It’s a CARVE-up. R you prepared…?

In a world full of risk, it pays to have a range of tools in one’s mental toolbox for analyzing and assessing threats which may arise and their potential impact.

The Awbury team firmly believes that looking at, or framing an issue using one particular approach is both misguided and dangerous. The consequences of trying to fit any risk into a particular model tend to be ruinous in the tail.

So, we are intrigued by a risk identification and ranking system now called “CARVER” (as “CARVE” became “CARVER”), recently highlighted in the Harvard Business Review, which stands for:

Criticality- how essential is “x” to a particular business or entity (which could be yours)?
Accessibility- how vulnerable is “x” to attack or threat?
Recoverability- if “x” were impacted, how quickly would a business or entity recover?
Vulnerability- how well (or not) could “X” withstand an attack or threat?
Effect- what would be the consequences of a failure of “x”?
Recognizability- how easily identifiable is “x” by an adversary or competitor as a valuable target, or particular vulnerability?

The system was developed during WWII by the OSS (a precursor of the CIA) to provide French resistance forces with a means of target identification; and was further refined during the Vietnam War by US Army Special Forces to rank targets. Of course, these are “offensive” uses, but the approach can also be used defensively as a more systematized form of SWOT-analysis.

In its simplest form, one ranks each of the six factors described above on a scale of, say, 1 to 5, from “unimportant” to “critical” to build an aggregate score. This can be used in isolation to give an idea of robustness or vulnerability; or, if multiple components are included, to provide a rank-ordering between them. In the latter case, it could be used, for example, as means of budget allocation. Alternatively, it provides a framework for thinking about the risks that a corporate obligor might be most vulnerable to and which might, therefore, lead to default and bankruptcy.

One advantage the approach offers is that it requires a systematic assessment, with little room for “fudging” the outcome if it is used rigorously and objectively. Of course, it does involve judgement (which can be flawed or tainted by bias), but it also requires a justification to be provided as to why a ranking might be a 1 not a 5 for each factor. Rationally, it would form part of a team approach, in which individuals would each assess and create their “CARVER score” for a particular risk, with a radical difference in outcomes being, in itself, a valuable fact.

Like any model, one has to be careful that its form and content do not somehow lead to the need to “fit” everything within it so that there is a definitive “correct” answer. However, the simple use of the 6-factor checklist can lead to the teasing out of issues that might otherwise be avoided or overlooked.

At Awbury, we are always focused on ways in which we can maintain our edge in the identification, understanding, assessment and management of risk, and CARVER provides another means of doing so.

The Awbury Team

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Beware the Greeks Bearing Gifts…or A Little Trouble in Big China…

The company itself is relatively unimportant, and its name must now be seen in rather an ironic light, but the potential demise of Greek-listed jewellery and accessories chain, Folli Follie (the core of the FF Group) shows yet again that sometimes the numbers just do not add up.

In this case, it appears that the accounts of a key Asian subsidiary, supposedly generating sales in 2017 of EUR 1.1BN were largely a work of fiction, and it probably generated sales of 10% of that level according to a subsequent forensic accounting report prepared for management by Alvarez & Marsal. Similarly, accounts receivables booked at EUR 1BN, may actually amount to 10% of that level. However, it was the difference in actual vs. reported cash balances (EUR 6MM vs. EUR 297MM) that made us almost nostalgic for the epic fraud perpetrated in the Italian dairy company, Parmalat (which came to light in late 2003), when its auditors were duped by forged bank account acknowledgements. Parmalat, once restructured, survived; FF may not.

It is not yet clear whether, and to what extent, the various (small) Greek and Hong Kong audit firms appointed on behalf of the company were complicit, duped, or simply negligent. However, the reported scale, extent and location of the discrepancies would tend to indicate that, as a minimum, the audit process was seriously defective.

Interestingly, the investigation was triggered by a short-seller, Gabriel Grego of Quintessential Capital, pointing out that his investigations of the number of Chinese sales locations led him to believe that the actual number was far less than the company claimed. An example of what sounds like good, old-fashioned “leg work”.

The group’s founders, Dimitros and Ekaterini Koutsolioutos (the family controls 39% of the equity) appear as shocked as anyone else, although a statement including the words “it has not been possible to control the business of the Asian group of companies under my responsibility” begs many questions- particularly in respect of all that missing cash.

