The Saturday - 10/03/20 Edition
Volume 1, Issue 2.
I’ll be in Zion National Park with limited access to the internet by the time you read this, so hopefully no major story broke on Friday. I could never forgive myself if WeWork announced a SPAC while I was making s’mores. You deserve better than that.
It’s Saturday October 3, 2020.
Auditing Woes
Let me start by saying this: as an attorney in the financial industry and as a half-decent human being, I absolutely loathe fraud. I am sickened by individuals who cheat others in order to enrich themselves and I believe fraud is an affront to capitalism. No ifs, no buts.
Now…
You know how some (presumably good) people eat up stories and documentaries about gruesome murders? I feel similarly about corporate fraud. Schemes, money, and, if you’re hearing about it, bad guys being taken down? I love it.
Cue Wirecard: the gift that keeps on giving. There’s a lot to this story but, in short, Wirecard is a German payment processor that was the country’s tech darling and claimed to process over $140B in transactions per year. In March, the company was added to Germany’s Dax 30 and its $20B+ market cap eclipsed that of the country’s largest financial institution, Deutsche Bank.
By June, a KPMG special audit revealed that half of Wirecard’s purported business operations were unsubstantiated and that a Southeast Asian bank account purportedly holding $2B of its cash – an amount equal to all of its profits over the last decade – never existed. The company’s share price dropped from $72 to $0.46, its former COO is now on Interpol’s Most Wanted List after a Hollywood-esque escape from Germany, and SoftBank has to explain itself again.
Whenever these scandals break out, I can’t help but to wonder what the auditors were doing. By the time KPMG’s report hit the press, Ernst & Young had served as Wirecard’s independent auditor for over a decade, during which time the payment processor passed audit after audit with flying colors. Were there really no hints of impropriety?
There were.
On Tuesday, the Financial Times reported details of an unpublished addendum to KPMG’s special audit. Turns out that in 2016, an EY employee wrote a letter to higher ups in EY’s Stuggart office, reporting that “senior managers at Wirecard may have committed fraud and one had attempted to bribe an auditor.”
According to this whistleblower, senior Wirecard officials owned stakes in three payment processing companies in India that were subsequently purchased by the German company. The auditor’s letter also accused the conflicted individuals of “artificially inflating operating profits of the Indian businesses” in order to increase their earn outs in the acquisition. When first approached about the discrepancies, managers at Wirecard’s Indian subsidiary offered to pay the auditor to sign off on the sales numbers. The EY employee declined and reported these issues.
So, the auditing process worked! EY’s anti-fraud team even launched an investigation with a nifty codename: “Project Ring.” How official is that?
Unfortunately, however, the investigation fell flat. Wirecard executives, not EY, oversaw the forensic audit into their peers’ misconduct. When EY requested access to the emails of an executive named in the whistleblower’s letter, they were denied. When further “problematic observations” were raised, the now-fugitive COO shut down the probe.
What did EY do in the face of this adversity? It replaced its Indian audit team and continued giving Wirecard passing grades on their yearly audits. Meanwhile, not another word was spoken about the potential fraud until short sellers started their own investigations and KMPG published its report four years after the whistleblower’s letter. Heck, EY even prepared an unqualified audit in June 2020!
In many ways, auditors remind me of credit agencies. Both are tasked with providing independent, unbiased analyses of companies’ health and performance, all the while being retained and paid by those same companies. It’s a classic and perhaps inevitable conflict of interest. Remember the Big Short?
With the notable exception of Arthur Andersen (of Enron fame), I’ve always been amazed at auditors’ and credit agencies’ ability to dodge severe liability for egregious misses.
While structural conflicts of interest are inevitable, auditors must still discharge their duties with some degree of care for non-management stakeholders. Wirecard shareholders didn’t sign the checks, but they paid EY’s invoices. Creditors also rely on audits in deciding whether to extend credit and on what terms.
Though I’m sure EY usually operates professionally and ethically, in this instance, they allowed $20B to be squandered overnight. That feels negligent. Willfully? Recklessly? We’ll find out.
EY is now under investigation by German regulators and the subject of investor lawsuits.
You Get What You Need?
Speaking of Germany: last year, Deutsche Bank and Commerzbank, respectively the 1st and 4th largest banks in the country, explored a potential merger but those talks broke down over shareholder and regulatory concerns. It seems like Commerzbank had a Plan B.
After leadership shakeups at ING, Credit Suisse, and UBS, Commerzbank has become the latest European bank to appoint a new CEO in 2020. Its choice? Manfred Knof, head of Deutsche Bank’s retail banking division.
About two years passed between the beginning of merger negotiations and Knof’s hire. I’d wager that mirrors the non-solicitation clause pretty closely.
Big Hit, Squared
K-Pop powerhouse Big Hit Entertainment announced on Wednesday that it planned to raise over $800M in an October IPO, making it the largest South Korean IPO in three years. This would value the company at just over $4B, which is particularly impressive when you consider that one act, BTS, makes up 97% of its revenue.
