Hot CoCos: A Swiss Misfire

Unpacking how Crédit Suisse AT1 CoCo investors got Bern-ed by FINMA

Picture this, a sedate conference room in Bern filled with anodyne Swiss bureaucrats, shuffling through papers—mulling something serious.[1] Then one by one, “ja”, “oui,” “si,” “(fill in Romansch for yes).” It is decided, the Swiss Confederation has just declared war on Luxembourg. Wow, what a shock! Now notwithstanding the fact that this is almost certainly not how the Swiss constitutional order works—it would be quite a surprise to see the Swiss abandon one of their core things by abandoning nine millennia of neutrality. It would also be surprising to see the Swiss financial authorities and its central bank decide to embrace the philosophy of saying “yeah, f*ck ‘em” to a bunch of people who had loaned money to banks. Now, the first scenario would never happen, and I would have said the second never would either—until Sunday. I say until Sunday, as that is when FINMA, the Swiss Financial Market Supervisory Authority, revealed its plan to “save” Crédit Suisse by swapping out its shares for those in UBS on a basis that equates to 0.76CHF a share.[2] As part of that deal, FINMA said that this event would “trigger a complete write-down of the nominal value of all AT1 debt of Crédit Suisse in the amount of around CHF 16bn.[3]”

To put it plainly, the Swiss banking authorities decided to invert the normal hierarchy of claims and pay out equity holders[4] while telling bond holders that the cookie jar was empty and they would get rien, Nichts, niente, (insert Romansch for “nothing).” Of course these were not regular bonds—they were Additional Tier One Contingent Convertible bonds—or CoCos to their friends. In short, these hybrid instruments that gained popularity post GFC are designed to function as a shock absorber to the capital structure of financial institutions. When the gap between liabilities and assets gets to an uncomfortable place, which is to say equity gets too low, the CoCos convert from debt to equity. Hey presto your equity is now bigger. Critically, they can also be written down to zero. Everyone knows that AT1 CoCos are there to absorb losses which is why they are largely reserved for professionals and carry a significant premium to reflect their extreme risk. But at their core they are debt instruments until they are not and every understanding of what makes debt different from equity hinges on the principle that debt gets paid before equity. The CoCos did absorb losses here, and that is fair and to be expected. But, they did not convert; equity holders got paid out; CoCo investors got nothing. This raises some questions.[5]

Any distressed credit scenario is heavily reliant on legal issues, and I should be clear that I am not licensed to practice law at a federal or cantonal level in Switzerland.[6] Granted. I can however read in at least 1.5 languages. And a few points emerge from my research[7]. Before we get too far let me issue a further caveat—I don’t have access to the actual prospectus or debentures of these instruments and maybe they have language that allows these bonds to convert to the financial instrument equivalent of a joker card. However, I suspect that they do not. But the relevant law is easily available. Chapter 3, Articles 47 and 48 of l’Ordonnance de la FINMA sur l’insolvabilité bancaire spell out the normal hierarchy of debt and equity, that share capital must be completely reduced before debt converts to equity and that this is applies “en particulier” to CoCos.[8] The general Loi sur les banques is also pretty clear[9] that debt conversion or reduction is only possible if share capital has been written down entirely. There we have it in plain language. Seems suspect. I encourage you to read the full FT Alphaville piece—there is a twist at the end about how the Swiss did pass a law creating the mechanism for this write down—on Sunday, before FINMA released its plan. Cool. As an additional point aimed at the chorus of people saying “LOL losers, you should have read the prospectus before investing,” do you think the Swiss would have snuck in a little amendment to the law authorizing this approximately twelve minutes before they announced this? Seems unlikely, no?

Back to my first caveat—there might be a bunch of other legal issues going on that are beyond me and there may be a strong case for why this was all above-board, beyond a clearly ex post facto law. However at the very least these issues are in dispute—a bunch of CoCo investors will be filing suit. This will be settled eventually. But I can say with high certainty that the folks who invested in these instruments fully and reasonably expected to be treated as normal debt holders—albeit highly subordinated ones— until specific conditions were met. They are sophisticated investors who priced in the possibility that they could absorb losses—just not the losses of common shareholders. How did this happen?

We now turn to speculation. Do you think it is likely that a bunch of super serious Swiss Skoda enthusiasts sat down at the boardroom table and came up with a dubious scheme to wipe out institutional creditors in favour of common shareholders? I, for one, do not. Do I think that it is more likely that major institutional shareholders decided that they had the whip hand and insisted on this unorthodox solution to mitigate their own losses?[10] Yes, I very much do. Was this legal? We shall see. Was this just? Probably not. Will this have consequences? Oh, it very much will.

Bonds like these form a major component of the capital structure of a lot of European banks—there are more than $250bn of them on the market. There is one bank in particular that we could look at here that is especially fond of them—the Union Bank of Switzerland. Per Bloomberg, UBS has almost $13bn of them. They are not the biggest issuer—but they are among the most reliant on them as they measure up at 30% of the bank’s Tier One equity capital compared with about 21% and 13% for Société Générale and BNP Paribas respectively. You would think then, that UBS would be a bit more circumspect about taking part in a deal that fundamentally calls into question a source of funding on which they rely so heavily. Now, I assume the dust will settle on this relatively soon—the ECB and a whole alphabet soup of European financial authorities issued a joint statement saying “hold on, CoCos will not be absorbing equity losses too.” But as it stands, these bonds are tanking and tanking hard as markets cast scepticism over the entire asset class. Bloomberg data shows that average AT1 yields are now up from 7.8% in February to a whopping 15.3%. The average cost of equity for European banks is 13.4%. Let that sink in. Markets now view these fixed income securities which offer no upside beyond getting paid back as riskier than common equity. Did FINMA break this asset class? At least for the moment, yes.

As I suggested earlier, the dust will settle on this and I suspect that these bonds will climb back up and their yields will fall below the cost of equity as they should;  however, I suspect their yields will not fully recover and banks will look elsewhere for cheap hybrid capital. Furthermore, I suspect that after some litigation even the CS CoCo holders will get something. Both of these represent decent money making opportunities which my imaginary global macro fund will be taking advantage of. But that will not change the fact that European banks will face materially higher costs of capital for the foreseeable future and given the shape of the global banking sector right now that is an additional headwind they could easily do without.

That’s broader European banking, but on the other hand I think the Swiss have inflicted significant damage to their reputation as solid and predictable banking partners by doing something so erratic and against character. Even more granularly, UBS has done itself a great deal of harm by almost explicitly telling its AT1 creditors that it is probably untrustworthy and has no compunction in using serpentine tactics to slither out of making good on its debts to them. To them, I offer this quote from the owner of Dairy Queen “It takes 20 years to build a reputation and five minutes to ruin it. If you think about that, you'll do things differently.” The reputation of the Swiss banking sector has been built over centuries and it will take more than this to completely destroy it—but actions like this are a good way to start.

[1] Maybe it is the seven members of the Federal Council, the weird super Swiss multitudinous executive? Who could know, their identities are unknown—unknown because of Swiss restraint, not equally Swiss secrecy.

[2] Approx. 76 centimes more than 0

[3] Record scratch

[4] Admittedly, at a pretty severe haircut  

[5] Questions like “what?” “how?” “why?”

[6] Or, anywhere for that matter.

[7] Thanks in large part to FT Alphaville, without them I would have had to spend much more time crawling through legal French: https://www.ft.com/content/2e5ac49b-b055-4bd0-a9fd-8a41e19028b9

[8] les emprunts à conversion obligatoire sous certaines conditions, if you prefer

[9] As clear as the sapphire crystal of a Rolex. I promised myself that I could make only one watch joke and one chocolate joke. Please applaud my restraint, especially given that these things are called CoCos.

[10] Losses which, I might add, at least one investor instigated by loudly declaring CS to be in trouble and that they would be doing SFA to help.