When the details are finally known as to how the debacle happened, close attention is likely to be paid to a seemingly unexplained rapid growth in sales and receivables in a key Asian subsidiary, and how accounts (which now seem likely to be demonstrated to be worthless) could be signed off on by management, Board and auditors. Who was relying upon whom? Not surprisingly, the Greek authorities are closely involved in trying to understand what happened, with hints made that reports have been, or shortly will be submitted to local prosecutors for action, while the company is also the subject of various court actions by creditors, and is seeking protection in an attempt to create a viable restructuring plan by mid-November.

One might ask why the Awbury Team should care about such a relatively obscure saga. The answer is simple. While there may seem to be little, if anything, new under the sun in terms of how such apparent frauds are perpetrated, one always learns something from understanding what actually happened and why. The events serve as a reminder that, as always, if something does not make sense or seems too good to be true, one should not just shrug one’s shoulders and accept a facile explanation, but ensure that one keeps searching until one understands the truth and reality of a situation.

The Awbury Team

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Fabled animals and fantastical creatures…

Unicorns used to be seen only on coats of arms, or in the pages of mediaeval romances, as mythical beasts with the power to grant those who were pure of heart and of a virtuous nature wisdom and miraculous powers, while the Cheshire Cat was made popular in Lewis Carroll’s Alice’s Adventures in Wonderland, often disappearing and leaving behind only its grin.

Now, of course, unicorns are proliferating at an unprecedented rate across the world, characterized by those start-up, or relatively new, non-public market businesses which have raised funding at levels that give the overall enterprise a valuation of over USD 1BN, or equivalent.

So, one has to assume that the title of a recent paper by 2 professors, Martin Kenney of UC Davis and John Zysman of UC Berkeley, entitled “Unicorns, Cheshire Cats and the New Dilemmas of Entrepreneurial Finance?” (which we commend as worth reading in its entirety) was designed in part at least to poke fun and provoke.

In it, the authors postulate that, post the “dot.com” crash of 2000, the combination of decreased costs, and increased speed of entry to a market provided by the growth in open source software, digital platforms and cloud computing led to what one might term a “phase change” in not only the number of start-ups, but also the diversity and scale of private funding sources, as well as the infrastructure (incubators and accelerators) available to encourage the developing ecosystem.

It is certainly a strange world in which Masayoshi Son’s Softbank, with supposedly USD 100BN to deploy, has refined what we like to think of as the “Reverse Highwayman”- “Take the money, or else the business gets it…!” (so to speak). This has led to an economic arm’s race, in which Venture Capital (VC) investors seem compelled to advertise that they are raising ever larger funds to make sure they are not left out as the price of entry keeps rising.

Apart from the serious dislocations being seen in the San Francisco Bay Area’s housing market and social patterns, these developments bring to mind the usual thought: “How will it all end?” Whole industries are being up-ended by the entry of competitors who are able to bear large losses and burn ridiculous amounts of cash for longer than before, in the hope that eventually they will not only supplant the hitherto dominant incumbents, but also out-compete (as the paper’s authors state) “other lavishly-funded start-ups”, who have also had the temerity to attempt to enter the same space. VC was always intended to provide entrepreneurs with (another quotation) “sufficient funding to cross the infamous “financial valley of death””- which is not quite as life-threatening and foolhardily brave as charging the Russian cannon at Balaclava, but hitherto probably had even higher casualty rates.

The irony here is that the collateral damage (the existing incumbents), which is usually conventionally and conservatively funded, has to be profitable in order to be able to compete and sustain the financial barrage from those aiming to put them out of business, because the insurgents are being allowed to play by different rules, in which rising attritional losses are a badge of honour- at least as long as the original “business case” is still seen as valid by its supporters. And this approach is exacerbated by the fact that, in many areas, there is a potential Winner Takes All (WTA) outcome in which the successful “platform” simply overwhelms all other competitors. Google’s search business is probably the most famous exemplar of that reality.

