Welcome to the latest issue of Net Interest, and in particular to the 1,400 readers who have joined since last week thanks to our mutual friend, Packy McCormick. Every Friday I go deep on a topic of interest in the financial sector and highlight a few other trending themes below. If you aren’t subscribed, join the crew and sign up here:
Last summer, Steve Clapham and I collaborated on a piece about Greensill Capital. At the time, Greensill was valued at $3.5 billion, flying high alongside the likes of Revolut and Klarna among the most valuable financial technology companies in Europe. In truth, it wasn’t really a fintech, but the company wasn’t shy to promote itself as one and, armed with Softbank investment and a sky-high multiple on sales, it looked like it may have been getting away with it.
Nevertheless, a look under the surface revealed that all was not right. Founded in 2011 by Lex Greensill, the company was a pioneer in a new field of supply chain finance. Steve is an expert in forensic accounting and I’ve seen a fair few financial companies in my time and we agreed – this was a wrong ‘un. We concluded:
The result is an institution drawn to scandal which itself raises several red flags. No-one comes out of this looking good – not the pioneer, nor its main investor, nor the companies it services.
The incoming correspondence each of us received after publishing was very high. Clearly, Greensill was raising eyebrows far and wide.
This week, Greensill collapsed. On Monday, an important insurance contract underpinning some of the company’s assets didn’t renew; later that day Credit Suisse suspended redemptions on funds linked to Greensill assets; in Australia, the company was refused insolvency protection; in Germany, regulators closed down its bank; and at headquarters in the UK, Greensill began the process of filing for bankruptcy.
Financial companies go bust surprisingly often. In the past six months, two banks in America have failed - one in Florida and one in Kansas. In the past five years, over twenty have gone down. In some respects, these are more interesting failures than the ones that get caught in the downdraught of a financial crisis. The environment looks fine, there’s plenty of liquidity sloshing around and yet, in spite of that supportive backdrop … plop.
The demise of Greensill provides a case study of what can go wrong for a financial company when all around it is going right. Steve and I got back together to have a look.
Two Sided Platform
Most financial companies operate two-sided platforms. They take money in on the one side and invest it out on the other. This can create imbalances – it’s very difficult keeping both sides spinning in sync. Marketplace lenders failed to find the equilibrium. When they came to market, firms like Lending Club and Funding Circle saw plenty of demand from people wanting to borrow money but not enough money coming in to fund it. They recruited institutional capital, but that tipped the scales too far the other way, so they loosened lending standards to create more demand.
Banks get around this problem by inserting themselves between the two sides. Depositors don’t even have to worry what is happening on the other side of the balance sheet because deposit insurance creates a firewall. The bank can ratchet up or down its lending standards all it likes, and the depositor is guaranteed their first $250,000 / €100,000 / £85,000 back. Deposit insurance makes owning a bank quite attractive, a point not lost on Greensill, who bought one in 2014.
But Lex Greensill’s ambitions went beyond the perimeter of his bank’s balance sheet, so he still needed to address the challenge of growing his funding sources and growing his pools of demand – and doing them at the same time. His solution was to operate on both sides of the book:
He won over Vodafone as a customer of his core supply-chain finance product but also got Vodafone to participate as an investor. (And to cement the bond further, he hired Vodafone’s treasurer as his CFO.)
He funded Softbank portfolio companies with money provided by … Softbank. (All while Softbank was also an investor in Greensill.)
In each case, funding was withdrawn once it had been exposed by the press. But not before it had represented the market as bigger than it was and flattered Greensill’s position within it. And if these seem like conflicts of interest, they are just the tip of the iceberg.
Conflicts of Interest
There’s a saying in financial services, “one man’s synergies are another man’s conflicts of interest.”
In Greensill’s case, there is little confusion:
💥 Between September 2016 and May 2018, Swiss asset manager GAM became a very large investor in Greensill-sponsored assets. But it also channeled funds into Greensill itself. In fact, the relationship between GAM and Greensill was very cosy: Greensill invested in GAM funds, it lavished the GAM portfolio manager with gifts and it recruited GAM’s former CEO as a senior advisor.
💥 Even after the GAM scandal blew up, causing enormous collateral damage for GAM, Credit Suisse doesn’t seem to have been put off from doing business with Greensill. Lex Greensill is a private banking customer of Credit Suisse and the bank was happy to structure funds around Greensill-sponsored assets which it marketed to clients. It was the suspension of these funds earlier in the week that triggered the group’s downfall. Credit Suisse had also been involved in Greensill’s IPO plans, and lent the company $140 million as a bridge to IPO.