It’s Not the Bus’s Fault When You Step in Front of It: SVB Chapter I

I’ve been chewing on the SVB collapse for a bit now and I have a lot of thoughts on what went on in the Valley and now in DC and Wall Street. There is a lot of time to think about what happened at the bank and I will get to that later. However, for now, let’s focus on what this isn’t about.

I have seen both in straight news coverage and the unmediated dumpster fire of the vanities[1] that this is a result of Fed rate hikes. Now sure, is this rate hike a proximate cause for SVB’s implosion? Sure, I guess. In the same way that a bus driver choosing to operate her bus at 35mph[2] on a public street is a proximate cause for you getting hit by same bus because you didn’t see a bus in that exact spot yesterday even though it’s a bus lane. You should have seen it coming; you could have seen it coming. You walked in front of a bus. You know how to cross the street and you aren’t even a professional street crosser with a head of street crossing risk management. Just as motor vehicle traffic is one of the biggest risks you have to manage when crossing the street—rate risk is one of the biggest risks in banking.[3] OK, let’s depart from the metaphor.

At the heart of modern[4] banking is the principle of short borrowing to finance long lending. I give my 10 florins to Piero at 5% on the understanding I can get those florins whenever I want, and Piero turns around and lends out those 10 florins to Paolo on the understanding that he gets 12 back in a year. Groovy, Piero is up 1.5 florins and I don’t have to hide my florins in my boot—a true win-win. This is of course a simplification along many axes and we won’t complicate it too much except for one way. As the prevailing market rates change, the values of my deposit and Paolo’s loan change and debts with longer maturities will change in value more than those with shorter. But my deposit value doesn’t change at all because I have an unlimited call provision on my loan to Paolo—which is to say I can go to him and say “give me my 10 florins” and he has to give them to me—and if he doesn’t have 10 florins he will have to sell something to raise that money. Except if rates have gone up and his future 12 florins from Paolo is worth much less, so he has to sell that loan to Cosimo for 7 florins. Oops, now Paolo is up il ruscello di merda. And that is duration mismatch.[5]

Luckily along the road people have put a lot of effort into developing bond math so you can predict how the value of debt will change as rates change and then you can use that to manage exposure to the risk of rate changes. You can even run stress tests to see what happens to your portfolio when rates change. You can even develop a department and several disciplines devoted to this practice[6]. Now you won’t eliminate this risk because then you won’t earn any money on the spread between the short term rates you pay and the long term rates you earn, but you have to understand it and limit it. Unluckily[7] for SVB, it seems like they didn’t manage this risk in any meaningful way. The bond math is in many ways immutable—the timing and scale of rate movements may not be fully knowable, but their effects on the values of debt securities is pretty effing knowable. And either through complacency or avarice,[8] the folks at SVB took the ¯\_(ツ)_/¯ approach to risk management.

SVB had a tonne of deposits[9] funding a huge position in long dated bonds—amounting to a bet that rates would not go up. Either they chose to take that bet or wandered into it—but at the end of they day they positioned their bank on the assumption that rates would not increase despite all evidence to the contrary. They were so accustomed to operating in the ZIRP[10] times that they were simply not prepared for anything else. So yeah, they kind of walked into the bus. A lot of really strange market behaviour has ensued during the years post-GFC and a lot of people have made an awful lot of money at a time when it was easy to do so and accordingly have not prepared themselves to do business under a different paradigm. Now, they probably should have prepared themselves for a time when things were different—and this is true for everyone. But people running a bank should not have forgotten or decided to just skip the fundamental risk management that being a credible bank is built upon. SVB did just that when they built this position for themselves and their depositors. There is a lot more to be said and to develop in this crisis. But I just wanted to get started by clearing my throat a bit and saying: this isn’t because rates went up—it is because SVB was completely unprepared for when they did.

It is on them, not Jay Powell.[11]      

[1] Twitter Dot Com

[2] 56.33 kph for the metrically minded.

[3] Maybe the biggest risk.

[4] I mean modern in classical historical sense—i.e. the banking system as it has developed since Italian guys issued loans and took deposits at their benches (banchi) in Venice and Florence.

[5] I realize this a very profound simplification of fractional banking. But hey, I feel I have covered what needs covering.

[6] As has happened

[7] Or very stupidly

[8] Or a toxic combo

[9] Most of which were highly concentrated in size and in one very insular industry, more on this later

[10] Zero Interest Rate Paradigm

[11] It’s on a few other people too, but that is for later

Do something you Dumdums; the Debt Ceiling approaches.

Is this the solution?

It’s that time again—no, not the time when Dry January becomes F-It I Will Have that Whisky January. Rather, it’s another instalment of Debt Ceiling Crisis Time. Unlike not-so Dry January this is happily not an annual occurrence—but rather only when the stars align can we experience this magical season. The stars in question appear to be the United States running up against its credit limit while—and this is the critical component—there is some degree of divided government with the Republicans holding some degree of power in the Congress and a Democrat occupies 1600 Penn Ave. The first condition was met twice during the last administration when the other condition did not hold. So, for some reason[1] the limit was suspended. So here we are, once again looking down the gun barrel of an American sovereign default. Despite the brinksmanship—I assume that eventually everyone will come together and agree to raise the limit, but not without maximum Sturm und Drang and concomitant chaos and damage to the finances of the United States and the global economy.

The so-called Debt Ceiling is a statutorily defined limit on debt incurred by the United States. While much of the resistance[2] is framed around issues of keeping runaway spending in check—the Debt Ceiling has only a secondary relationship to spending as it has nothing to with appropriations. To think of it on an accrual basis, the appropriation is the real spending—limiting the Debt Ceiling only hinders the Treasury from settling our big national payables account. To put it even more simply in household terms, the United States has bought a new 70” 4K OLED TV, paid its rent, and bought groceries on the credit card—but now some are saying we shouldn’t pay the credit card bill because the 70” 4K OLED TV was an extravagant purchase and we shouldn’t buy a new Dolby Atmos surround sound system in the future.[3] Charitably, you could say that the members of Team Let’s Not Pay our Bills is holding out to bring everyone to the table to agree to get future spending down before they agree to settle debts. But to believe that would require you to believe we are in a world where members of Congress will take a serious bite out of spending on defence and entitlements like Social Security and Medicare.[4]

Now, the Democrats could have dealt with this issue at the end of last session when they controlled both houses of Congress. They did not. Presumably they didn’t do this prior to the election because they didn’t want to be portrayed as Socialist Spending Addicts[5] by a Republican Party that has once again discovered fiscal probity as one of its guiding principles. But they could have done it in the Lame Duck surely? Of course they could have, but then they would have deprived themselves of the opportunity to point out that they are the reasonable ones and their political opponents are pointing a gun at the Full Faith and Credit of the United States.[6]

But we are here now and the disciples of True Conservatism have decided that the Conservative-est thing to do is to welsh on our debts. I will not belabour this much more, but the party of personal responsibility and fiscal probity[7] has decided the best course of action is to dishonour contractual obligations and to not pay what is owed on monies that have already been spent—putting the US into default. SMDH, as the kids say.[8] I have seen proposals to avoid a full default by going through and prioritizing what liabilities to pay now and which ones can be paid later—I am no lawyer but I am pretty sure that is Chapter XI Bankruptcy. Furthermore, playing games like this runs against the spirit and letter of Section 4 of the 14th Amendment of the Constitution: “The validity of the public debt of the United States, authorized by law, including debts incurred for payment of pensions and bounties for services in suppressing insurrection or rebellion, shall not be questioned.” Let me repeat: shall not be questioned. If you are raising doubts as to whether you will pay a debt you have incurred, you are questioning the validity of that debt.

