Citadel Securities filing gives peek at Griffin Bank startup

Citadel Securities LLC, the brokerage firm started by Ken Griffin, reported earnings of $81.6 million on revenue of $1.01 billion last year, providing a glimpse of the hedge-fund manager's efforts to build a competitor to Wall Street banks such as Goldman Sachs Group Inc.

Most of the revenue came from the closely held firm's nine- year-old options and equities market-making business, according to financial statements filed Feb. 25 with the U.S. Securities and Exchange Commission that the agency inadvertently released on its website. Citadel Securities' investment-banking operation, which started up in the fourth quarter, accounted for $5.4 million of revenue.

The filing, which doesn't include comparable 2008 results, shows Griffin used $60 million from a non-hedge-fund affiliate last year to reimburse Citadel Securities for investment-banking costs such as compensation for new hires. He's struggled to find the right people to lead the securities firm, with four senior executives quitting or being pushed out since early 2008.

"While Citadel has a tremendous name as a market-maker and hedge-fund manager, they are a relatively unknown brand in the investment-banking world," said Dushyant Shahrawat, a senior research director at TowerGroup, a financial-services research firm in Needham, Massachusetts. "The Microsofts and Dells of the world need to know Citadel, which takes time."

John Heine, an SEC spokesman in Washington, said the earnings statement, intended for internal agency review, was taken off the site. The portion of the filing required for public disclosure was posted on April 22.

Options to BankingGriffin, 41, oversees $12 billion in hedge funds at Chicago-based Citadel Investment Group LLC, which he founded in 1990 as a student at Harvard University. That firm provides investment and administrative services to Citadel Securities.The combined businesses account for about 8 percent of U.S. stock-market transactions and 30 percent of trading in listed equity options, according to a February letter from Citadel Investment to the SEC.Griffin, in a first for a hedge-fund manager, decided to start his own investment bank following the collapse of Bear Stearns Cos. and Lehman Brothers Holdings Inc. in 2008, even as he struggled with hedge-fund losses of 55 percent that year. Citadel Securities will be "one of the great sales and trading operations" within five years, he said in a September 2009 interview."We are making a significant investment in this business and we see tremendous opportunity for our clients," said Katie Spring, a spokeswoman for Citadel Securities in Chicago. In a May 3 memo to employees, Griffin said the firm had 24 investment-banking deals lined up and more than 500 institutional accounts for sales and trading of high-yield and distressed credits.Competitive ThreatWhile he copes with below-average returns at his hedge funds this year, Griffin could pose a competitive threat to investment banks such as Morgan Stanley and Goldman Sachs as they face possible new U.S. regulation that could cut their profits, said Richard Bove, a financial-services analyst at Rochdale Securities in Lutz, Florida."An unregulated company coming into this sector has a real good shot," said Bove. Citadel Securities, unlike Goldman and Morgan Stanley, isn't overseen as a bank holding company by the Federal Reserve Board, he said.Potential RegulationCongress is debating a legislative overhaul for the financial-services industry that could limit the ability of Wall Street banks to trade with their own capital and subject their derivatives trading to more oversight. Hedge funds may also face more regulation under bills pending in Europe and in the U.S., where Congress may require larger funds to register with the SEC and provide data on their risk-taking.Citadel Securities, incorporated in 2001, started out making markets in equity options, which are financial contracts that entitle the holder to buy or sell stocks at a set price in the future. Griffin hired former Merrill Lynch Co. executive Rohit D'Souza as CEO in October 2008 to diversify Citadel Securities into securities underwriting, institutional sales and trading, and mergers-and-acquisitions advice.When D'Souza left a year later, Griffin replaced him with Patrik Edsparr, only to oust him in April following disagreements over business strategy and management. Citadel Securities didn't actually begin doing deals until last year's fourth quarter, when it helped manage offers by Advanced Micro Devices Inc. and Targa Resources Inc. to buy back debt.Management Turmoil"The turmoil at the top is in many ways a cultural issue," said Brad Hintz, an analyst at Sanford C. Bernstein Co. in New York who follows the securities industry. "The very skill set one needs to exceed in that short-term, immediate- performance world of hedge funds may lead to an unwillingness to be patient in the relationship-oriented world of investment banking."Citadel's biggest hedge funds lost 0.85 percent this year through April. Hedge funds on average rose 2.5 percent in the same period, according to the HFRX Global Hedge Fund Index compiled by Hedge Fund Research Inc.Citadel Securities included its 2009 earnings statement in an annual audited report submitted to the SEC, a requirement for all registered broker-dealers. As allowed by the SEC, Citadel Securities requested confidential treatment for certain portions of the report. Heine decline to comment on why the earnings were published on the SEC website.Principal TransactionsAccording to the confidential filing, Citadel Securities reported $621.6 million of revenue from principal transactions and another $300.4 million from clearance income. The principal transactions category included $717 million in gains recognized last year from trading equity derivatives such as options.Net income for 2009 included the $60 million reimbursement from a non-hedge-fund affiliate for expenses incurred to expand its primary businesses, including investment banking and securities dealing. The payment was meant to offset expenses that "would have otherwise been borne" by Citadel Derivatives Group Investors LLC, a private fund that owns at least 50 percent of Citadel Securities, the filing shows.Several investors in the Citadel Derivatives partnership reported in regulatory filings that they earned a 6.8 percent return last year from the fund, down from 36 percent in 2008. The partnership was set up to hold a stake in the market-making operation that was previously owned by Citadel Wellington LLC, one of the firm's largest hedge funds.Return on EquityAbsent that payment, 2009 net income would have been about $21 million, representing a 1.9 percent return on equity of $1.1 billion. Goldman reported a 22.5 percent return on equity, a measure used to gauge the financial performance of investment banks. New York-based Goldman earned $13.39 billion in 2009."Citadel saw the opportunity with their capital to step in at a time when Wall Street was wounded," said David Mortimer, who runs option sales and trading for Pipeline Trading Systems LLC in New York. "But they are probably finding the banks have come back pretty quickly."Interactive Brokers Group Inc., whose market-making unit had pretax profit margins of 76 percent in 2008, saw its income slashed last year by competition, in part from high-frequency traders. The Greenwich, Connecticut, firm reported a 54 percent pretax operating margin at its market making unit last year, as income before income taxes fell to $330.8 million in 2009 from $1.03 billion in 2008.Citadel Securities recorded compensation and benefit expense of $274.3 million, or about 27 percent of revenue."That 27 percent is a reasonable number," said Richard Repetto, an analyst at Sandler O'Neill Partners LP in New York who follows market-making firms. "In theory, Citadel should never get to the equivalent of the big broker-dealers because it has so much automation," which reduces labor costs.