The problem with the WTA approach is that it has a corollary- LLA- the Losers Lose All, crashing to oblivion, having burned through their resources. As the paper’s authors state: “It may ultimately be the case that these Unicorns may turn out to be a very short-lived breed such as the Cheshire Cat… all that would remain was the iconic grin.” However, rather than dispensing wisdom and miracles, they may by then have laid waste to large sections of the economy and potentially changed the development of whole societies- but that is a topic for another post.

The Awbury Team

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The long weekend…

While perhaps not comparable with the assassinations of John F Kennedy and Dr. Martin Luther King Junior, or the horror of 9/11, the weekend during which Lehman was allowed to fail and the rescue of AIG was arranged will certainly scar the memory of all those who were in the finance industry at the time, as well as of all who suffered its consequences.

With hindsight, to quote Wellington after the Battle of Waterloo: “…[it was] the closest run thing you ever saw in your life”. Unlike during the Great Depression, there were no material bank runs (at least in the US), although anecdotally those were averted more by happenstance than direct action, but the Federal Reserve, acting on behalf of the US Treasury, subsequently pumped literally hundreds of billions of dollars (and, ultimately, trillions) into the financial system and economy; and the GSEs, Fannie Mae and Freddie Mac were effectively nationalized, as was AIG. Lehman’s disorderly failure was, however, the catalyst.

While the merits or otherwise of whether Lehman should have been allowed to fail are still hotly debated, and arguably it would have been a lot “cheaper” to rescue the firm, the decision was a political one, not a rational economic one. The politicians were worried about being castigated for “bailing out the fat cats” as they were when JPM Morgan absorbed Bear Stearns. In view of what subsequently happened, a little more intestinal fortitude might have been in order, even if socializing risks accumulated by private capital is morally distasteful.

Naturally, this post is one of probably hundreds of articles that have appeared recently. So one might ask- to what purpose? Who cares?

Well, anyone who has any exposure to the financial system (and everyone does, directly or indirectly) should care. Most wealth is now not held in material form, or as “cash under the mattress”, but in the form of de-materialized claims, almost all of which exist in the books of a private financial institution. Very few of us have the privilege of, literally, having an account at the Fed or the Bank of England.

So, it behooves anyone who cares about the long term welfare of themselves, their business or family to consider whether much has changed since the dark days of 2008-9; what might signal the onset of another financial crisis (and there will be one- they occur frequently); and how they can protect against the consequences.

Awbury’s business was built in the aftermath of the GFC, because its creators saw that while fear, uncertainty and dislocation were widespread, economic life would go one; the need for sophisticated and bespoke solutions to credit, financial and economic problems would not go away; and thus there was an opportunity for an experienced, diverse and disciplined team of credit underwriters and managers to create a franchise. While, even in the face of reasonable success, we remain habitually paranoid, almost 7 years later that is exactly what we have done.

Of course, when we start hearing the phrase “this time it’s different” uttered regularly, we will know that the time is again approaching to batten down the hatches, drop the storm anchors, and be prepared to ride out the approaching storm- even if its precise origin and direction remain unclear. The aim will be to be in a position to “buy” when it passes. During a Wharton seminar, James Dinan of York Capital recently amended an oft-repeated Rothschild dictum (also from the time of the Battle of Waterloo): “The best time to buy is when there’s blood in the streets, but not if it’s your blood.” He also commented: “Credit investors smell the fear before equity investors do.”

Ten years is still, in one sense, quite a long time in the course of a human lifespan. People tend to forget, or become complacent. They should not.

The Awbury Team

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Ten Green Bottles…or Last Person Standing…?

The current open season on (re)insurance M&A, brought to mind the children’s song, with its image of objects falling one by one. Alternatively, one might start to wonder about who, amidst all the activity and the apparent significant narrowing of the pool of available “targets” will remain the last person standing.

We are sure, as the industry heads to Monte Carlo for several days of frenzied meetings and hospitality, that speculation will be rife as to whether further transactions may be agreed at 3am, in venues carefully screened from the Tables.

Already this year AIG has acquired Validus; Axa should shortly complete its acquisition of XL; while Aspen is likely to disappear into the portfolio of the Apollo Group. The market capitalizations or likely acquisition price of those peer entities which remain independent certainly opens them to being in the sights of a range of potential acquirers, with none invulnerable in simple economic terms to a bid.