Look, I am pretty sure that the limit will be raised or suspended or something once an appropriate[9] amount of time has elapsed, and everyone has gotten their breathless cable news appearances in and scared up a few million bucks with yet more breathless fundraising emails. But the potential for damage is immense. When this happened in 2011 S&P downgraded the US’s rating for the first time in ever, even though the Ceiling was eventually raised. This triggered a market selloff and it is worth noting that markets are pretty, pretty volatile and tenuous right now and a similar event would be extremely not good. We do not need this added chaos right now as the Fed walks a tightrope towards the soft landing which we all desperately want.

Alas, here we are—which leads me to a scheme that is so crazy that it just might work. MINT THE COIN. Long story short, the Treasury is legislatively empowered  to mint platinum coins in any denomination it chooses. With that in mind, a group of whackos who are clearly among the more clearheaded people talking about this issue right now have proposed using a law for the minting of collector coins to create a $1tn platinum coin the Treasury can deposit at the Fed. While this coin certainly sounds like the McGuffin in a new instalment in Nicolas Cage’s National Treasure franchise—it would presumably allow the Treasury to skirt this entire issue and go on to settle the liabilities that are coming due almost magically by depositing the coin in our national checking account. Would this have unforeseen monetary consequences? Maybe, but this would just put a $1tn dollar deposit liability on the Fed’s balance sheet instead of an equivalent sum in bonds—so I presume it wouldn’t make much difference.[10] Plus, think of the heist movies[11] this would inspire!

Maybe minting the coin isn’t what needs to be done. But something does. Money is not banknotes; it is not a coin; it is not securities. Money is trust. Right now a band of dangerous idiots is actively working to undermine our money by saying almost explicitly that the most important bank in the world cannot be trusted. The coin is simply a tool to say that the Treasury, the Fed, and fundamentally the United States can be trusted. This trust is a bedrock of the entire global economy. If we don’t do something firm and pretty quickly—we are gonna chip away at that bedrock. All this at a time that really nobody can afford it. Get your act together dumdums—this is both entirely unnecessary and dangerous.    

[1] Hmmm, what reason could that be?

[2] At least nominal resistance

[3] Except they also bought the TV, love watching the TV and are super stoked to buy the stereo too.

[4] To misuse the language of Economics, this would be a highly stylized scenario. But frankly, the assumptions do not hold.  

[5] This would be an extremely bad faith accusation by a party that has about the same predilection for spending and furthermore, as we have seen above, this isn’t about spending.  

[6] The downside of this is that in order to have this opportunity they had to let it happen.

[7] Wink

[8] Do they? I don’t know any.

[9] “appropriate”  

[10] Important caveat: I am NOT expert in monetary economics. Meta-caveat: I am pretty sure I am more expert than 99% of the membership of the House of Representatives.

[11] One of the best genres of movies. This is my opinion but it is also a fact.

Beep Boop Beep, The Rise of Robo-Charles

As I was sitting in my plush office in Jouy-en-Josas, sipping on my artisanal latte and staring at the Bloomberg terminal, I couldn't help but wonder: is ChatGPT going to replace us all? Will the rise of artificial intelligence and automation lead to the downfall of white collar workers like myself? I decided to do some digging[1]to find out.

First of all, let's talk about ChatGPT and what it is. ChatGPT is a large language model trained by OpenAI, designed to assist users with a variety of tasks, from answering questions to generating text. It's pretty impressive stuff, but the question on everyone's mind is: will it be able to take over our jobs?

Ha, I tricked you! That wasn’t me writing; it was a robot impersonating me. It has humour, analogies, and a conversational tone—everything you have come to expect here at CPDC. It even makes jokes in the footnotes! But we are getting ahead of ourselves.

Unless you have been living in a cave for the past few weeks you have no doubt heard about OpenAI’s ChatGPT. In case you haven’t, it is a natural language chatbot that will answer your questions, produce text, write Python scripts, etc. It can also suck up hours of your time with processing times, error messages and the endless temptation to have it pitch you ideas about Christmas movies set in Riyadh or produce kindergarten level explanations of why you would want to domicile a hedge fund in the Cayman Islands.[2] The results can be quite funny but also shockingly good. The question on everyone’s mind is what the long-term impact of AI systems like this will be and to what extent they can replace humans as producers, interpreters, and synthesizers of knowledge.

One area that ChatGPT excels in is mimicking text that is written by humans, and it can be quite specific in that mimicry. To test this, I turned ChatGPT loose through the wilds of Charles Pierson Dot Com and then asked it to write new articles as me. Robo-Charles came up with gems like “Exploring the ups and downs of the bond market and why it's like your ex” and “Repo Madness: A Charles Pierson Investigation.” These articles read like a well-researched Wikipedia article at times, but the degree to which it can capture tone is pretty decent. Here is a passage from “Repo Madness:”

First things first, what is repo? Repo, short for "repurchase agreement," is essentially a short-term loan secured by collateral. Here's how it works: a borrower (usually a bank or other financial institution) will sell a security (like a Treasury bond) to a lender and agree to buy it back at a later date, usually the next day or even the same day. The lender gets to use the security as collateral and earns a little interest in the process, while the borrower gets some cash to meet its short-term funding needs. It's like pawning your grandma's antique vase to pay for your rent, except on a much larger scale and with a lot more complicated paperwork[3].

Yeah, that’s pretty much it and the fact that it kind of makes a joke using my footnote format is truly impressive. However it isn’t always that good, like this from Robo-Charles’s piece on bonds:

On one hand, bonds are a great source of stability and income for investors. They offer relatively low volatility and a steady stream of interest payments. They're the reliable partner that you can always count on. But then there's the other side of the coin. Bond prices can be volatile and unpredictable, especially when interest rates are on the rise. It's like your ex who said they would always be there for you, but then ghosted when things got tough…

But bonds also come with their fair share of risks. The biggest one is interest rate risk. When interest rates rise, bond prices tend to fall, which can result in losses for bondholders. This is because investors will often sell their bonds and buy newer, higher-yielding bonds instead. It's like when your ex starts dating someone else who is more attractive and successful than you – it hurts, but you just have to move on and find a new bond to love.

Things go off the rails here for Robo-Charles. He starts with what seems like an anodyne definition of bonds but then starts to contradict himself[4] and then it just stops making sense. When yields rise investors sell their bonds to get even higher yields which is why prices fall and that’s like when your ex finds someone hotter and richer? This is what happens with ChatGPT in a lot of instances. You get complete nonsense trash that only superficially resembles human speech. Furthermore I have found that to really get something good you must be very specific in the output you want, as well as provide it with the information your think it needs. And even then, you often have to massage the questions and know what the outcome should look like. If you put in significant effort you can produce some stunning work.

For example I was able to produce more than a millennium’s worth of Jewish thought on a made up topic. From a Torah passage it fabricated, it produced relevant Talmudic passages from the Mishnah and Gemara, successive commentaries from Maimonides and Rashi, a Kabalistic passage from the Zohar, an illustrative anecdote about the Baal Shem Tov and further commentary from the Vilna Gaon and Moses Mendelsohn giving the Mitnagged and Halskalic perspectives on this made up issue. I was even able to tie all of this together in a sermon given by a fake Reform rabbi named Sarah Levine. I knew what this should all look like and was able to guide it to produce something that was almost perfect—but it still was able to do it. Wow.

So this has been fun, but what kind of actual analysis can ChatGPT produce? For this experiment I asked ChatGPT[5] to settle in as my amanuensis and help me produce something that generally takes a lot of work to produce de novo: an equity research report. I picked a name I follow[6] so I could easily assess the quality of the final product. Let’s see if this robot really can take over. The results are interesting:

In 2021, Crocs reported full year revenues of $1.3 billion, representing a 14.6% increase from the previous year. The company also reported a net income of $109.9 million, a significant improvement from the net loss of $29.4 million in 2020. This strong performance was driven by strong demand for the company's products, as well as successful marketing campaigns and partnerships with celebrity endorsements.

