Market Thinking

making sense of the narrative

Paging Michael Lewis

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The revelation this week not only that Wirecard has filed for insolvency and CEO Marcus Braun been arrested, but that the ex derivative traders now running the SoftBank Vision fund had constructed something akin to a pump and dump scheme for a convertible bond scheme are building into a saga that needs the skills of someone like Michael Lewis to write a whole book about it.

In the absence of someone more talented, I will try to do it some justice, not least because it brings together a number of important market themes. As good a place to start as any is perhaps with SoftBank, or SoftTouch as we are now going to call it. Seemingly having broken with the past tradition of large Japanese corporates being taken for a ride by canny westerners, SoftTouch – which importantly is a conglomerate not a bank – was founded in September 1981 by Masayoshi Son, then only 24 years old and was basically a publisher, but their big break came with a joint venture in the 1990s with Yahoo and the creation of Yahoo Japan. Then, referring back to our article on Foxes versus Hedgehogs they hit the “One Big Thing’ or OBT; a $20m investment in a tiny startup called AliBaba, which made them $60bn when AliBaba went public in 2014 and as reported this week is now worth $150bn. SoftTouch subsequently traded like any conglomerate, mainly in the tech and telecom space, culminating in the purchase of UK chip designed ARM in 2016. However, there was always a suspicion that Mr Son got one very big and very lucky break. An accidental Hedgehog who thinks he is a fox.

However, it was in 2017 that things began to get interesting from our point of view. SoftTouch teamed up with the Saudi Arabia Sovereign Wealth Fund to launch the so called Vision Fund, with $100bn of funding for technology investments. Importantly, what wasn’t really explained at the time was that the Saudis and another Middle East Sovereign wealth fund from Abu Dhabi, Mubadala, did not so much invest, but bought convertible bonds, issued by the Vision Fund, making for a relatively high cost of capital. The fact that the Vision Fund was not being run by a tech visionary skilled in identifying future winners, but by a former derivatives trader from Deutsche Bank was not much highlighted either. Rajeev Misra had been second in command to Anshu Jain, at DB at the time of the financial crisis and his role at the Vision Fund was clearly one of capital raising. One of their early investments was WeWork, which will probably have a book written about it all to itself, as well as Uber. Both stocks were heavily written down this year leading to an $18bn loss at the Vision Fund. In turn this has led to problems at the underlying SoftTouch, with borrowings from the big Japanese lenders now approaching 2 trillion Yen ($20bn). Vision Fund has now announced that it is laying off 15% of its 500 staff, even as Rajeev Misra’s pay was doubled to $15m.

So here we have SoftTouch being led by a capital markets trader, pouring money into all sorts of tech start ups, including ones such as WontWork where the tech aspect is dubious to say the least and where the recipients of the ‘investment’ seem particularly keen to consume it as quickly as possible in the manner of the comedy/documentary that is HBOs Silicon Valley. This is point 1, with the launch of VisionFund, SoftTouch has fuelled an already overheated tech startup boom, mainly in the US, which has led to excess demand for cloud services and digital advertising as well as weest coast real estate. Moreover, as a buyer from VC funds it has enabled the earlier stages of the infrastructure as well.

Next we have the same SoftTouch involved in alleged round-tripping, where they invest in a fund, that in turn lends money to companies where the Vision Fund has investments. As reported by the FT (who have really upped their game recently in this area) SoftTouch quietly put $500m into these Credit Suisse /GAM supply chain funds. Meanwhile, as we pointed out last week, the ‘bank’ at the centre of this supply chain strategy is run by a man called Lex Greensill, a former Morgan Stanley Banker based in Australia, who was also a beneficiary of investment from SoftTouch, a small part of which he put to good use in buying four private jets. The potential for conflicts of interest are obviously significant and as noted last week, the fact that several of the counter-parties to the reverse factoring business have defaulted, most notably BR Shetty of NMC healthcare and finablr and Sanjeev Gupta of GFG Alliance has led to a run for the exits from the Credit Suisse funds by institutional investors who were told such funds were ‘safe’.

This then is point 2. The foolishness of the risk management process whereby institutional investors basically continue to be told that since volatility equals risk, they must avoid it and that illiquid bonds are therefore ‘safer’ than liquid equities. We have seemingly learned nothing from the Financial Crisis when the same institutions were herded into illiquid credit structures called Credit Default Swaps on the basis they were ‘safe’ or even when 20 yers earlier they were encouraged to buy Mike Milken’s junk bonds on the same basis. Simply put, in order to avoid mark to market volatility, these custodians of other people’s money continue to put it in higher yielding instruments without acknowledging the liquidity risk or the credit risk.

Meanwhile, we hear this week that Credit Suisse helped structure a $900m convertible bond for Wirecard last year that was launched at the same time as SoftTouch announced a “strategic co-operation agreement”. The investors behind the bond were actually the senior management of SoftTouch’s vision fund as well as Mubadala. This helped put on a large short squeeze in Wirecard stock such that five months after the initial bond ‘offering’ CS structured a new bond, enabling the Vision Fund insiders to exit at a profit and without having had to put any of their own money in. while keeping equity upside. In effect Rajeev Mishra and his close associate Akshay Naheta as well as Mubadela got a free option in wirecard. Obviously now that has essentially disappeared, but then again , the ‘investors’ that CS brought in are currently seeing their bonds at 13c on the euro according to the FT.

