What do a British Asset Manager, French CEO and German Financier have in common?
A €1.6billion bet gone awry
Hi there!
Happy New Year!
In the wild world of finance there is never a dull moment.
Some scandals come to light in an explosive way while others simmer for years beneath the surface.
I recently came across one such story which is too interesting not to share.
The saga of H2O Asset Management and its love for illiquid bonds.
Let's begin.
John Maynard Keynes, the renowned economist said “If you owe your bank a hundred pounds, you have a problem. But if you owe your bank a million pounds, it has.”
A few years ago, The Economist added “If you owe your bank a billion pounds, everybody has a problem”.
The latter is playing out due to transactions between H2O an asset management company and Lars Windhorst a German financier.
Who is Lars Windhorst?
Lars Windhorst has quite a storied past. Once considered a business wunderkind, he began his career by trading computer parts when he was 14. By the time he was 34, he had weathered the collapse of two companies, personal bankruptcy and a suspended jail sentence for “breach of trust”.
Currently he is best known for his stake in the luxury lingerie brand, La Perla.
What about H2O?
H2O is an asset management firm based out of London and is described as a "global macro investment management company". It is headed by Bruno Crastes since its founding in 2010. Crastes is best known for betting big on Greek bonds during the Eurozone crisis. Embracing risk in the hope of outsized rewards isn't something he shies away from.
How are H2O and Windhorst linked?
In 2018, H2O’s funds were among Europe’s best-performing alternative funds. One of its strategies returned an impressive 32.9%. The astounding returns, led to H2O’s assets under management increasing ten-fold in six years. They soared from €3bn in 2013 to €30bn in 2019.
But these returns and growth masked something deeper that was amiss.
As per Financial Times, H2O held more than €1.4bn in bonds, issued by financial vehicles linked to Mr Windhorst across six of H2O’s funds.
These bonds were thinly traded making them hard to sell at short notice, while H2O’s funds are mandated to allow retail investors to withdraw their money daily. While the returns were coming in, no one had a problem.
Issues began when an investment made by H2O in a Sapinda Invest bond failed to pay its coupons on time.
Sapinda was one of Lars Windhorst's firms.
When a bond fails to pay its coupons on time, it could be a sign of deeper trouble.
In 2016, PWC, the auditor of H2O’s funds, issued a qualification relating to Sapinda Invest bond.
As part of their findings PWC highlighted a price mismatch.
It mentioned that H2O used a price contributed by an intermediary while the quotes received by PWC from other brokers were vastly different.
The discrepancy may have represented more than 1% of the net assets of one of H2O’s funds.
Disturbingly, the accounts for the next year H2O removed the investment from the balance sheet. How?
By rolling over the investment from Sapinda Invest bond into another one of bonds related to Mr Windhorst entities.
Going back to Keynes' quote, a lender’s thinking is - it is better to give a borrower more time to pay back rather than force them to repay. Because if they owe you a lot of money it is better to give the illusion that everything is okay instead of telling investors we lost your money.
FT Alphaville reported the story of H2O’s bad bets in June 2019. Seeing the market uproar (investors redeemed more than €5bn in a week after the story) H2O sought to stem the bad PR.
H2O told investors they had begun selling the illiquid bonds. (Spoiler alert - they did not sell the assets). They mentioned that these measures would take the exposure to these bonds below 2% of their assets under management.
Given the fact the bonds were thinly traded, and H2O had a significant stake which it was trying to sell in one shot this was going to be challenging task. Adding in the bad publicity of all the actors and the questionable capacity of Windhorst to honour his debt further complicated matters.
So how could the asset manager evade further scrutiny?
Stitch up the injury by doing some creative accounting
Enter solution: Buy and Sell back the assets.
Meaning H2O would sell the illiquid debt and buy liquid assets such a listed stocks, and government bonds from brokers. With the understanding that H2O at a future date would buy back the hard-to-sell debt at a specified price. Also called a reverse repo and like a sale and repurchase transaction.
As per FT,
In H2O’s case, entering into these agreements allowed it to reclassify some of the troublesome illiquid bonds outside its main portfolio holdings. (“H2O relied on minor brokerages to shuffle illiquid debt”) Crucially, this meant that these securities were outside the scope of a 10 per cent cap on unlisted investments that applies to open-ended funds.
H2O’s funds were marketed as mainly holding government bonds, providing daily liquidity and regulated under European rules. Meaning they could hold a maximum of 10% of their funds in assets that could be hard to sell.
By massaging their books, they found an innovative solution to side stepping the 10% cap. This method allowed them to segregate the assets from the main pool and show a rosy picture to investors.
For now,
In 2020, COVID hit and threw the markets in turmoil impacting H2O as well.
Smelling some fishiness, the French market regulator suspended a series of H2O funds.
Details emerged that ~a third of an H2O fund was invested in illiquid bonds. More than three times higher than the regulatory limit of 10% on hard-to-sell assets.
These illiquid assets became more problematic because several of H2O’s funds lost more than 50% of their value. The collapse in the value of the funds made it harder for the asset manager to comply with the cap.
This led to a spiral where, as the value of the liquid assets falls the proportion of illiquid assets rises. Plus, with more investors withdrawing their money the asset manager would tend to dispose of assets that are easier to sell, such as large-cap stocks or government bonds. What is leftover would be the higher share of harder to sell assets.
As per FT, a letter from H2O to its investors in August 2020 showed,
The highest proportion of illiquid bonds it held directly in any of its funds was 9 per cent at the end of August. But some of its funds had as much as 25 per cent of additional exposures held as a result of so-called “buy and sell back” trades — where they took on additional bonds with an agreement to sell them back later.
Meaning H2O is stuck with the dead assets.
Where do things stand today?
Wrapping up the saga,
As of November 2022, Lars Windhorst is being investigated by German authorities under the country’s banking law, the French regulator is seeking to levy a €15m fine on Bruno Crastes, along with a ban from the investment industry for a decade. And a record €75m fine on H2O Asset Management for grave deficiencies in its investment process.
Investors have €1.6bn of their savings trapped for more than two years. And talks about repayment from Windhorst are at a standstill.
Leading to an uncertain future for retail investors who trusted H2O to protect their savings.
The point is, valuing private debt is opaque. Leaving open the possibility that bond issuers and asset manager executives could manufacture a win-win situation while the retail investors are left in the dust waiting for their monies to be repaid.
I hope you enjoyed this article and learnt something like I did when I wrote it. For more details, please read FT coverage of the entire story here
https://www.ft.com/content/51b425fc-94b6-3cc5-a4ea-47d72dca5e75
https://www.ft.com/content/8f086692-f440-4704-a066-3886caf22a09
https://www.ft.com/content/45e13fde-8ccf-4d5c-a460-f2f40872a9b7
https://www.ft.com/content/0e21e6d0-829b-43c4-9332-92dc0115b4f1
https://www.ft.com/content/041946c4-aac5-4d5a-bf0b-68f2596401dc
https://www.ft.com/content/2c25e2e2-97e3-11e9-9573-ee5cbb98ed36
I hope you enjoyed this edition of Filtered Kapi. Do let me know if something struck a chord with you.
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