. banking organizations have structured similar deals. For example, we recently advised an insurance company that proposed to issue an insurance policy to a banking organization specifically to secure capital relief under the Basel framework (the transaction was never consummated). In that proposed transaction, the underlying policy and the risks it insured were structured to meet specific requirements under the regulatory capital rules.
It appears likely that these types of risk transfer transactions will become more popular as the Basel III capital requirements come into effect. The Blackstone transaction, as well as our own experience, demonstrate that these transactions can accommodate a variety of counterparties (e.g., insurance groups or funds) and structuring options (e.g., tailoring risk transfer arrangements to specific provisions of the regulatory capital rules). These transactions appear to be particularly good opportunities for funds to generate revenue by providing targeted credit support, while retaining the ability to actively deploy capital as needed.
While it remains to be seen if transactions of this type can be structured in ways that are appropriate and attractive for a traditional private equity fund, it is yet another example of the innovative emerging opportunities for capital providers to make effective use of balance sheet capital as banking organizations adjust to the post-crisis regulatory paradigm. We will keep you updated on future developments in this area.
1. For more information on implementation of the Basel III capital requirements in the United States, see Debevoise & Plimpton Client Update, The New Capital Framework Proposals: Enhanced Burdens Across the Banking Industry (June 13, 2012).