This is the third point. Where was the regulator in all this? As discussed last week, the German regulator not only tried to sue the authors of the FT article raising concerns about Wirecard earlier this year, but also banned short selling in the stock. And yet a year earlier there was clearly a cause for concern in the way that SoftTouch Vision fund executives appeared to be leveraging ‘news flow’ from their parent company to shift structured products to their own benefit. Moreover, the fact that several German investors at DWS bought over Eur500m of Wirecard stock after the FT article, taking the company as a single stock position in excess of 10% in their funds appeared to attract no official attention.

For investors, it is vital that they diversify away idiosyncratic (stock specific) risk and when alerts such as the FT article appear the action should be to reduce positions not double down. This is the fourth point. Where were the risk managers? The job of the portfolio manager is to construct and manage a portfolio of stocks. It is not, as the former ‘star’ manager from Jupiter who at one point had 17% of his fund in Wirecard claimed to just to ‘pick good companies’. Wirecard had more red flags than a Communist Party May Day parade and yet a number of these ‘active’ managers increased what was already huge idiosyncratic risk. Investors should always remember that in order to generate return you must take some risk and in order to generate relative return you must take a different set of risks than the benchmark. Sometimes that means taking less risk and sometimes more but at all times it requires acknowledging and understanding the risks being taken.

To return to the people who structured the bond used to ‘help’ Wirecard’s share price in 2019, Credit Suisse, the circle gets even tighter. As well as helping the management of Vision Fund and Mubadala get their free options in Wirecard and the fact that Credit Suisse and GAM are behind the supply chain funds we discussed last week where SoftTouch are being questioned about possible round tripping, we might recall that GAM also had a scandal in 2018 when one of their managers was forced to resign over a whistleblower scandal involving bonds from the same GFG business run by Sanjeev Gupta that has just failed to meet it supply chain fund obligations as well. In the end, GAM investors were made whole on the funds and one wonders if the money to pay those investors came from the next round of investors in those CS/GAM supply chain funds.

As an aside, we note that the original GAM GFG bonds were brokered by a certain David Solo, who had previously been the head of GAM as well as earlier in his career on the board of UBS where at an early age he headed the investment bank. UBS was created from the merger of Union Bank of Switzerland and Swiss Bank Corp, when the original UBS was blown up by their derivative trading desk. David Solo came from SBC O’Connor, where he was…a derivatives trader.

So to conclude, the Wirecard, SoftTouch, Credit Suisse/GAM saga raises a series of important points and lessons for investors generally. First, the old saw that ‘A fool and his money are some party’ applies not only to rules based institutional investors who are repeatedly encouraged to ‘minimise risk’ by taking completely inappropriate levels of credit, hidden leverage and liquidity risk, but also to accidental hedgehogs like Masayoshi Son. Like many other ‘great investors’, such as many of those ‘who predicted the 2008 crash’, people who win at the first spin of the roulette wheel usually end up giving it all back.

Usually we find that the first to stand at their elbow to help them ‘reinvest’ their winnings are from the often slippery world of derivatives trading and for some reason Deutsche Bank and the Swiss Banks and their alumni seem to feature heavily. They usually produce ‘low risk’ investments that minimise volatility – the variable being targeted as ‘risk’ – but at the expense of liquidity or hidden levels of leverage. In this example they have also introduced hidden levels of credit risk – did the buyers of the GAM supply chain funds understand that they were actually taking on the credit risk of GFG, the same company that had imperilled the earlier GAM Global Absolute Return Bond funds?

Second, investors must do their own due diligence, not only when looking at structured products, but also at the individual stock level. The fact that a regulator does not intervene, or in this case that they intervened to support the company under suspicion, does not mean that there is nothing wrong. Equally, the fact that accounts are signed off by expensive auditors does not appear to be much comfort either. This is not to say that short sellers are always right, but that if they are seeking to pick individual stocks, investors need to at least be aware of some of the more obvious red flags. The indicators we mentioned last week – lots of private jets and high living for executives in traditional low margin businesses suddenly transformed – can help, but a good place to start is to look out for standard accounting ‘tricks’ which are nearly always exposed through declared sales not appearing to result in expected cash flow. Hiding this with a lot of acquisitions is a classic signal, which certainly appears to have happened here.

Third, if outsourcing that due diligence by investing with active managers it is important to understand what risk the managers are taking in order to generate return. Even with a strong grasp on company finances (as not always demonstrated here), a proper risk management process is essential. A large tracking error is fine as long as it is understood. However, a large idiosyncratic risk, eg a stock >5% let alone 10% of a portfolio should be a red flag of sorts and especially if when that risk rises a fund manager does not reduce the exposure. If instead they double down or insist that ‘the market is wrong’ this in turn should be an additional warning sign.

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