The K-Pop business model is truly unique. Basically, record labels recruit aspiring artists, train them for years, develop distinct and meticulously crafted personas for each of them, and then bundle a handful (or more) into ensembles. The labels then apply a near-mathematical approach to hit-making and invest heavily in building cult-like followings for their newly formed supergroups. This might not sound so different than American labels, but the precise and deliberate cultivation of personalities and programmatic song crafting is unmatched. The Explained series on Netflix dedicates an episode to this phenomenon. Worth watching.
As for BTS, they have a colorable claim to being the biggest act in the world. Their 2019 tour was the fifth-highest grossing tour that year and, earlier in 2020, their first full-English single Dynamite debuted at #1 on the Billboard Hot 100 and reached the #1 spot on iTunes with 8 hours of release. That’s a record.
Two things make this IPO fascinating. First, this is essentially one band going public at a $4B valuation. Second, South Korea has an astonishingly… active investor base? From cryptocurrency to small caps, there are no half-measures in South Korean markets and the country has more than enough capital to move asset prices.
BTS’ legion of fans across the world refer to themselves as ARMY and their dedication lives up to the name. Think of them as Tesla bulls, but more passionate. Something tells me that this IPO will be massively popular among retail investors, especially in South Korea. There will be shorts, but that hasn’t stopped Tesla yet, and I wouldn’t bet on BTS skeptics being able to match the believers’ fervor.
I sense a big hit for Big Hit.
(Please never take puns as investment advice.)
Emails You Shouldn’t Send
On Thursday, the DOJ announced criminal charges against the four founders of Bitmex, a major cryptocurrency exchange, for “willfully failing to establish, implement, and maintain an adequate anti-money laundering program.” Criminal penalties for AML violations are severe and can extend to officers and employees, so the accused have more than just money on the line.
This bit from the indictment doesn’t bode well:
In or about July 2019, HAYES bragged that the Seychelles was a more friendly jurisdiction for BitMEX because it cost less to bribe Seychellois authorities – just “a coconut” – than it would cost to bribe regulators in the United States and elsewhere.
Yeah. Next time, maybe don’t put that in writing?
A Tale of Two Risk Hedging Strategies
Last April, the California Public Employees’ Retirement System (CalPERS) made headlines for the wrong reasons. In a bid to cut costs, CalPERS made the decision to unwind its tail-risk insurance program with Universa Investments and LongTail Alpha.
This program cost $2.5M per year to insure $5B of assets against dramatic collapses in financial markets. You know, the kind of collapse that would be a caused by a global pandemic. CalPERS cut the program in October 2019 and the rest is history. The largest pension fund in America would have netted over $1B had it held through March. Ouch.
In fairness to CalPERS, however, COVID-19 was a true black swan event and risk hedging strategies don’t always work.
From The Bond Buyer:
The pension plans for New York’s Metropolitan Transportation Authority are suing fund manager Allianz Global Investors in federal court, claiming risky investments “decimated” their balances when COVID-19 struck.
These MTA plaintiffs lost 97.3% of the value of their investments between Dec. 31 and their final redemptions on April 23, according to a complaint filed Sept. 23 in the U.S. District Court for the Southern District of New York in Manhattan.
$291M of the MTA’s $300M investment has vanished and, according to MarketWatch, the MTA isn’t the only loser:
Others suing Allianz are the Blue Cross Blue Shield National Retirement Trust, Lehigh University, the Arkansas’ Teacher Retirement, and the Teamsters. So far.
Blue Cross Blue Shield says it had $2.9 billion in the fund at the start of the year and suffered “staggering” losses. Lehigh had $62 million in the fund. The Arkansas teachers lost an astonishing $774 million.
Many investors suffered significant losses this spring and an even greater amount of individuals lost their incomes, so COVID wiping out a fund doesn’t seem all that newsworthy. Now, consider that Allianz’ Structured Alpha fund was (allegedly) marketed as an “all-weather” fund designed to outperform in downturns… that didn’t work.
The popular reaction to these losses has been to blame hedge funds and exotic financial products. Personally, I don’t find those arguments compelling. While “Pension fund decimated by complex, high-risk trading strategy!” makes for an eye-catching headline, it understates the sophistication of pension fund managers and their advisors.
My two cents: this isn’t a story of hedge funds exploiting pensioners or bespoke trading strategies being inherently bad. It’s a mix of bad luck and bad strategy. Universa’s risk-hedging strategy worked, Allianz’ didn’t, and the pension funds stuck to the wrong trade. The suits may reveal that Allianz was a bad actor and misled investors, in which case I hope investors get even in court, but that’s not an indictment of an entire industry.
I don’t mean to downplay the harm to the real victims here: the pensioners whose retirements are at the mercy of fund managers’ decision-making. It’s also unfair to place all the blame on the fund managers. Their funds have funding obligations to meet and, in a near-zero rate environment, risk-taking activities are not only encouraged, but necessary.
It’s all very unfortunate.
About SPACs…
I started today’s post by sharing my fear that WeWork would announce a SPAC deal while I was out of pocket. Well:
Playboy is going public again after being acquired by a SPAC. The transaction values the company at $415M. For those keeping score, Hugh Hefner’s estate sold its 1/3 interest in Playboy for $35M in 2018. $PLBY is expected to trade by the end of 2020.
That’s your SPAC of the week. Playboy bunnies aren’t as naughty as Adam Neumann, but they will have to do for now.
Have a great weekend.