What would Benford (or Newcomb) have thought?

Given Awbury’s focus on credit and related risks, we have long been paranoid about missing something “obvious” when analyzing, say, a set of financial accounts.

Our team has been around long enough to remember the likes of Enron, Worldcom and Parmalat; and the sense that in hindsight, the accounting and business frauds should have been obvious, in spite of the fact of information asymmetry between “insiders” and “outsiders”.

Therefore, we are always interested in research that might help to identify and flag situations in which “something does not add up”, thereby leading to closer examination. Naturally, forensic accountants make a living from analyzing fraud and financial malfeasance, but they are almost invariably brought in after the fact, once a problem has been identified.

So, we read with interest of work being undertaken in various quarters intended to provide mechanisms to identify problems ex ante, rather than ex post facto. It seems that, in the era of Big Data and increased computing power, a number of these are based upon the so-called Benford’s Law (also called the First Digit Law, and pre-figured by work done by Newcomb), which posits:

“In lists of numbers from many real-life sources of data, the leading digit is distributed in a specific, non-uniform way.”

So, for example, in any random set of numbers one might expect each number from 1 to 9 to be distributed uniformly (i.e., roughly 11.1% each.) However, somewhat surprisingly, that is not the case. In fact, the number 1 tends to appear some 30.1% of the time and each number from 2 to 9 with gradually decreasing frequency down to number 9 at a mere 4.6%.

This means that the financial data of companies whose accounts do not conform with the Law may be concealing some form of accounting manipulation. Of course, this then begs the question of whether a truly sophisticated financial fraudster, being aware of this fact, could “game” the algorithms being used to detect potential anomalies!

In reality, while a quantitative or statistical approach is no doubt valuable, fraud or malfeasance is committed by human beings (at least in advance of General AI), who do so for many different reasons, not just personal gain. Alignment of incentives, and appropriate governance structures and checks and balances are essential, but not sufficient, in any business; while the human tendency to look for patterns, or to prefer smooth rather than volatile progressions (say, in revenue growth or earnings) can lead to ignoring the fact that the real world is a messy and disorderly place. As the infamous Madoff case demonstrated, smooth and stable returns over lengthening periods of time often mask wrongdoing. And anyone who has been in business long enough knows that a forecast becomes inaccurate the moment it is finalized and published.

Accounting can be mind-numbingly complex, while accounting conventions can also depart from reality. This means that, while one still needs to be able to understand the detail, it is also important to look at the context of a set of accounts and the real-world factors that will have influenced the underlying business, so that one stands a reasonable chance of recognizing when something simply does not make sense, or look right.

In sum, there is no one technique or approach which is likely to identify financial or accounting fraud. One needs to cast the net a widely as possible.

As we said at the start, at Awbury we are constitutionally paranoid; and aim to bring to bear the full range of our knowledge and experience to minimize the risk that we will miss something that should have been “obvious”.

The Awbury Team


It’s not just about China…

As recently volatility in the world’s capital and trading markets has shown, China matters. Concerns about a “hard landing”, currency manipulation, a credit crisis, or geopolitical “frictions” are there for all to see.

Similarly, the impact of low oil prices, the decline of the US coal industry, and dislocations in the NG and LNG markets all matter. And one could go on listing many other examples, both economic and political.

But what if the abilities and authority of one, hitherto obscure, 30-year-old could have a major impact on a broad range of markets and issues? Such is the case with Prince Mohammed bin Salman al-Saud, son of Saudi Arabia’s current monarch, King Salman, who is now widely regarded as the centre of power within the Kingdom.

With a fiscal break-even level estimated at somewhere close to USD 70/barrel of crude oil, and a revenue base almost entirely dependent upon exports of hydrocarbons and petrochemicals, the Kingdom’s finances are severely strained; and it is rapidly eroding its investment balances and reserves at a rate that is unsustainable in the absence of a significant further rise in the price of oil.

So far, so conventional and obvious.

Now, however, the prince has unveiled a plan, entitled “Vision 2030” (bearing the hallmarks of McKinsey’s management consultants) which is premised on weaning the country off what is described as its “addiction to oil”, creating a regional logistics, services and tourism hub (think a larger version of Dubai, with oil) and raising the contribution of the private sector to 65% from 40% by 2030. More startlingly, the prince said that he wants the Kingdom “to live without oil by 2020”. Equally radical is the potential creation of a USD 2 to 3TN sovereign wealth fund, underpinned by an IPO of Saudi Aramco, the source of the Kingdom’s wealth. Bear in mind that the largest existing SWF is currently Norway’s, at less than USD 1TN equivalent.

