By now most of the readership, we assume, has heard about the Archegos Capital fiasco. A situation that, last Friday, shook global equity markets. A series of events wiping out close to 50% of the market capitalisation of Discovery, more than 50% of Viacom, 20% off Baidu to name a few, not to mention the fact that it has led to an increased level of volatility in global markets. But, just in case you haven’t and you are an investor who has been scratching his/her head at what has been happening in terms of price action, read on.
A Little Context
Before we explore the current situation further, a little history into Archegos. Archegos Capital Management, is an outfit run by Bill Hwang, an interesting character who would in any other situation deserve a full article for himself in my opinion. Mr. Hwang made his mark in the finance world close to two decades ago as the protege of Julian Robertson, part of a club now referred to as the Tiger Cubs (i.e. the alumni of Tiger Management who went on to form their own hedge funds once the mother firm folded in 2001). This particular cub was originally inducted into Tiger in the 90s after he had managed to be particularly lucrative for the firm as a broker at Hyundai securities. Following the roll up of Tiger in 2001, Mr Hwang branched out on his own, investing for himself and starting his own outfit in Asia.
That particular outfit, rather creatively named Tiger Asia, was not only bankrolled by Robertson himself but became one of the largest investors in Asia, managing billions at its peak. However, having shown stellar returns through much of the decade, Mr Hwang decided to leave another kind mark on the industry, this time making him rather infamous. Underlying the stellar returns Mr Hwang had been showing, it seemed that there were certain irregularities. These particular irregularities included insider trading and market manipulation, which eventually resulted in a ban from trading on the Honk Kong exchange and penalties by the SEC to the tune of $40m USD.
So that should’ve been the end of it right? Wrong.
Twelve months after the collapse of Tiger Asia, Hwang launched a second firm, Archegos Capital Management in 2013. This time he had converted the firm into a family office, a setup that managed to rid him of the pesky headache of regulatory requirements (family offices are exempt from the SEC’s reporting requirements for investment firms). The firm grew by leaps and bounds, not only in size and scope but also risk appetite. The initial principal of $200m grew steadily over the years to about $10bn (as recently as last week).
This brings the second question, how did a family office grow big enough to make a global impact? The key here is that the fund had, it seems, been using previously unheard of levels of leverage, often borrowing close to seven times principal in order to amplify returns. A scenario that allowed it to grow by leaps and bounds over a close to decade-long bull market. The music was playing, so to speak, and everyone was dancing; institutions as well as prime brokers were bending over backwards to extend lines of credit for lucrative commissions. Aside from being a prime example of what excesses and low interest rate environments can create in terms of dislocations, this particular situation also brings to the forefront another example of the risk management practices (or lack thereof) at global institutions. After all, we have seen this play out before, though many have forgotten about it, in a little blip called the GFC and, for those of you that wish to go back further in history, LTCM (Long-Term Capital Management) that in many ways exacerbated the Asian Financial Crisis.
But who do we kid? There is no protection against human nature, after all. If the upside is lucrative enough, we are all prone to bite the bullet and play along. So much so it seems that most of the brokerage teams had been lobbying the risk departments to turn a blind-eye to Mr. Hwang’s rather chequered past. Hwang was, after all, seen as a “money-making genius” and maybe this time would be different. The fees would certainly make up for it and hopefully they wouldn’t be the last one standing in the room if it went wrong.
Unfortunately, it did go wrong when shares in some of Archegos’s biggest positions started to decline and warranted a margin call. By Friday of last week two of his biggest lenders, Goldman and Morgan Stanley, initiated the sale of some of his biggest positions, $20bn USD worth of it to be exact. On Friday alone, Goldman and Morgan Stanley managed to sell off $19bn USD at seemingly garage sale prices, wiping out close to $33bn USD in the market capitalisation for the companies involved and potentially more to come. Unfortunately in situations like this, there is a domino effect whereby the sale triggers broader sell-offs and panic starts to set in.
It seems that Archegos has exposure via more institutions, including Credit Suisse and Nomura to name a couple. That particular information led the market to sell off Credit Suisse, which lost close to 15%, and though the impact upon Nomura was more muted, it might still have the potential to wipe out the firms second half profits. Credit Suisse and Nomura have to unwind another $20bn USD, potentially more pain to come?
What does this mean for investors and what can we take away?
All these events are going to bring increasing levels of scrutiny by regulators and the extent of leverage within the broader markets. All things equal, we are at the very least likely to see a lowering off the risk-appetite and de-leveraging within the broader markets. As firms ask their clients to taper off some of their risk exposures.
As for the regulators, the only thing done so far has been to ensure that brokers aren’t coordinating the sale and breaching antitrust regulations, apparently we’ve at least moved on from the 80s. But, as the world continues to stay at lower rates for longer, the quest for returns will continue to drive risk appetite and leverage (for lack of a better option). And while we might see some turbulence as financial institutions at least pretend to tighten credit lending requirements, somehow we doubt this will be the end of it.
For the discerning investor with a longer time horizon, hold in there. After all, you could’ve bought Discovery 40% cheaper with no news flow and no changes to what the underlying metrics were pre-selloff. And add in our tendency to have the collective memories of goldfish, as soon as the markets and media find another hot topic, it will be business as usual. The fact that most of the financial institutions globally have been showing some of the best capital markets returns in years should tell you that, depending on how quickly the world moves on, the siren call will be too hard to resist. Market participants are creatures of habit after all, insisting like a chronic gambler that this will either be the last time or this time will be different. Clue: it never is. For yourself, at least understand what is driving moves like this and have a longer time horizon, these types of markets also present immense opportunities.
There is a novel idea in finance, the two main drivers of human behaviour in markets are fear and greed, understand them and learn to use them to your advantage.
Markets & Commentary
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