It all started the morning of Mother’s Day.
A rare Sunday e-mail from Blackstone Group LP invited banks to submit pitches to underwrite 90 million shares in hotel-chain Hilton Worldwide Holdings Inc. that the private equity-firm needed to unload fast -- a $2.7 billion stake.
Dozens of bankers abandoned their mothers and families to cobble together due diligence and propose prices. Bank of America Corp., Citigroup Inc. and Deutsche Bank AG landed the deal, buying 30 million shares each from Blackstone at $29.71 to sell the next day at $29.85. Trouble was, the market didn’t cooperate.
On Monday, May 11, about 26 million shares traded as Hilton’s stock slid to close at $29.69 -- 2 cents below where the firms acquired it. They probably were stuck with about two-thirds, or more, of their positions after that first day, according to people with knowledge of the situation. The stock never recovered, leaving banks to sell at lower prices -- in some cases much lower.
By June 18, the stock had tumbled an additional 4.5 percent to $28.36, while a number of smaller blocks sold into the market. Combined losses at Bank of America, Citigroup and Deutsche Bank may have climbed to about $90 million, said the people, who don’t work at the firms and asked not to be identified because some transactions used to measure losses were confidential. The situation isn’t great for Blackstone either. It still owned 46 percent of Hilton after the deal.
Spokesmen for the three banks and Blackstone declined to comment.
It’s an awkward time to botch a block trade. Much of the Volcker Rule came into force Tuesday, limiting how banks wager their money while letting them continue facilitating clients’ transactions. Handling a block of stock should be fine, as long as banks are conservative enough that the government doesn’t deem it a proprietary bet, said James Angel, a professor of finance at Georgetown University in Washington.
“They run a slight regulatory risk that a year from now some regulator is going to look at the trade and raise questions,” he said. With Volcker so new, “we’re entering a period of rulemaking by enforcement, in which regulators will look at stuff, give it the smell test and say, ‘That’s OK,’ or give it a sniff and say, ‘That’s not OK.’”
The losses weren’t visible in last week’s earnings reports for Bank of America and Citigroup and didn’t matter much to their bottom lines this time: Both firms saw a massive jump in second-quarter profit as litigation and other costs declined. Deutsche Bank is set to report results next week.
However, the losses would’ve been enough to dent quarterly revenue within the banks’ equity capital markets divisions. It underscores the dangers firms must navigate when underwriting block trades and the pressures they face to appease powerful clients and beat competitors.
Such risks haven’t deterred banks from handling a record amount of U.S. block trades this year. More than $20 billion of stock was sold through 43 blocks by July 20, exceeding the amount divested in any previous year by that date, according to data compiled by Bloomberg.
Investment banks can limit their risks by instead handling big sales as marketed offerings, similar to how they manage initial public offerings: They meet with potential buyers, assess demand and set a price based on that.
From a client’s perspective, that book-building method can be costly -- both in time and fees. With block trades, a seller typically tells banks what it wants to unload and gathers bids from them while the market is closed, almost always at a haircut to the stock’s most recent price. The winning banks look to resell those shares for a bit more than they paid, ideally within a day. It all boils down to an educated bet, because banks can’t line up buyers in advance. Things sometimes go wrong.
“Market conditions can change,” said Jay Ritter, a finance professor at the University of Florida who co-authored a paper on follow-on offerings in 2010. “Or they mis-guess what the market is going to be willing to pay, and the underwriters wind up taking a bath.”
The new rules increase the pressure on banks to get it right so they don’t raise red flags with regulators, said Angel, the Georgetown professor.
“Volcker makes the trades riskier for the dealers, and therefore they have to charge more for it,” he said. “They will obviously try to give themselves as big a cushion as possible. But they are in a competitive industry.”