So this reads really quite well, but none of the numbers are correct. Later on it says it used a DCF and comps to come up with a price target of $100 representing an upside of 20%.[7] I then asked it to explain its valuation and it used all the right words but it was just wrong. It is worth noting that it wasn’t even consistently wrong—the EPS figure it gave[8] and the P/E ratio it claimed to derive from comps[9] produced a number that was 2.5x higher than the valuation it offered. Now, in many ways these small factual errors are the easiest thing to fix. However, what we see is a being that knows what something complicated is supposed to look like but has a hard time piecing together why facts are important or indeed how they fit together. To be fair, this isn’t a specialized tool and the way this programme can produce pieces that synthesize information to produce passages explaining concepts makes me suspect that it could do a much better job if it was specifically programmed to complete this task.

However, I am less sure that it, or any artificial intelligence, can exercise the judgement necessary produce work of meaningful quality. To continue the example of an equity research report, the assembling of the data is in many ways mechanical even when a person does it but the selection and weighting of that data is much more complicated. I have no doubt that if properly set up it could produce valuations using comps, consensus projections, etc.—but I have strong doubts that it could look at years of financial statements and determine what costs are operating costs, what expenses and revenues are meaningfully recurring, and the myriad other points of art without strong human guidance at a minimum. These are decisions that are informed by rules and definitions but are executed as judgement calls on ambiguous information. While a machine is great at applying rules, I have reservations about its ability to make judgements and how it would deal with ambiguity. Furthermore, what ChatGPT excels at is taking vast amounts of existing information and putting it together—this can resemble analysis but I am not convinced it is analysis per se.

Will AI change the way white-collar, intellectual work is performed? Of course, and it already has. Will it replace us all? I doubt it.

[1] I did not actually do any digging. [ChatGPT Generated]

[2] “Domiciling your hedge fund in the Cayman Islands is kind of like storing your treasures in a beautiful castle on the beach. Your treasures will be safe and easy to access, and you can visit them whenever you want.”

[3] Don't worry, I'm not suggesting that you should actually go pawn your grandma's vase. That would be a terrible idea. [ChatGPT Generated]

[4] More than usual.

[5] In a session where I had not trained it to be me.

[6] It’s Crocs, the ugly sandal company.

[7] FYI It’s currently trading in the mid $90s

[8] Which was wrong

[9] Also wrong

Unpeeling the FTX Onion

What the hell is this mess? What do we do? Part II in a series coming to grips with Crypto, DeFi, and Shenanigans

Image credit: Bloomberg

As you probably could have guessed, I spend a fair bit of time reading about the unfolding train wreck that is the FTX bankruptcy and the broader unraveling of the crypto universe. I have discussed before my feeling[1] of Schadenfreude, but what I feel when I read many post-mortems and “WTF happened at FTX?” stories is a feeling best described by Jacobim Mugatu. I feel like I am taking crazy pills. I feel like I am being gaslit. On a recent episode of Bloomberg’s Odd Lots, cohost Tracy Alloway said “I don't know, it feels like the speculative mania kind of reached almost its purest form when it comes to crypto. Like this is about making money with pretend money that we have created. That's what it feels like to me.” I feel like I am taking crazy pills, because I vividly remember screaming this sentiment in my internal monologue whenever I encountered any talk of crypto.[2] But now, it seems, this has become self-evident ex-post. If you took one step back during the craze—what is obvious now was obvious then. That is, if you weren’t actively putting scales into your eyes. You did not need to wait for a Damascene moment—the truth was always there to see. In the instance of FTX, you could have listened to Sam Bankman-Fried’s own words on a now-infamous episode of Odd Lots.[3] What is clear is that FTX and similar actors were, at best, creating a financial system that existed purely for speculation which was a giant house of cards.  

You should read or listen to the whole thing—it is nuts. In the episode, SBF describes “yield-farming” using an instructive[4] metaphor of a “box.” In this metaphor you put money into a “box” in exchange for a token[5] that “promises that anything cool that happens because of this box is going to ultimately be usable by, you know, governance vote of holders of the X tokens.” It’s cool, no? The idea is that these tokens have value from these ill-defined governance rights and represent some kind of claim on the money in the box. Hence the more money there is in the box, the more value in the token, right? SBF then goes on to talk about “yields” and “multiples” on the value in the box. Except there is no value in the box. There are assets in the form of the money or crypto “assets” in the box, but the box contains offsetting liabilities too because you can always redeem the token for your money, I guess. When pressed, SBF concedes there is normatively no value here, but that from a descriptive perspective there is an observable market value. OK fair, whatever, but if you “invest” in something you know has no normative value—you are not investing even if it has a market price. But the more people “invest” in this thing with no real value, the more return the early investors see on their value in the market. This isn’t a new idea; that concept was popularized by financial engineering pioneer, Carlo “Charles” Ponzi.  But hey, you can lose money being right all the time on the short side, so SBF was justified when he asked “like you're kind of the guy calling and saying, no, this thing's actually worthless, but in what sense are you right?” Well, you are right when the music stops. And right now, FTX as a major holder of these boxes has $1.7mm in crypto assets and $151.5mm in liabilities.[6] So, uh… the music stopped somewhere.  

So what was FTX even doing? On the surface it was an exchange for crypto “assets” like these tokens that made money the normal way an exchange does. That’s fine, even if the assets on it are kind of scammy and people shouldn’t really buy them. But this is not the FTX story—enter Alameda Research, SBF’s proprietary trading firm.[7] Alameda functioned as a major market-maker on FTX—that’s fine, lots of prop-traders function as market makers. Except Alameda was also controlled by SBF & co; he held 90% of its equity and cofounder Gary Wang held the other 10%. The positive gloss on this is that Alameda was providing early liquidity on FTX until things got going and the training wheels could come off. But the order of events and the link between the two entities suggests that rather than Alameda stepping in to provide liquidity for FTX—FTX was created to provide a captive pool of traders for Alameda to make money from. Beyond normal activities that would entail, it appears that Alameda was using its privileged position[8] in a host of ways including front-running tokens about to list on FTX. Black Edge[9] or not, Alameda was making money on delta-neutral strategies[10] until they decided to take massive directional bets too. Eventually a bunch of these positions blew up when the prices of these “assets” imploded and Alameda found itself in a very deep hole. They tried to fill this hole by borrowing $10b from FTX[11] in margin loans secured with FTT and other tokens.[12] Now, anyone can take a margin loan, but usually these loans come with a lot of conditions. You have to post a lot more value in securities than money you borrow. You have to borrow it from someone else. That someone else can’t just take that money out of brokerage accounts of their customers, and those securities have to be real. They can’t be thinly-traded non-securities you hold so much of that you can easily manipulate their price. None of these conditions held for this transaction. Without these risk precautions both borrower and lender would find themselves in a very precarious place—this is obviously compounded when the lender and the borrower are the same entity. So if there is an other person who could affect the value of the collateral securities decides that he wants to dump his holdings to screw you—you are, indeed, screwed. And that happened when Changpeng Zhao of Binance decided he had had enough of SBF. So things blew up and the marks rushed to get their money back. But the money was gone. After the blow-up a lot more was revealed—and a lot of it is mind-blowingly stupid and likely criminal.