As S&P pointed out in its recent “Bulking Up: The Global Reinsurance Sector Marches Towards Consolidation” report, the entire sector faces tough market conditions and structural changes, which weaken competitive positions (as well as lower returns on equity- largely mediocre at best), driving senior executives to seek cover in M&A activity and an attempt to increase premium flow through a supposedly more efficient cost structure and a broader range of product lines.

The problem is, if everyone is doing it, what is really going to differentiate the “thrivers” from the survivors, let alone the obsolescent zombies hoping to shuffle along without being finally put out of their misery? It is a truism of corporate lore that many mergers do not deliver the promised “synergies and efficiencies”, and are often value destructive because vested interests (and self-preservation) prevent the implementation of truly radical actions which could deliver clear benefits.

Of course, the reinsurance market, while it contains a number of “big beasts”, is hardly dominated by them, as they are not able to extract rents because of the availability of alternative capital. The market still remains quite fragmented even after years of consolidation. This then begs the question of whether reinsurance M&A is now “offensive” or “defensive”. In most cases, it appears defensive, as the acquirers are trying more to protect themselves against increasing market pressures, rather than gain capabilities that will truly enable them to break away from the pack.

In reality, no-one is going to be surprised by the next M&A announcement as long as the current patterns and behaviour persist. There is little or no originality being exhibited, with most of the excitement now arising in the form of Insurtech investments, and attempts to change business models internally. If that is the case, one could argue that a potential acquirer’s management should ask itself some hard questions about the true purpose of an intended acquisition and how it will truly improve the acquirer’s competitive position.

It seems to us that, while there may be a need for some “one stop shops”, there also remains a clear need for innovative business models that break away from the realm of the “expected” and deliver products and services to their clients that the “big beasts”, weighed down by their often bureaucratic structures and processes, find it hard to provide.

The Awbury Team

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A FIRRMA Hand…

Until fairly recently, the meaning of the acronym CFIUS was probably opaque to most people. While the Committee on Foreign Investment in the United States was created by President Ford under Executive Order in 1975 and given expanded powers by a further Executive Order by President Reagan in 1988, its existence and functions were fairly obscure until the last few years. It is chaired by the Secretary of the Treasury, with membership drawn from a broad range of federal departments and agencies.

Now, however, under legislation recently signed into law by President Trump (the Foreign Investment Risk Review Act- FIRRMA), CFIUS has been granted a greatly expanded remit and enhanced powers. The reasons for this lie in concerns by the US Administration and Congress that foreign actors (code, in particular, for entities from or associated with the PRC, an obvious strategic rival) are taking advantage of lacunae in existing rules to take control of or gain access to businesses and assets (both real and virtual) essential to the national security interests of the US, creating the potential for serious harm.

The definition in the legislation of a “covered transaction” subject to CFIUS review has been significantly broadened to include non-controlling investments (“other investments”) in US businesses, as well as investments in real estate near US military or national security related sites (including, potentially, Trump Tower in Manhattan.) Not only that but the definition of a “US business” has been amended to “a person engaged in interstate commerce in the US”. In addition there is now a requirement that potential acquirers give notice to CFIUS of a transaction that may fall within its purview.

The focus of CFIUS’s new mandate will be on businesses involved in 3 key areas: “critical infrastructure”; “critical technologies”; or maintaining or collecting “sensitive personal data of US citizens that may be exploited in a manner that threatens national security”.

One can see from all this that the probability of CFIUS becoming involved in reviewing direct and indirect (i.e., foreign investor) proposed transactions has now greatly increased, with any would be acquirer having to seek advice on navigating a process for which the parameters have yet to be defined (as CFIUS is supposed to publish regulations clarifying its interpretation of the new FIRRMA provisions.) This begs the questions of whether sufficient resources will be provided to manage the processes now created.

There is also now the concept of a “Country of Special Concern”, which leads to heightened scrutiny by CFIUS. These countries are not identified in the legislation, but it does not require too much guesswork to identify not only the primary target (the PRC), but also the level of discretion given to CFIUS to act against particular “out of favour” jurisdictions.