💥 Pull on any thread in the Greensill story and you eventually get to Sanjeev Gupta and his company, GFG Alliance. No other company has been as big a user of Greensill’s financing solutions as GFG Alliance. The Financial Times has reported that as much as half the assets on the €3.5 billion balance sheet of Greensill’s German bank might be Gupta-related; the Australian Financial Review reported that at one point around a third of the financing for a local Gupta business came from Greensill. In the UK, Greensill channeled government-guaranteed coronavirus business interruption loans to Gupta.
And guess what? Sanjeev Gupta used to be a shareholder of Greensill.
In some countries, a legal separation is imposed between commerce and banking to eliminate conflicts that can arise if an industrialist has access to his own bank. In the US, the separation was introduced in the National Bank Act of 1863. The board of Greensill recognised the conflict in 2016 and Gupta agreed to sell his shares back to the founders. But the ‘synergy’ remained: Gupta was hungry for financing and Greensill was hungry to give it.
After he’d sold his shares in Greensill back to the founders, Gupta bought his own bank which he named Wyelands, after his Welsh country estate. “It is part of his vision to support industrial business growth in the UK and around the world, where there is so much untapped potential for growth,” says the website. Yet a lot of Wyelands’ lending found its way into Gupta-controlled companies. UK regulators started looking around, and this week ordered the bank to repay all of its depositors.
The Gupta part of the story is still unravelling, but in his capture of Greensill and Wyelands, it shares many similarities with banking scandals across the world. In 2019, the Punjab and Maharashtra Cooperative Bank in India collapsed after allocating almost three quarters of its loan book to one client – Housing Development and Infrastructure Ltd (HDIL), owned by the Wadhawan family. These banks breach a golden rule of risk management: concentration risk.
Diversification is one of the most basic principles of finance. The European Banking Authority is not underplaying it when it states, “concentration is one of the main possible causes of major losses in a credit institution.”
In order to shield investors from potential losses, Credit Suisse, as a manager of Greensill-sponsored assets, took out credit insurance. Like any good risk manager, Credit Suisse knew to spread even that risk among multiple insurance carriers. It imposed a 20% exposure limit to a single insurer. Unfortunately, it didn’t stick to its own guidelines. Its biggest insurer supplied coverage over 40% of its portfolio, a figure that rose to 75% by July 2020.
It turns out that the insurer breached its own limits. An employee, who has been named in court documents, was fired last summer for signing off on numerous unauthorised policies. When this came to light and the insurer refused to renew, Greensill was left scrabbling around looking for cover.
The demise of Greensill reflects excessive concentration around a few credit exposures like the Gupta group of companies as well as excessive concentration on a few insurance carriers. Why Greensill needed the insurance at all is the next question to ask.
Underwriting credit risk is hard work and like any work that’s hard, people sometimes take short cuts. Last week we discussed Citigroup. In the late 1980s, the bank lent heavily to less-developed countries. When Fed chairman Paul Volcker expressed concerns, Citi’s CEO, Walter Wriston replied: “They’re the best loans I have. Sovereign nations don’t go bankrupt.” (Spoiler: they do, and they did.)
Greensill may have felt less pressure to do the work because of its recourse to insurance.
Yet its underlying credit record is pretty poor. In the past couple of years, at least three Greensill clients have gone bust. These include hospital operator NMC Health, retailer BrightHouse and Singaporean commodities trader Agitrade. Credit insurance placed a veneer over the portfolio and allowed funds managed by Credit Suisse to post stable returns. But as the Governor of the Reserve Bank of India once said, “You can put lipstick on a pig but it doesn’t become a princess.”
Just as monopolists won’t admit it while non-monopolists envy it, a similar dynamic plays out among financial companies. Those too-big-to-fail will do what they can to minimise the look; everyone else puffs themselves up. When Greensill was in court earlier this week arguing for its life, it suggested that its failure could “trigger further adverse consequences” leading to the loss of 50,000 jobs worldwide.
That seems like a bit of an exaggeration, but there will be spillovers. In particular there’s the light it shines on Greensill’s clients. One of the reservations we expressed about Greensill (and supply chain finance in general) is that the practice helps companies disguise their true cash generation capacity and levels of working capital from investors and lenders.
In order to look more closely at the sort of quoted companies which have been using the Greensill facility to move working capital off their balance sheet, we examined the latest published report for the Credit Suisse funds, which lists every single transaction held at the year-end. It contains some interesting clues.
Failed hospital operator NMC Health stands out. It appears to have two subsidiaries securitising debt, NMC Healthcare and Emirates Hospital Group – between them, the fund had over $100 million of exposure, or 18% of the last reported accounts receivable and 26% of cash from operations. Care is required in the comparison of cash from operations, as the securitisation may have occurred over a period of more than one year so it would be better to look at cumulative cash generation, but if this occurred over 2-3 years, the ratio would be 13% or 9% – still highly significant.
