12 May 2021
The biggest lesson from Archegos fiasco is that risk management function should not be a side-kick and should be manned by independent, non-partisan executives who will not bend come what may. While this can slow down the growth, at least the institution will survive to analyze. If not, the board meetings will only happen in corporate cemeteries!
While 99% of today’s news is centered around COVID-19 and its multiple waves across the world, on March 23, 2021 a hedge fund blow-up rattled US and global markets thanks to the little known name called Archegos s (a Greek word, which means “someone who leads the way”). Based in New York, Archegos family office is a hedge fund owned and managed by Bill Hwang, an US immigrant from South Korea. After working with Tiger management (of Robertson fame) Bill Hwang went on to found his own hedge fund to manage his wealth in 2013 with a capital of $200 mn. He managed a long-short portfolio (mainly long), which comprised technology stocks focused on Asian geography. The initial success of Archegos was mainly on star-studded technology names like Amazon, Linkedln, and Netflix. Emboldened by its success, Bill moved to take bets on lesser known technology names like ViacomCBS, Farfetch, Iqiyi, Vipstop, etc. Over time, his successful bets enabled him to grow his firm from $200 mn to $20 bn without the attendant limelight normally associated with such star managers. The fact that Bill remained a lowprofile little-known hedge fund manager speaks volumes about his modus operandi which I explain in the following paragraphs.
Archegos built a portfolio of mainly Asian technology stocks through Total Return Swaps (TRS) with prime brokers. In this arrangement, the prime broker buys the designated stocks (called portfolio) and swaps the return of the portfolio with Archegos for a fee. Technically, the portfolio risk is assumed by Archegos while prime brokers make money through the fees but end up holding the stocks in their books. Additionally, the prime broker also lends money to Archegos to lever up the portfolio and earns interest on this leverage. Archegos dealt with several reputed prime brokers including Morgan Stanley, Goldman Sachs, Credit Suisse, Nomura, Wells Fargo, Deutsche Bank and Mitsubishi.
Where things went wrong?
So, what went wrong? As they say, the party can last as long as the music is playing. In leveraged bets, everyone makes money when the underlying stock price keeps moving up. Technically in that situation, the portfolio value moves up where the investment bank will hand over the profit to Archegos in return for a fixed fee. The increasing value of the portfolio positions Archegos even more favourably now to borrow more and lever up even further. However, the real fun starts when the opposite happens. When the underlying stock price tanks, the exposed investment bank will now demand more collateral from Archegos. If not provided, then it will resort to margin call by selling the underlying stocks and reducing its exposure. This triggers a price fall.
In this particular case study of Archegos, the exposure to ViacomCBS turned sour. After experiencing a tripling in price of the stock, the company decided to tap the market for additional funding in the form of stocks and convertible bonds mainly to shore up liquidity and face intense competition. While the company thought that it is a smart move since it is raising equity at elevated valuation, the market thought otherwise. The stock price of ViacomCBS tanked 9% on March 23rd and 23% on March 24th. Since Archegos has a concentrated portfolio, it triggered panic among the lenders who rushed to sell the portfolio which further reduced the value of all the underlying stocks. Finally, some investment banks escaped with little losses, while Credit Suisse and Nomura were left licking $4.7 billion and $2 billion in losses respectively. Also, Archegos as a firm crumbled to the floor and what was a $20 billion liquid empire came to naughts in about 2 days.
There are several interesting risk management lessons from this Archegos saga.
Risk management back in focus
Investment management business is fiercely competitive and the first casualty of this is the risk management. Risk management is a critical function for both the hedge funds and the lending institutions. In many institutions, the unfortunate truth is that risk management is seen more as an irksome middlemen function preventing the business from growing. Some institutions veer around this problem by assigning ex-business heads to lead the risk management function so that they can have a ‘friendly’ attitude to investing decisions like enrolling risky clients or endorsing risky transactions. Needless to say, risk management function should not be a side-kick and should be manned by independent, nonpartisan executives who will not bend come what may. While this can slow down the growth, at least the institution will survive to analyze. If not, the board meetings will only happen in corporate cemeteries!
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