One can certainly understand the reasons behind the new FIRRMA legislation, in a world in which powers over trade and commerce are being much more explicitly wielded as weapons to modify or compel particular actions. However, the level of uncertainty which its significantly expanded but, as yet, undefined scope and interpretation introduces may create a potentially chilling effect upon capital allocation and cross-border FDI in which a “US business” is the subject of interest.

And it would be foolish to expect other states not to reciprocate, thereby potentially affecting the ability of US investors to deploy capital globally. One can envision the potential for both misunderstanding of FIRRMA’s applications and for earnest signaling of “peaceful intentions” by governments that do not wish to find their own multinationals or investment arms shut out of acquisitions in the US markets.

At Awbury, understanding and assessing FIRRMa’s implications will be another factor in our comprehensive assessment of the all the transactions which we undertake.

The Awbury Team

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Time for a pack of Balkan Sobranie and a bottle of Arak as well as that Turkish bath…?

Kemal Ataturk, founder of the Republic of Turkey, must be trying to break out of his mausoleum by now. Is it just coincidence that, at the centenary of the dissolution of the multi-ethnic Ottoman Empire (the original “Sick Man or Europe”) in 1918, Turkey finds itself under a new executive president, whose official residence in Ankara rivals the legendary palaces and mosques of Istanbul in scale, if falling somewhat short on architectural merit?

One could argue that the current and growing economic crisis in Turkey (compounded by its political spat with the US) was unexpected. However, in reality, it had been building for some while, particularly in the wake of the attempted coup in 2016, which led to the gutting of much of the bureaucracy for its supposed Gulenist tendencies and the intimidation of some of the country’s leading business conglomerates through the (mis)use of the tax system, leading to increasing uncertainty over FDI. In addition, the President quite clearly suborned the supposed independence of the Central Bank in order to keep interest rates lower than they would otherwise have been. While this is not exactly unique behaviour for a politician, it added to the belief that economic policy was now subject o the whims of an individual who believed that, somehow, the usual outcomes would be avoided.

All this is somewhat ironic, as, during the early days of his period in government, now-President Erdogan and his senior AK Party colleagues restructured Turkey’s economy in ways that brought it into the modern era and enabled a significant rise in productivity and standards of living, as well as the prospect of full membership of the EU. As a result, there was hope that the economy could escape from what had been a cycle of boom and bust, with its dependency on foreign currency borrowings, and persistent structural weaknesses in its balance of payments.

That achievement is now under serious threat, with potential consequences that reach far beyond the country’s borders, as questions arise about the possibility of a new emerging markets crisis, with Turkey as the tipping point.

Firstly, while not yet quite in freefall, the Turkish lira is doing a very good impression of repeatedly diving off cliffs to reach successive lows against the US Dollar- down over 40% year-to-date. Amongst other things, as the FT pointed out, this now makes the cost of oil imports (always a weakness for the economy) in Lira terms almost 3 times what they were when Brent crude peaked at USD 147.50/barrel in 2008.

Secondly, the US is using sanctions against Turkey on items such as steel and aluminium to try to compel the Turkish government to release a detained US citizen. Again, hardly unique, but it adds to uncertainty over the extent to which the US will arbitrarily use sanctions over even the smallest perceived “slight”. One wonders when the “gunboats” will appear on the horizon

Thirdly, the ECB is clearly becoming worried about the impact of events in Turkey on the balance sheets of several major European banks (a re-run of the Greek debacle), whom we suspect will not have fully modelled the deteriorating scenario now unfolding. Already credit spreads on those seen as having the greatest potential exposure are widening.

Fourthly, there is likely to be a major showdown over the use by its NATO “allies” of Turkey’s key Incirlik air base, which is vital for providing aircover across numerous US and NATO military operations in the region.

Fifthly, good old-fashioned roll-over risk is returning within the Turkish banking system; with the BIS estimating that the system’s external liabilities now exceed its external assets by almost 3:1. In addition, it seems inevitable that the quality of domestic banking books will deteriorate.

So, definitely another situation to add to the list of stressors for the global economy, even if that beach holiday in Antalya’s “Turkish Riviera” is now much cheaper.

As always at Awbury, even when we have no direct exposures, we are monitoring potential second- and third order effects. Long experience has taught us that failure to pay attention to rapidly-changing systemic dynamics can have unforeseen and unfortunate consequences. No August “off”!

The Awbury Team

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