“Never in my career have I seen such a complete failure of corporate controls and such a complete absence of trustworthy financial information as occurred here.” This is how current FTX CEO, John J. Ray sets the table in FTX’s bankruptcy filing. And to put a finer point on it, this dude unwound Enron. Let that sink in. Here are a few highlights of FTX’s boundless cupidity and moronism. The level of misappropriation of funds is pretty wild; Alameda “loaned” SBF $1b. Corporate funds were used to buy real estate and other stuff for employees without any real oversight or documentation. They racked up an outstanding payable to Margaritaville to the tune of $55 grand. Their oversight for expenses seemed to be an open Slack channel with authorization granted through emoji reactions.[13] FTX tried to function like a bank, but the folks there didn’t really bother writing down what money there was or whom it belonged to—even a street loan shark or bookie does that. None of this was viewed as a problem by the firm’s/firms’[14] auditor—an auditor Ray has never heard of but does boast a Metaverse HQ.[15] Compounding all this malfeasance ex ante, a bunch of people and entities appear to have looted the firm(s) of assets after the declaration of bankruptcy. Yet worse, this appears to have happened with the connivance or even participation of Bahamian regulators.     

It is clear that regulators need to step in here, as do the criminal authorities. It is beyond doubt that existing rules and laws have been broken. Furthermore the Bahamians need to get their act together. The folks in Nassau should hew to the values expressed by the pre-1973 motto of "Expulsis piratis, restituta commercia"[16] and arrest SBF and prepare him for extradition to the US. This started as one level of scam that is probably not illegal and snowballed into several levels that almost certainly are. Regardless of what happens next there are a few people who need to face justice.

 This comes to the thorny issue of how regulators should move forward. But before we leap to establishing a new regulatory regime for Crypto and DeFi I think we should take a step back and ask what regulations are for and why SBF was such an outspoken proponent of regulation of this space. To take on the first issue—regulations exist to protect ordinary people and their money from people who would take advantage. SBF and his ilk are clearly the wolves we must protect against. But SBF wanted a regulatory regime to use as a tool to further fleece sheep even more unwitting than those he already did. On the “box” episode of Odd Lots he said “I do think this is the thing that makes me the [most] bullish about like crypto asset pricing is just the amount of money that isn't able to access it today or able to, that isn't accessing it today, you know, one way or another, but directly could be, and very well might start doing so over the next few years.” Here the Ponzi Schemer is arguing that the greatest case for the appreciation of his assets is that there are many more Greater Fools just waiting to further inflate prices. The thing he identifies[17] as stopping them is the lack of a regulatory framework. Lacking an applicable framework, most institutional investors[18] were effectively barred from investing in the space. In this instance a lack of regulation was what protected the greatest number of investors and kept this cancer from metastasizing throughout the greater financial system. A lack of regulation likely stopped some banks from filling their balance sheets with FTT style junk and retail investors from piling into crypto ETF products. SBF is almost explicitly calling for regulation as a fig-leaf to open the gates to even more money to flow into crypto—almost explicitly to pump its market value. So, maybe instead of granting this fig leaf that would legitimize this meshuges—we should just let it burn and punish those who were outright frauds. This leaves a lot of people with some serious losses—but in gambling in this space they took on knowable risks chasing outlandish returns. That toothpaste is well and truly out of the tube—what remains is trying to limit the damage schemes like this can do in the future. Speculation is a feature of the financial system, and we have a host of regulations that limit its activities, even in legitimate cases. To wit, it is illegal to trade onion futures because it is very easy to manipulate onion prices.[19] But at the end of the day—people need onions; they do not need SBF’s magic box and similar schemes. If we can deny onion speculation[20] the legitimacy of regulation, we ought to deny it to this.     

[1] Immense and slightly smug feeling to be exact.

[2] Sometimes out-loud to myself as I listened to Odd Lots episodes about Crypto and DeFi.

[3] Seriously, it turns out to be worse than what he said but even when FTX was going at full flank it was manifestly sketchy.

[4] Even more instructive than he thought, and not in a “well as it turns out” way. Matt Levine saw right through it.  

[5] Read: unlicensed, unregistered non-security.

[6] I don’t know how much of this is to do with the “boxes,” but nor does anyone else. More on that later.

[7] People call it a hedge fund—this is the latest instance of a profound abuse of that term. Hedge funds classically defined are more than just big pools of money that do whatever. And usually they have investors, as far as I can tell Alameda does/did not. These people were not good at record keeping. Or they were good at not record keeping. Jury’s out… metaphorically. The jury hasn’t been empanelled yet.   

[8]IE being indistinct from the exchange itself.

[9] IE cheating.

[10] That is to say, strategies that don’t rely on movements in underlying prices.

[11] Which it bears repeating was not a different organization run by different people.

[12] Non-security, non-money invented by SBF.

[13] I cannot wait to find out what emojis they used… I hope it was 🔥 or 💯. Probably should be 🤡.

[14] This issue is vague.

[15] You really cannot make this shit up.

[16] Latin for “Pirates expelled, commerce restored.” This motto features on a very cool Blue Ensign defaced with the arms of the Crown Colony of the Bahama Islands which was replaced when the archipelago achieved full independence in 1973 after about a decade of home rule dominated by a clique of white businessmen know as the “Bay Street Boys,” which will sound like an off-brand boy band to some readers but to others may evoke a crew of RBC MDs named “Gord” and “Hugh” getting plastered at the Granite after playing shinny against “some boys from Osler’s.” IYKYK.

[17] Correctly, I may add.

[18] Who invest the money of normal people and pension funds.

[19] Seriously, read about it. It is a wild story.

[20] I guess you can engage in all the OTC onion speculation you want, but normals can’t use exchange traded instruments.

Shock Shock

Part I in a series coming to grips with Crypto, DeFi, and Shenanigans

“What’s shocking is the fall from grace, it was so rapid… we’re learning that value can evaporate within minutes in crypto, that’s the most shocking thing.” When I read this statement from a Mizuho analyst for the crypto “asset”[1] class my first reaction was shock—shock that someone could be shocked at this realization or that it was even a realization at all. I will admit as a long-time skeptic of the crypto phenomenon I am currently experiencing one of der besten Freuden there is, Schadenfreude, at the massive implosion of FTX and the general tanking of the crypto world. I have long believed the whole space is an absurdity that can largely be explained by the Austrian Business Cycle Theory of malinvestment—wherein an artificially low cost of credit and increased money supply lead to investment in shit of suspect value. In this case the post Global Financial Crisis world of ZIRP,[2] near ZIRP, and Quantitative Easing has created so much excess liquidity that, beyond flowing into and driving up every asset class under the sun, has spurred the creation of new highly suspect “asset” classes. [3]

As the TikTokers and celebrities rushed for the door in—I remained skeptical and confident that the music would stop and there would be no chairs to sit on if we ever inched closer to realistic pricing of risk. Well here we are—rates are up and crypto is down. Now that the hysteria is starting to wear off—the flaws that were always there are easier to see. Our current monetary system is the product of nearly one millennium of development, much of which has been characterized by extreme growing pains—to say the least. As Winston Churchill is purported to have observed of democracy—the monetary system we have is the worst system imaginable, except for all the others. The crypto and DeFi people were ok at identifying problems with the current system but it seems that building a monetary system de novo was harder than they thought.[4]

Let us begin with my base case argument on cryptocurrencies—for this discussion we will focus on the least insane of them, Bitcoin. I recall being subjected to lectures by people I know and people in the media writ-large about the virtues of Bitcoin. I was told that actually, Charles, money has three characteristics. It functions as a medium of exchange, a unit of account, and as a store of value! The implication being that if I understood this about money itself—I would get Bitcoin and cryptocurrency.[5] Twist: I did in-fact know this ECON100 level pseudo-insight about the nature of money—and that knowledge[6] was one of the underpinnings of my wariness. Now all these things could be true about cryptocurrencies—but they were not in practice true. Bitcoin was and is highly volatile and it is this constant change in its value that makes it highly, highly unsuitable for any of these core functions. Money allows people to transact across time—and if the value is constantly changing through time it is very hard to use it as a medium of exchange. Simply put if I charge you 1 Charlescoin for a Key Lime Pie[7] in the morning and the fluctuation in the value of Charlescoin means that my ingredients cost 1.5 Charlescoins in the afternoon—well that sucks for me doesn’t it? Furthermore if I have a full vault of limes and condensed milk that I have to keep track of, I am going to have to remark the value of that inventory ALL THE TIME and those records will be pretty useless. I could obviate these stresses by transacting and denominating my hoard in limes and cans of milk—but then why have money? Furthermore, I have very little certainty about how many new limes and cans of milk I will be able to buy with all my Charlescoins that I have socked away in my “wallet”—so it’s probably better to store that value more directly in actual goods, as limes[8] are more predictable.

