Lack of ODD Led to Failure to Identify Losses at Archegos
We’ve posted articles in the past about the importance of a robust and ideally, automated Operational Due Diligence solution. We’ve shared theoretical evidence of how a lack of effective ODD can lead to increased risk and operational failures for any company. But to better illustrate our point, we’d like to bring in some real world examples of how a lack of ODD can cause huge problems, sometimes leading to losses of hundreds of millions of dollars or more.
In this situation, the participants in question (i.e.the Banks and the Prime Brokers) didn’t truly understand the strategy being employed by their target company, Archegos, and how many companies were involved in the larger equation of Archego’s investment strategy. This led to a huge lack of understanding of the stakes of their transactions, something that might have been avoided with Operational Due Diligence processes firmly in place.
No ODD = Big Losses: The Story of Archegos
Bill Hwang started out as a successful businessman. He was in charge of Tiger Asia Management, a spin-off of Julian Roberston’s Tiger Management after he closed his fund in 2000. Many are even familiar with this part of Mr. Hwang’s story: how after pleading guilty in 2012 to insider trading he was forced to pay out 44 million dollars in a settlement, and close down all aspects of his business except for a family office, Archegos, which was created in 2013.
As a family office, Hwang’s Archegos was not obligated to disclose positions under the “private adviser exemption” provided under the Advisers Act (to firms that advise less than 15 clients), and therefore was immune to many of the regulatory reporting requirements generally involved in this type of wealth management. Archegos used a clever method of “total return swaps” to essentially place a bet that a stock would rise in value without actually owning the stock, giving companies working with them an inflated sense of the funds overall size.
Using this method, Archegos bought a large volume of a relatively small number of big name stocks. When stock prices rose for these companies, Archegos rode the market to new highs. For a while, they were highly successful with this strategy. The company posted gains of 148% in 2020. They had over 30 billion dollars in assets, and approximately 6 times leverage in 2020. In other words, everything was going smoothly on the surface, and they had every reason to believe they would continue their climb using their method of swaps, carefully cultivated relationships, and a lack of oversight.
Unfortunately, all was not as it seemed. Because no one was diving into Archegos’ records, and because due to the family office exemption, Archegos was not required to file due diligence and create transparency in the market, few were aware (until it was too late) that Archegos’ worth was inflated, and they didn’t have necessary capital available in the event of a market downturn.
As such, Hwang did not have the capital to satisfy margin calls when shares like Viacom CBS and Discovery Communications Inc. started dropping precipitously. This then required liquidation, which further caused a drop in the fund to an untenable amount. Archegos had contracts outstanding with many banks, each not knowing the full extent of their exposure due to the aforementioned lack of transparency.
This led to an intense amount of financial wreckage and substantial losses taken on by companies outside Archegos. In 2013, the company boasted 200 million dollars. With gains and margins, at its height, that number grew to 30 billion dollars. For their troubles, many culpable banks lost big (close to 10 billion dollars overall), from Credit Suisse to Nomura.
What we can learn from Archegos about ODD:
Like any cautionary tale, there are lessons to be learned from Archegos’ failure and the losses sustained by their negligence. Helpfully, Morgan Stanley issued a report in which they found three key takeaways to be gleaned from this substantial mishap in the form of lessons learned:
- The banking system was in much better shape than in 2006, so banks were more open to these types of arrangements, for better or worse.
- Weak regulatory oversight existed for non-bank entities like family offices, creating a loophole in the oversight process.
- The solution was: better onboarding and diligence processes to improve transparency.
This, of course, largely refers to better operational due diligence practices being implemented from the get-go, to avoid this sort of speculative problem of lack of oversight spiraling out of control.
In the case of Bill Hwang, there were a few key issues that an intensive ODD process could have easily spotted and taken into consideration. These are: the fact that an individual lender did not fully understand the extent to which the family office was levered, that the strategies employed by Archegos as a fund were not clearly enumerated, and that there was not full transparency to senior management as to the full extent of the risk taken on by their bank.
We believe that by the fund completing a Due Diligence Questionnaire, the banks involved in this financial tragedy would have a solid understanding of the exposure to the market, been able to fully evaluate Archegos’ holdings and infrastructure in view of its assets and leverage, review the regulatory history of the founder to see where weak points might be lurking, and of course, assess the operational integrity to include the competency of the staff and system as a whole, at every step of their transactions.
The bottom line is this: if a competent ODD process had been undertaken with Archegos, the banks that suffered losses would have had a much better chance of mitigating the issues of the family office shell from early on, and likely either never have agreed to do business with Archegos, or at least to have gotten out before they sustained significant losses themselves.
This means that any company looking for protection from potential exposure, whether on the level of Archegos or not, should consider their current ODD practices. If they are found to be lacking, they should be looking to actively upgrade and invest in strengthening these practices to avoid potential devastation.