INTELLECTUAL PROPERTY: Cutting the nose off to spite the face

Zoe Hughes

Once the largest financial institution in the US, Citi is now only the third largest after racking up more than $100 billion of credit losses and write downs during the credit crisis … Every bank has been forced to change its focus.

Buying at the height and selling out at the bottom is the antithesis of what any financial institution should do. However, that’s exactly what Citi is doing after deciding to sell its private equity real estate platform, Citi Property Investors. Five years after first launching the group, Citi has now placed CPI into its “bad bank” holding structure while it talks with the limited partners of its five property vehicles regarding a potential sale.

The bank is following the lead of other large financial services organizations in trying to reduce its balance sheet volatility by exiting principal investment businesses. But in doing so, banks like Citi are merely cutting off their noses to spite their faces. Citi’s decision is certainly not about generating cash.

When Lehman Brothers Holdings approved a management buyout of its platform, the deal was sealed for “much less” than $10 million, according to sources. That transaction saw Lehman Brothers Real Estate Private Equity’s existing management team take over the management entity of REPE and the management of its three opportunistic funds. As part of the deal, LPs and Lehman were allowed to forgo their unfunded commitments.

Like Lehman, Citi is believed to be considering selling the management entity of CPI, rather than its GP stakes in the property funds. Whether that takes the form of a management buyout, a third party sale or simply managing its existing assets and funds, few can say.

People familiar with the matter, though, said the bank was watching the disposal of Lehman, AIG and Merrill Lynch’s private equity real estate groups with interest. For Citi, the move is understandably about reducing risk.

Once the largest financial institution in the US, Citi is now only the third largest after racking up more than $100 billion of credit losses and write downs during the credit crisis that started in 2007. Every bank has been forced to change its focus. But will selling a people business, such as CPI, leave Citi any less exposed?

People close to the process told PERE one option was “no more likely” than the other. However, an external sale could be fraught with issues for Citi. 67 percent of limited partners in CPI funds have to approve any sale. For those LPs that disagree with the disposition, they will likely have the right to withdraw their unfunded commitments – one of the most appealing aspects of a fund manager acquiring a private equity real estate platform in the first place.

LPs that did remain though could be tempted to think again if the existing management team dissolved following a third party sale. After all, what incentives will there be for CPI veterans to stay loyal once a new parent company is put in situ? Such a loss of knowledge is unappealing for all sides. Of course, a management buyout is no less tricky. If Citi follows the Lehman route, the bank would still have some skin in the game with its, albeit reduced, GP stakes.

The management team, though, knows the legacy assets intimately and, like Lehman’s REPE team, could be incentivised to manage them proactively, while being able to position itself for future independent growth. As reported in this issue of PERE, CPI president and chief executive officer Roger Orf is not believed to be actively pursuing a management buyout, although sources said he has told Citi and CPI limited partners he would throw his hat into the ring if so desired.

The middle way of taking no action and simply managing the existing portfolio will please no side, including the current management team, who will have no potential for future carry, and limited partners, who haven’t paid five years' worth of fees to end up with an asset management service.

Precedent suggests a management buyout will be the most likely outcome. Either way, the decision to exit the business will ensure Citi misses out on the potential for a second chance to generate outsized returns and build the world class real estate platform they originally attempted.