But here is the kicker, this waffle about the three qualities of money, which Bitcoin allegedly demonstrated, was cited to me as the bull case for its rapid appreciation. Lets sum up this ouroboros of nonsense. The monetary qualities of Bitcoin were why it was appreciating so much; the extreme appreciation and concomitant speculation was why it was so volatile; the volatility was why Bitcoin didn’t actually live up to its alleged monetary qualities. So, it was appreciating so much for reasons that couldn’t be true because it was appreciating so much—circular logic that doesn’t actually close as a circle and forms more of a lower-case “e” shape. Now if Bitcoin, et al, had a stable value—all of these things could be true, but both could not be true at the same time, let alone could one be the reason for the other. This fundamentally leaves us with Buffet’s Iron Law of Speculation, Greater Idiot Theory. Momentum was the name of the game—not value.

Now Bitcoin, et al have shed a huge amount of value[9] in the past year—Bitcoin is down 70% TTM. But Bitcoin represents the end of the spectrum that is closer to reasonable and acting in good faith. The real problem is the world of Decentralized Finance or DeFi. I will admit I am not great expert in this field but as I understand it the idea is to create a new financial system, free from intermediation by financial institutions. And sure, I get it banks are bad, we hate banks, lets get rid of the banks.[10] But the rub is that the world of DeFi seems to be rife with institutions and people who function as intermediaries,[11] many of whom appear to be involved in behaviours banks are barred from by “a shitload of really good laws” to paraphrase Tom Hanks as Representative Charles Wilson (D-TX). The bank-like activities these folks engage in involve schemes[12] like the creation of taking deposits, making loans, acting as exchanges and clearing-houses, making markets, or issuing securities that are backed by other assets. But unlike banks, these institutions face no regulation on reserve requirements, leverage, or really anything at all. So the stablecoin you have that’s backed by honest-to-God, take-it-to-the-bank USD… maybe they don’t actually have those dollars to back that up. Maybe their risk management process is, or maybe it simply isn’t. The balance sheet they are lending against, maybe it is made up of complete horseshit low-liquidity assets whose value is easily manipulated. The Bahamian domiciled fund that is the biggest market-maker on an exchange? Maybe it is run by the same 29 year old freaks as the exchange itself and that exchange largely exists to lure marks for their scheme.

Maybe it’s not “maybe” at all.

So when I read so-called experts who are shocked that this could all fall apart so easily. I think about this stuff and am shocked that they are shocked. Nobody could have predicted the exact details of what is unfolding—but the broad shape of it was highly foreseeable.

Stay tuned for the next instalment when I take a deeper dive into the Nightmare in Nassau AKA the FTX Fuckery featuring SBF and his merry band of incompetents / fraudsters.

[1] The OECD defines asset as “entities functioning as stores of value and over which ownership rights are enforced by institutional units, individually or collectively, and from which economic benefits may be derived by their owners by holding them, or using them, over a period of time (the economic benefits consist of primary incomes derived from the use of the asset and the value, including possible holding gains/losses, that could be realised by disposing of the asset or terminating it).” I am not 100% sold cryptocurrencies fit this definition—the strongest case for in on the “holding gains/losses” point.

[2] Zero Interest Rate Policy

[3] I imagine FA Hayek, et al were probably originally thinking about an extra widget line a factory didn’t need and not equity in companies that never will make money, JPEGs of monkeys that you can buy but not own, or fake internet money that exists almost exclusively as a medium of speculation and has less underlying value than a Princess Diana endorsed purple bear plush toy.

[4] Here, I am ascribing to everyone in the space the presumption of good faith—this is a stylized scenario to say the least. I am pretty sure that this assumption does not hold.

[5] Question Begging in the extreme.

[6] I feel stupid calling this knowledge—it’s much like saying that knowing that there are 50 states is knowledge. Yes, one knows it—but it’s not that interesting. It barely rises to the level of a fact.

[7] Objectively, the best dessert. It combines richness and acidity in a way that few other desserts do as well—and it takes only marginally more effort to make than a bowl of ice cream.

[8] Which will quite literally decompose

[9] As ascribed by the market

[10] Blah blah blah—having a banking system is one of the major reasons I get to write this on a computer, sit on an ok chair in a warm house, buy things without having to carry around a bunch of shiny metal or engage in barter, not die from cutting my hand or a toothache… the list goes on. But if you think the banks are robbing you or enslaving you—try living somewhere or sometime that didn’t have them. I hope you like warlords. This is a simplification—but not much.

[11] Because financial intermediaries are useful. Do you like buying stuff or getting paid with relative ease? Thank a financial intermediary.  

[12] Take this in the value neutral, descriptive British sense, e.g. a “parking scheme” or the normative North American sense, e.g. a “Ponzi scheme.” Either works for me.

Do We Get the Full Picture of PE?

Are PE GPs telling the full truth, the whole truth, and nothing but the truth? Do LPs want them to? I shakily stand on the shoulders of giants to find out.

Image Credit: FT Alphaville

Picture this: I was sitting in my room in Jouy-en-Josas, working on a case for my LBO class and mulling the PE industry’s vaunted outperformance of public markets since the dawn of time, when I discovered[1] a 2019 article by Clifford Asness called “The Illiquidity Discount?” that picked away at the conventional thinking about PE. In the article Cliff argued that PE LPs were arguably accepting lower expected returns in exchange for illiquid assets and the understated volatility implicit in that illiquidity. Colour me intrigued. Part of his argument rested on the PE industry measuring itself against inappropriate benchmarks.[2] So I figured I would investigate this and went off to talk about it with my friend and professor, Denis Gromb.[3] When I told him about the article he leapt up[4] to his white board to draw a curve from a paper he had recently read about revisions to prospect theory,[5] showing his characteristic enthusiasm. We lamented that it was too late for me to turn this into an MBA project but I resolved to undertake some research to really look into this. Well long story short I hit a wall in this project[6]—I am no economist and my knowledge of quantitative finance is more suited to its consumption than its production.[7] Jump-cut to the present day when I came across an FT Alphaville post about the phenomenon using the provocative term “Volatility Laundering” featuring the above funny meme-esque image.

Image Credit: Bain & Co. 2022 Global Private Equity Report

But, before we dive into Volatility Laundering, let’s talk a bit about PE returns and how great they are and how they clobber their public comps. Man, just look at how much better those top quartile performers are. Furthermore, the folks at Bain who put this together for their 2022 Global Private Equity Report would like to remind you that most of the S&P appreciation lately has been driven by exposure to giants like Microsoft, Apple, and Amazon—I suppose implying that the buyout funds are actually doing even better than you think! Are they? Depends on how you measure. The Cliff Asness post that got me on this road drew heavy inspiration from and highlighted a paper produced by his ACQ colleagues, “Demystifying Illiquid Assets: Expected Returns for Private Equity” published in The Journal of Alternative Investments. It’s a good technical read—but here are a few things I took away. First, using a large cap index designed to capture the entire equity market (i.e. with a β of 1) is not appropriate for buyout funds who are very clearly not investing in the whole market but rather generally in companies that have greater exposure to the size factor. Furthermore they don’t account for the L word.[8] Accordingly they propose using a leveraged small-cap portfolio as a benchmark. When you measure using that yardstick—the outperformance seems less… outperform-y. They note that from 1986-2017 while PE outperformed large caps by 2.3% p.a. (on an arithmetic mean basis) that gap shrunk to 0.7% against a1.2x levered small cap index. and compared to a Fama French small-value factor portfolio,[9] PE underperformed by 1.6%. Take a look-see at this graph comparing PME vs the S&P 500 and a leverage and factor adjusted S&P 600. Not so rosy. Now granted this stops in 2014 and PE has been on a absolute rip of late.[10]

