It is important to first state that a lot of facts are not know about the charges against Archegos Capital Management’s owner Bill Hwang and former Chief Financial Officer Patrick Halligan.
While the headlines are sensational this is far from the first scandal of this nature and it will not be the last.
Upon reading the release, we first thought that the questions we ask during Due Diligence with regards to fund managers’ investment restrictions and/or leverage/cash borrowing limits, are indeed crucial to protect investors. It seems that a lack of restrictions lead to the downfall of Archegos. While Archegos Capital Management is a family office, the fallout will clearly demonstrate that provisions allowing unrestricted investment and unlimited leverage create risk and is neither prudent nor best practice, for managers, investors, but also intermediaries. How could Wall Street allow this to happen?
After digesting the news, there are more questions than answers. Only time will tell if we understand the facts fully or if this scandal leads to some improvements in the industry’s attitude to risk when it comes to make money. In the meantime, one is left to wonder:
- How an individual who in 2012 settled insider trading charges passed client due diligence with banks and whether any “enhanced” due diligence was performed on the persons or the products at hand as would have been required;
- How great (or little) were the “deceptions” that Archegos’ deployed to induce its counterparties to extend leverage and why they would do so;
- How established risk management controls allowed position exposures to continually increase and who signed off on the increases; and
- Whether security shareholding reporting should change;
The SEC has stated that they will not have fulfilled their mission if they fail to serve and safeguard the retail investor. It is interesting that the lawsuit appears to concentrate on Archegos’ deceptions. In the finance industry as elsewhere, usually, it takes two to tango, one party alone could not without the assistance of the other, reach that level of exposure and indeed that is why banks have their own risk departments. On the surface, it appears that several banks were willing to take on more risk than their controls should have allowed. It seems they chose to become the exposed party for the underlying total return swaps (“TRS”). What review, if any, will be required of the participating banks’ compliance and risk controls? Could this lead to an outcome that could potentially change the direction of the case? This issue is relevant also because banks are owned by shareholders, namely retail investors.
Borrowing and leverage will remain a topic that elicits strong opinions. Laven’s due diligence team assesses the use of leverage and cash borrowing across different asset classes including traditional hedge funds to leveraged private equity transaction, credit funds and cryptocurrency. It goes without saying, but as managers chase returns in an uncertain market it is essential that investors are mindful and understand how leverage and cash borrowing are being deployed.