Think about it: for decades Saudi Arabia has managed to survive the cyclical nature of its resources base; being in a “bad neighbourhod”; and periodic expectations of the fall of the House of Saud; muddling through, suppressing dissent and avoiding any radical changes.

And consider the issues faced:

– A growing, relatively young population, most of whom are under- or mis-educated because of the nature of the educational system
– The constraints imposed across society by the influence of the Wahhabist doctrine
– The scale and complexity of the membership of the House of Saud
– The focus of much employment on government make-work
– An Islamic equivalent of the old Maoist “iron rice bowl”
– The essentially inward-looking and narrow definitions of what is considered acceptable
– Addressing dissent within the Shia minority; and the border war in the Yemen
– The influence of the military-security complex
– The continuing proxy wars and rivalry with Iran

There seems little doubt that the prince is sincere in his aims. However, he is one man- admittedly powerful and largely unchallenged (at least publicly)- and vulnerable.

The irony is that his actions and intentions may well bring about the very thing which he is most assuredly trying to avoid- the fall of the House of Saud- because the brittle nature of Saudi society and culture, and the relatively short time frame in which significant changes are envisaged, are likely to set up tensions and conflicts that could tear that society apart.

Of course, another irony would be that any conflagration within the Kingdom, and interruption in its ability to pump and export crude oil are likely to cause the prices to spike, with significant consequences far beyond the borders of Saudi Arabia.

At Awbury, we shall be keeping a close eye on developments within the Kingdom as part of our constant risk monitoring and assessment.

The Awbury Team


So, you think your company pension is safe and sacrosanct? Dream on…

Given our interest and expertise in managing the sponsor covenant and other risks inherent in defined benefit (DB) pension schemes, we pay close attention to events and disclosures in that area.

Therefore, we have been following the developing “BHS saga” and the increasingly heated controversies surrounding it closely, based upon published information.

To summarize very briefly the background: struggling British high street chain BHS (with a history dating back to 1928) was sold in 2015 by its former owner for GBP 1- to a new management team, which attempted to restructure the business. However, in March 2016, BHS entered a form of voluntary bankruptcy, called a CVA, making further attempts to re-finance and continue in operation. However, on April 25th, the company filed for administration, with there being a real risk that it will be liquidated, affecting some 11,000 employees

As unfortunate as this may be for BHS’s trade creditors and landlords, the real controversy surrounds the extent of underfunding in the company’s DB pension scheme, estimated at GBP 571MM (USD 830MM), and the fact that its assets now fall into the control of the Pension Protection Fund (PPF), which becomes an unsecured creditor of the bankruptcy estate, and is likely to suffer a significant hit to its financial capacity as a result. One consequence will be that the expectations of scheme members in terms of existing and future pension payments will not be met because of the constraints on what the PPF is obligated to pay. Extraordinarily, it appears that there was an agreement between the sponsor and the scheme’s trustees that the deficit could be amortized over 23 (sic) years.

While the PPF was set up by the UK government, it is funded by a levy on risk-based existing UK DB schemes, and does not have a government guarantee of its obligations. While the PPF is currently in a much better financial position that the, in reality, insolvent Pension Benefit Guaranty Corp (PBGC) in the US, the collapse of BHS, and likely resulting shortfall in recoveries, means that the PPF will almost certainly have to increase levies on its Members, potentially provoking a downward spiral of further DB scheme closures and rising levies on the “survivors”.

Naturally, questions are being asked about the legality and morality of the actions of BHS’s former owners, as well as why, at the time of last year’s sale, “pre-clearance” from The Pensions Regulator (TPR) was not sought by the DB scheme’s trustees.

We shall not debate here the merits or potential outcomes of the controversy. Suffice it to say that it seems obvious that both TPR and the PPF will pursue all available avenues to understand and learn from what happened, as well as seek recovery of the deficit as widely as possible because of the “moral hazard” and legal issues the BHS case raises.

Our purpose in writing this post is that Awbury can structure and provide realistic, tailored, private market solutions for both Sponsors and scheme trustees to manage the risks inherent in relying upon the Sponsor covenant, and to bridge the inherent gap and potential conflicts between the interests of both parties, such that the ultimate purpose of any DB scheme, namely providing an agreed level of pension and ancillary benefits to all a scheme’s members is honoured in full.

The Awbury Team