Image Credit: “Demystifying Illiquid Assets: Expected Returns for Private Equity”

So, that’s returns. Look, they are good. Nobody can argue that. Are they as good as they should be though? Unclear. And that’s why we now turn our attention to return’s good buddy and long-time denominator co-star, risk. Earlier, I pointed out that the ACQ folks identified a mismatch in factor tilt of PE benchmarks and, implicitly, questioned the way we think about PE portfolios. Choosing the S&P 500 as benchmark suggests that PE funds have a β of 1. To put it succinctly, that beggars belief. A priori, it is easy to doubt this, as the whole animating principle of PE and especially good PE is being selective and investing in good companies and not the whole market—to say nothing of investing in smaller companies that generally have higher βs. Don’t take my word for it, the folks at ACQ note that “many empirical studies have concluded that a beta estimate of 1.2–1.5 is more realistic.” The corollary, PE’s volatility is higher than implied and hence risk adjusted returns are overstated.

This leads me to the next issue and the one that Asness originally got me thinking about which is how does illiquidity impact volatility. Let’s engage in a thought experiment:[11]

Image Credit: NOAA

Above we have a week’s worth of tide data for Charles Pierson Dot Com’s Global HQ in Rockland, ME. As we can see the tides vary about 2 metres. We can see that there is a lot of variation in how high the water is and were we to constantly record its height we could get a very accurate picture of its variation. Let’s call this, I don’t know, the public market approach. What if I decided[12] to see this as a much more stable level of water. I could easily do that by only going and looking at the water level at high tide or at low tide. Hey presto, my σ is now close to 0. For symmetry, let’s call this the private market approach. Point is, if you only look some of the times at something that moves a lot instead of all the time, you will miss a lot of the volatility. Furthermore, if I want to show you that the water level is always high, I can just measure it at high tide.[13] Public markets are naturally going to show you all the movement and even if you are really, really assiduous in private markets you will miss much of that movement.

That’s if you are assiduous. But what if you are incentivized to be less assiduous. Well you get this:

What are we looking at? Well, it’s private companies over a billion in valuation and the latest greatest IPO stocks like Airbnb, Palantir and Rivian. This doesn’t perfectly isolate public vs private as a factor, but it’s close. They track closely throughout time as they probably should. But let’s zoom in on early 2020 when we can see the public companies tank and the private companies… don’t. This break in correlation ends once things start ripping again with a bit of a lag for the privates. Now look at the beginning 2022, when things started going pear shaped for markets. After a bit of a drop the privates just… stop moving. A very compelling theory here is that the people who mark the value of these assets just stop when things get rough and then wait until the all-clear has been sounded and they can start credibly marking their assets up again.[14] Generally speaking, asset correlations increase in times of market stress, the opposite appears to be the case here. And it is hard not to draw the conclusion that there is something afoot.

But are PE LP’s just the marks of GP’s here? Let’s see what Bob Maynard, the CIO of Idaho’s Public Employee Retirement System said at a CalPERS conference in 2015:

We did know that our actuaries and accountants would accept the smoothing that the [Private Equity] accounting would do. It may be phony happiness, but we just want to think we are happy and they actually do have consequences for actual contribution rates we are going to be able to put in place[.] Even if [Private Equity] just gave public market returns, we’d be in favor of it because it has some smoothing effects on both reported and actual risks.

So I guess if Bob here is representative, the LPs want to close their eyes and think of a happy place while their GPs tell them stories? Yeah, that’s pretty much what some researchers at University of Florida argue in their paper “Catering and Return Manipulation in Private Equity.” They compare the performance of REITs and PERE[15] returns to show that not only do the PE fund manipulate return and volatility characteristics but that funds that do so are rewarded by LPs. This passage sticks out and highlights how agency theory could explain this[16]:

If a GP boosts or smooths returns, perhaps by strategically timing asset acquisitions and dispositions or by misstating the values of underlying assets, investment managers within LP organizations can report artificially higher Sharpe ratios, alphas, and top-line returns, such as IRRs, to their trustees or other overseers. In doing so, these investment managers, whose median tenure of four years often expires years before the ultimate returns of a PE fund are realized, might improve their internal job security or potential labor market outcomes.

Oof. Now they largely address the issue of IRR manipulation, which is pretty easy to manipulate when you exercise some control over the timing of cashflows. Especially noteworthy is how IRRs seem to peak around times that they are raising money. Viz:

Image Credit: “Catering and Return Manipulation in Private Equity”

They do point out that GPs do not engage in direct overstatement of fund NAVs. And that funds that do are often punished for doing so. But I think the tidal thought experiment is still instructive here—if you measure less often you will observe less volatility. And then it’s hard to look at the IPO vs private unicorn graph and not have some questions about NAV accuracy leap out at you.  

Fundamentally I think the questions raised, and to some extent addressed, here lead me to further question what we we are doing with PE as an asset class. I am not saying PE is bad, far from it, I think PE and especially PE done well is an important activity. At the core, the idea of buying businesses to make them better and then sell them for more than you paid is a good one. But a capital A Alternative is meant to provide uncorrelated returns and enhanced risk/return characteristics. And I am less than convinced that PE actually does that now, despite what people may say. I think at one point when PE and LBOs were new and value abounded it was much easier and less risky for smart people to do this—but that that is increasingly difficult to do in a climate where so much money is chasing a finite number of good deals. Furthermore, I think we are coming out of a low rate environment where equity and debt financing was plentiful, prices always went up, and Alternatives were less and less an alternative. There appear to be structural issues that allow PE to be used as a tool to dress up performance in a host of ways. So we shall see where PE goes from here. And look—there are still tonnes of Mittelstand businesses to roll up in Germany. So with that in mind, who wants to give me some money? I’ll do 1&15 and I promise to not mark NAV too often.  

[1] Read: I was distracting myself on Twitter  

[2] More on that later

[3] It pains me to even think about this, as we have lost tragically lost Denis. Denis meant and still means a lot to me and to everyone in the HEC community. Please read more about Denis and his immense academic, pedagogical, and personal contributions here or here  

[4] No doubt fuelled by the coffee and Auchan escargots de chocolat he had been forcing on me and consuming himself. This was just one of the many memories that people who knew and worked with Denis will always cherish It was a pleasure to know a person who was so comprehensively generous and it breaks my heart that he’s gone. But his memory will live on in all the lives he touched and the work he inspired   

[5] I think; this was all very deep economics that is frankly beyond me. Clearly I should have taken notes—I could have closed this lacuna

[6] That is to say, the wall of my lack of experiment design ability and rudimentary R and Python skills

[7] I can read a paper about it—but I sure cannot write one

[8] No, not the Showtime series—leverage. It’s leverage.

[9] And what is a good buyout target if not a smaller undervalued company??

[10] But so has everything, thanks ZIRP! (Probably)

[11] Long-time readers rejoice: it’s a nautical metaphor

[12] Or was financially incentivized

[13] Caveat time: yeah I know that this metaphor isn’t perfect because tides are totally predictable unlike markets… look, you get it though

[14] I am not saying definitively that is what they are doing, but there is strong circumstantial evidence supported by a priori reasoning to think that they may be.

[15] Private Equity Real Estate

[16] Sorry, another block quote.