The charts below show some other groups which have been involved – Vodafone, General Mills and Newell Brands – with the significance to the accounts receivable balance and to operating cash flow. We have used the closest year end and would again emphasise that cumulative cash flow would be a better tool, but we would need more data.
Vodafone’s involvement with Greensill is touched on above. We were quite surprised by General Mills, however, as this is a high level of securitisation relative to the other quoted companies we looked at.
Looking at the General Mills accounting policies, the Revenue Recognition Note says: “Receivables from customers generally do not bear interest. Payment terms and collection patterns are short-term, and vary around the world and by channel, and as such, we do not have any significant financing components”. That’s an interesting description, given what we see here.
Newell Brands and Henkel are at a lower level but again we would question why they were employing this financing strategy and ask what else they are doing – this is exactly the type of situation where at a hedge fund, we would have expended some effort in looking at the potential short case.
The numbers are less significant to cash generated and as this is a cumulative effect it’s hard to conclude that, with the clear exception of NMC, there has been a distortion of cash generation.
Lord Myners probably put it best when he said last year, “I have taken an interest in Greensill for more than a year. The explosive growth of Greensill in a competitive sector is intriguing.”
When it comes to financial companies, growth is not necessarily good and when it comes quickly, it’s time to ask questions.
Thanks to Steve Clapham for another great collaboration.
More Net Interest
Front Month has a good overview of the Coinbase investment case. The author points out that the core to Coinbase’s offering is liquidity which, like at other exchanges, can be created by enticing institutional investors into its ecosystem at preferential fee rates. As of Q4 2020, institutional customers accounted for two-thirds of trading volume but only 5% of transaction revenue. Coinbase is currently employing enhanced incentives to drive liquidity in traditionally less liquid crypto assets (i.e. not BTC or ETH).
Institutions are able to participate more extensively in the crypto spot market at Coinbase thanks to the vibrant hedging market available over at CME. The Front Month author points out that Coinbase’s market share in crypto began to increase when CME launched Bitcoin futures at the end of 2017. Coinbase is a lot more vertically integrated than other exchanges – it does brokerage, custody and payments as well. It doesn’t do derivatives, although some of its value stems from the fact that CME does.
Jack of Two Trades
This week I collaborated with ace newsletter writer and all round good guy Packy McCormick on a piece comparing Jack Dorsey’s stewardship of Twitter with his stewardship of Square. Although Square has massively outperformed Twitter on Jack’s watch, Twitter is getting its groove back. The grand vision of the two companies are not as far apart as it may seem. From the piece:
… as it stands, Jack currently runs two companies with combined market caps of $165 billion and a clear path to $500 billion in combined market cap within five years. He’s built two companies that have had a bigger impact on giving the Power to the Person than nearly any other -- Square by “blurring the lines between B2C and B2B” and giving small businesses a growing suite of ecommerce and financial tools, Twitter by being the place that the Creator Economy goes to build (and now monetize) an audience.
After we published, Square announced the acquisition of Jay-Z’s Tidal music streaming platform (with Jay-Z joining Square’s board). At one level, the deal gives Square a new acquisition tool and a means to engage customers. At another level, it unlocks something else. As we discussed in Jack of Two Trades, identifying the underserved customer base kick-started growth in both the merchant seller and the consumer Cash App sides of the business. Tidal provides an underserved customer segment where Square can test the convergence between the two.
My most popular reader request is for an overview of the Indian payments landscape. I’ll get to it eventually, I promise!
It’s an interesting (and ongoing) case study – a testbed for how to optimise payment infrastructure. Local policymakers recognised the upside from creating a digital payment infrastructure as a public good, like the internet and GPS, which were initially developed by the US government. They developed the Unified Payments Interface (UPI) in 2016, an instant real-time payment system operated by the National Payments Corporation of India (NPCI) – a not-for-profit organisation owned by the Reserve Bank of India and the commercial banks. UPI went on to do considerable volume (although growth could now be slowing down).
However, in its 2019 Financial Stability Report, the Reserve Bank noted that “NPCI has emerged as a systemically important payment system entity” and opened up a path for private sector involvement. This would, “besides addressing concentration risk, also encourage competition and innovation.”
The window for private sector applications closes at the end of this month. So far, four consortia are in the mix. They comprise a hot shot list of the best local financial companies, the best local strategic investors and the best global tech companies: local banks have partnered up with the likes of Google, Amazon, Facebook, Visa, Mastercard, Reliance, Ola, Airtel. Things are going to get interesting.
Picture credit: Financial Times