Candidate 30171

1.Does this transaction seem sensible for Blackstone? Why does Citigroup wish to sell the
portfolio of leveraged loans?

From Blackstone’s point of view:

Considering a risk-return analysis.
Risks for Blackstone:
- Exposure to market risk due to mark-to-market debt from Citigroup.
- Uncertainty in financial markets, potential deep recession.
- Risk of providing additional collateral if loan value drops below a certain percentage.
- Operational risks from defaults, without the power to influence management decisions.

Return Potential for Blackstone:

- Conducted research and due diligence to understand portfolio risks.
- Partnership with TPG, which has insights from participating in the loan’s original LBOs.
- Potential to buy loans at values below their fundamental worth, as Citigroup has suffered
losses on these loans.

From Citigroup’s point of view:

- The loan volume presents challenges for Citigroup.
Regulatory capital cost:
- Leveraged loans are costly, with a 100% risk weight, requiring higher returns.
- An 8% capital requirement necessitates $80 million of capital for every billion of leveraged
loans.

Strategic Financial Moves:

- Selling leveraged loans eases the capital requirement burden.
- Mark-to-market accounting has led to significant losses due to falling loan values.

Impact on Financials:
- Citigroup’s earnings and stock price are affected by the volatile leveraged-loan market.
- Quantitative pricing methods needed to determine the transaction's meaningfulness for
financial institutions.
2. What is the value of the deal in terms of NPV and IRR?

For NPV, I’ll use the DCF approach using the following formula. Expected Discounted Cash Flow
= (interest payment * Prob(survival)+recovery Rate * Prob (default))/Discount Rate
For IRR, NPV should be 0
I’ll use the discount rate of 11.27%
And with all that I get IRR of 27.67%

3. Assess the purchase price using CDS spread.

a.Using historical recovery rates, what is the implied probability of default? The implied IRR?
The implied probability of default and implied Internal Rate of Return (IRR) using historical
data. For the default probability, I determine it by dividing the Credit Default Swap (CDS)
spread by the complement of the recovery rate. Selecting data from March 1 to March 14,
2008, taking into account both secured and unsecured debts, with adjustments based on
debt types and their proportions in the portfolio. It result in a 23.57% annual default rate,
factoring in a weighted average recovery rate of 69.35%.For the implied IRR, we update our
model to reflect the 23.57% default rate. The higher default rate, coupled with a relatively
high recovery rate, influences the net cash flow, particularly making it negative in Year 5 due
to decreased chances of full principal recovery and ongoing obligations. This results in a
total undiscounted cash flow of -$312 million over five years, making IRR calculation
infeasible under these conditions.Additionally, a scenario analysis using August 2007 data
with more favourable market conditions suggests a lower implied default rate of 15% and an
implied IRR of 25.46%, indicating how market sentiment can significantly impact financial
outcomes.

b.Buying a loan with a CDS on the loan essentially makes the investor’s payoffs riskless. What a
re the annual cash flows from such an investment? How would you discount and thus value tho
se cash flows?
In my analysis, I simplify the annual cash flows from investing in a loan combined with
purchasing a Credit Default Swap (CDS) on that loan. This approach essentially removes
the investment risk. There are two key adjustments to the annual cash flows:
1. If the loan defaults, the CDS issuer ensures full payment to the investor, resulting in a
100% recovery rate.
2. If the loan doesn't default in a given year, the investor pays a CDS premium, reducing the
net cash flow from interest or principal by the premium amount.
For discounting these cash flows, the investment, being secured by the CDS, should be
discounted at the risk-free rate. I consider two options: the forward LIBOR and the swap
curve. The swap curve is preferred over LIBOR because while LIBOR only accounts for
interest rate risk, it does not encapsulate all other risks like an asset swap does. However, I
discard using the swap curve as a benchmark due to discrepancies between portfolio returns
and CDS spreads reflecting crisis sentiment versus future market recovery.
Using the same method as in a previous analysis, I value this investment at $5.381 billion, or
$88.08 for every $100 of debt face value.
4. What valuation approach seems best?

In my analysis, I compare two valuation approaches based on their treatment of default

probability. The first approach relies on historical data spanning from 1981 to 2005, a period
marked by significant economic crises and recoveries, including the early 1980s global
economic downturn, the US loan crisis, the Asian financial crisis, and the dot-com bubble.
This method assumes the market will recover from recessions, using historical default rates
to estimate fair value without the influence of current market sentiment.
The second approach, however, adopts a market-based perspective, particularly relevant in
the context of the economic expansion leading up to and immediately following the collapse
of Lehman Brothers. This method uses Credit Default Swap (CDS) spreads, which reflect
contemporary market views and the perceived risk of default. Given that CDS spreads
began to widen in early 2007, indicating growing concern among major financial institutions
about impending risks, this approach is deemed more suitable for pricing the deal under the
circumstances of increasing market volatility and uncertainty.
I have greater confidence in the market-based approach utilizing CDS spreads for valuation.
This preference stems from its ability to capture real-time market sentiments and risks,
offering a more immediate and relevant assessment of default probabilities in rapidly
changing economic environments.