Hubris and the Worst LBO in History

The Internet’s leading microblogging platform and home of The Discourse has turned in on itself and become The Discourse itself over the past several months beginning with Elon Musk’s April takeover bid at $54.20[1] representing between a 54%-38% premium depending on the point from which you do the measurement and an EV/EBITDA multiple of way-too-effing-much. After rejecting initial plans to shove a poison pill into this gift horse’s gaping mouth[2] Twitter Dot Com’s board listened to its shareholders who wanted to cash out on this rich offer and accepted.[3] Bluff called, evidently. After much bad-faith hemming and hawing about bots and other nonsense, Musk was looking down the barrel of being forced to follow through with his offer by a Delaware chancery court. So he closed. Here begineth the fun.  

Beyond being the world’s richest man and a genuine pioneer in a few fields, Elon is one of the world’s preeminent Internet trolls.[4] It is in this context as troll that one can best understand what he is up to in buying Twitter. The world’s richest man wants to stick it to the “élites”—in this case people in the media who probably would need a geologic amount of time to equal his net worth and earnings. He claims to want Twitter to be a beacon of true free speech—it is easy to cynically interpret this as a place where you can freely scream slurs and spread conspiracy theories about Paul Pelosi while safe from people engaging in real hate speech and disinformation, i.e. making fun of Elon Musk. More charitably, he believes Twitter will be better with less content moderation. Either way, thumbing his nose at Twitter’s base of power users seems to be at least one of his core goals. Which I guess is a fun project if you are bored of launching rockets.

However, Elon’s wealth is very illiquid and he simply could not afford an all-cash transaction. Accordingly he recruited a few other equity investors like former long-term Ritz Carlton guest Al Waleed bin Talal Al Saud and a bunch of other serious institutional investors. That still wasn’t enough and left a yawning $25.5 billion chasm that needed to be filled with debt. So, Musk agreed to, tried to wriggle out of, and then was compelled to close on a transaction that can be viewed as The Worst LBO in History. Mitt Romney and Henry Kravis didn’t become Mitt Romney and Henry Kravis by borrowing against their own assets to buy businesses with poor cash generation capacity, all while saddling them with truly bonkers debt.[5] What’s more Elon’s Icarus Capital is getting 0&0 on outside equity money. Bravo, world’s richest man.

Surely nobody but the world’s richest man and alleged comprehensive business genius could turn this struggling ship around despite having weighed it down with so much debt that the ship in question has about one inch of freeboard.[6] In the words of Musk’s #1 competitor for society’s biggest troll and fellow absurd leverage enthusiast, Donald J Trump: “WRONG!” Musk’s Twitter now faces about $1 billion in annual interest expense, a modest increase of 2,000% from $50mm. Oh and to put that in perspective Twitter’s 2021 EBITDA was $211mm. YIKES! Holding revenue and expense constant, this is an almost nightmare scenario. Well surely, he can cut costs? Yes, he can and has by halving staff through one of corporate history’s most heartless and inept layoffs. While I am sure that there is plenty of flab to be trimmed from the corporate corpus of Twitter—this is surely going well beyond cutting to the bone and is more likely excising limbs and critical organs. Musk’s Weight Watchers plan amounts to wholesale amputation and hepatectomy. But it’s worse than that. Given the human capital-intensive nature of a tech business reliant on ad sales, it is almost certainly a lobotomy too.

Well surely then, he can just grow revenues! I guess he could, even though probably not enough to slake the contractually justified thirst of his and Twitter’s creditors. Sadly, his current plans to do that are predicated on being an idiot. Plan A appears to follow the framework proposed by the strategy geniuses of the Underpants Gnomes in South Park. Step 1: Piss off advertisers[7] though increased site toxicity[8] and correlated decline in brand safety as well as through outright antagonism.[9] Step 2: ?. Step 3: revenue growth!  

Plan B isn’t much better and suffers from crossed wires with his real goal and idée fixe of annoying the “élites” by reworking Twitters Blue Checkmark system. Admittedly the Blue Checkmark system[10] is one of the world’s dumbest status symbols[11] and is due for serious overhaul.[12] Rather, Elon is going to change it into a premium service tier with some real and other dubious benefits for $96 a year[13] democratizing the Blue Checkmark and stripping the “élites” of their very non-cherished bauble. Of course, Elon sees that Twitter would still need a mark of verification and rolled out[14] the totally different Grey Checkmark authentication. Its prospects for adoption are not great, demand by normals for this semi-good is unknown and its elasticity for current holders doesn’t look good.[15]

One of the benefits your $96 Blue Checkmark buys is a 50% reduction in ads. OK, so how could this impact Elon’s ability to generate profit to pay the creditors? in this ad revenue-supported business Musk will trade half of the ad inventory for people who use Twitter most for $96 a year. So using very loose math and some no doubt tenuous proxies, if we assume that the top 10% of Twitters roughly 400mm users represents the target for the new Blue Checkmark and we can extrapolate that 92% of total tweets they generate is a decent proxy for their share of use and hence ad impressions. Furthermore, AdWeek forecasts $4.67 billion in 2022 ad revenue. That’s per New Bluecheck ad revenue of about $117. If they all take the $96 plunge Musk’s scheme could generate $1.5 billion in incremental revenue—hooray! Not so fast, at Twitter’s 2021 EBITDA margin of 4.03%, that’s only about $60mm in EBITDA for the rapacious creditors. Even at a radically improved margin it’s not a lot. And that’s if my assumptions are correct, CPMs and volume hold, and the plan is executed perfectly. This is of course a highly stylized scenario that is not gonna happen. This is admittedly loose math, but it shows the depth of the hole Elon has dug Twitter into and how hard it will be to build a ladder out.

Where now? Twitter was already a dog in the best of times as Meta, Alphabet, and the streamers were much better at selling ads. However, it is no longer the best of times. From a macro perspective, we are almost certainly heading into a recession or at least a prolonged period of uncertainty—not good for ad revenue. Furthermore all these tech companies are getting hammered by the end of the ZIRP times (which means Elon bought at near the top of the top which is reflected in his being forced into buying in the first place) very bad for exiting from this deal. Add in the fact that Elon has made some really, really bad decisions in structuring his acquisition with bonkers level debt and is making even worse decisions out of the gate on how to run this company. Structurally and executionally this whole deal is effed. In his capacity as Twitter CEO and as a margin borrower, Musk will be facing some very unpleasant calls with creditors who will be asking for their money, money that Twitter will not be able to generate. Perhaps this will be what extinguishes the perennial dumpster-fire that is Twitter Dot Com. Sadly, there will be much collateral damage including to Musk’s shareholders of his good, albeit very richly valued, company Tesla. Ultimately this company is almost certainly heading to bankruptcy or a deeply discounted sale—in either case Musk’s fate will resemble the closing act of Greek tragedy where man is confronted with the results of his own hubris. If it were just Musk taking himself down a peg, so be it. But people have lost their jobs and he has put his other companies in jeopardy—Elon has been the author of their fate as well.               

[1] LOL 420 weed?

[2] Monumentally dumb

[3] Smart

[4] He is also a leading troll IRL—having shouted “boring” at a Tesla creditor who had the temerity to question how the then deeply cash negative automaker would be able to meet its debt service obligations on an earnings call

[5] I suppose in some cases this point is debatable—but at least from their perspective they weren’t personally on the hook too

[6] I make no apologies for nautical references

[7] It is worth noting Twitter is already regarded by these folks as the absolute dog of dogs of social media advertising channels

[8] See: joyous chorus of antisemitic slurs and the N-word

[9] See: tweets from Musk himself threatening advertisers who are walking

[10] Which started as a means of distinguishing who and who was not the real Ashton Kutcher

[11] Which many of its holders don’t actually give a flying F about

[12] Why not open up verification to all users to encourage people to tweet under their real names hoping against hope that the decrease in bots and anonymity would make Twitter less of a hell-site?

[13] An $8 monthly charge negotiated down from $20 by Stephen King

[14] Or did he?

[15] Bloomberg has said they won’t pay for it for their staff.