December 20, 2007

Margin of Safety: Citadel investment in E-Trade

Citadel investment in E-Trade is a perfect example of the idea of margin of safety. The press have reported on the cash infusion made by Citadel in E-trade as a life line. It is a savvy investment not only for the 27 cents on the dollar purchase of subprime assets, you can argue that this is their market value, but to the value Citadel will gain even in the case of E-trade failure.

In total Citadel invested $2.6 Billion cash in E-trade; $800 million for $3 billion worth of subprime assets and $1.8 billion in a stake in the company, a combination of debt and equity. Citadel injection of $1.8 billion represents a 20% share of E-trade. Still any gains on the subprime papers sale may at best case scenario offset the $1.8 billion invested, if E-trade failed completely. Citadel could not have made the investment if this their margin of safety.

Obviously there are two scenarios for this investment: E-trade will right itself and Citadel will earn interest and capital gain on on its investment. However, the more interesting one is the failure of E-trade: what will Citadel gain?

Citadel is not just a successful hedge fund but it has a large back room operations and institutional services that it markets to other hedge funds and institutional clients. It is one of Citadel competitive advantage over other funds as it lowers its trading costs and hides its training strategies and positions from competitors. Citadel ambition is to be a large diversified financial services firm similar to the likes of Wall Street firms. And some of E-trade assets can be its ticket.

Citadel have grown in leaps and bounds over the last few years and mainly in its back room operations and services. And here where I think the win-win case for Citadel. E-trade has a market making and significant back room operations that have many institutional clients. If E-trade fails, the federal deposit act can cover retail deposits losses and Citadel can gain control of the back room operations. Citadel will not have to pay cent for it in this scenario. So its newly acquired back room operations costing $1.8 billion is far cheaper than doing it on its own.

I can imagine that Citadel have much more detailed analysis and due diligence and i can't wait to read about it at one point in the future. Citadel is great value investor they will be making money no matter what and their downside is very limited.

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