Sung Kook Hwang, known as “Bill”, is an unassuming (ex)billionaire. He first made his name in the financial markets under the tutelage of Julian Robertson, the founder of Tiger Capital. Under the Tiger Asia Management moniker, Bill and his alumni went on to manage in excess of USD 5 billion. Not unfamiliar with controversy, Bill is back in the news.
Tiger Asia was eventually wound up in 2012 after settling a civil lawsuit with the SEC for insider trading and price manipulation (Chinese financial stocks).
Archegos Capital Management, founded soon after the Tiger Asia collapse, is Bill Hwang’s private family office based in New York. Nothing out of the ordinary on the surface, this boutique investment firm hit the news wires over the weekend after decimating Wall Street’s banks’ profits, with estimated losses to date in excess of USD 20 Billion. Many wont shed a tear for those losing bonuses this year, but for those ‘Hedge Funds’ that rely on Wall Street (and the other financial centers) what does this mean?
Prime Brokerage is the life blood of the alternative investment sector. Financing and consolidating leverage and short selling, this banking product is not only hugely profitable it generates significant holistic relationships touching each part of the broader investment banking universe.
The profits derived from the prime brokerage model is relatively straight forward, they lend money to hedge funds, allowing them to invest multiples of their underlying asset base, and charge a handsome interest rate for the pleasure. On the short selling end, they generate fees from sourcing stocks to lend out and then utilizing the short sales proceeds to fund lending.
Those with long memories will no doubt recount the numerous market events that have either been sparked, or exacerbated, by the ‘Hedge Fund’ universe – LTCM, Amaranth and Madoff. One trend that cannot be denied, is the amount of capital involved in each case significantly increases event to event. And so, two important questions must be raised, why do prime brokers keep getting burned, and why do banks continue to offer this service?
It is Bill Hwang and Archegos’ turn to step out of the shadows and come under scrutiny. With an estimated asset base of USD 10bn, somehow Archegos has cost the banks USD 20bn. Some are unclear how this math works, and so to simply explain it: he was leveraged. If his principal investments had declined 50%, we can estimate that he must have been at least 6 times levered (i.e. borrowed 500% of his base assets). From that, one can estimate that the prime brokers would be applying a margin rate of anywhere between 15% and 20%. For someone who has been in the industry for over 20 years, I can assure that this scale of leverage is nothing out of the ordinary. So, we can satisfy that leverage was not the issue.
Standing from the outside, and with little knowledge of the Archegos portfolio, this appears to be a ‘concentration’ issue. Two factors affect this 1) concentrated exposure to a single or few investment and 2) market liquidity. The bigger the position you accumulate, the harder it is to exit that position when things go bad. And when they go bad on leverage, they go bad multiple times harder (six times in this case!)
To protect themselves in times of trouble, prime brokers have a contractual arrangement with their clients that allows them to take control of the client’s assets and, take responsibility for managing the risk. However, the prime brokers have multiple mechanisms in place (fire breaks) to ensure that this last resort is avoided at all cost. These include soft measures such as relationship management through to hard measures like daily margin reviews.
For the prime brokers involved in Archegos, these safety mechanisms failed. This is a very early-stage event, and much will be written in the future, but for now we must take a best guess at how this failure happened. Based on my experience, one over-arching theme in the recent reporting is the number of prime brokers involved. The banking business is very competitive, if you want to win, you have to play, and if you are going to play you going to play hard.
I believe Bill Hwang, with a combination of his asset size, reputation, and renowned salesmanship, created an environment of competitiveness that drove the prime brokers to deliver greater flexibility on lending pricing, leverage and position concentration. The prime brokers own desire to nibble at this pie has led to this catastrophic loss.
Where do we go?
The prime brokerage business is profitable and will continue to be so. The alternative investment industry is going to suffer for this though. The prime brokers will need to revisit their risk models and their appetite for lending. Those of us left in the game will feel that effect in our wallets: as someone will have to pay for this, and in our returns: lower leverage equals lower returns.
Archegos is an outside event, but in no way is this a black swan. It is no coincident that this has happened 20+ years after the ‘daddy’ of all spectacular hedge fund failures, LTCM: a firm with too much leverage, over concentrated positions and too many competing prime brokers.
The industry veterans who have seen these past hedge fund blow ups are no longer in prime brokerage space. That knowledge now resides in the buy side, such as Quay Partners. We now drive the industry, and we have a duty to protect the market and the participants. I do not believe this would have happened under our watch.
To learn how Quay Partners can guide your business to success…quaypartners.com .
Quay Partners Group delivers bespoke investment management solutions to independent hedge fund managers and family offices. Thomas Underwood, the Founder, has over 20 years’ experience in managing and operating hedge funds.
30th March 2021