It’s all in the price…?

It is probably a truism by now that P&C (re)insurers’ portfolios of Invested Assets (comprised mainly of Fixed Income securities) have suffered from relatively meagre returns because of some ten years of post-GFC interest rate suppression by the major global central banks.

So the fact that the Federal Reserve has gradually raised its benchmark rate (and is expected to continue to do so) and that 10-year US Treasuries now yield around 3% is often considered a precursor to higher portfolio NII, which is a good thing.

However, it is not as simple as that.

As Stuart Shipperlee of ratings-advisory firm Litmus Analysis recently pointed out, for reinsurers in particular, and especially for those with significant casualty books, expected investment returns on reserves are already built into reinsurance pricing models- and the brokers and their clients know that.

Therefore, if the reinsurance market is competitive and functioning as such, a dollar of premium booked which can be invested (and which is expected to provide a higher yield) becomes more valuable, leading to more competition for that dollar.

Of course, if reinsurers were operating in a generally hardening market, one might argue that they could be less aggressive on investment return assumptions and achieve better desired pricing. Unfortunately, and to state the obvious, that is not really happening except in particular loss-affected lines (and even then not to the necessary extent). The effectiveness of CAT pricing models has also gradually improved over time, so the risks of significant under-pricing should be receding. Unfortunately, that does not of itself lead to the ability to improve underwriting margins- only a truly “hard” market like 1992/1993 can do that.

So, as reinsurers approach the important 1/1 renewal season, one is beginning to hear the now-old refrain that the industry needs higher rates on line and to maintain “discipline” in the face of a broker market that has been used for years to shaving a little off the price every year. This is coupled with a hope that, if investment returns elsewhere begin to “normalize”, perhaps peak-ILS will eventually happen, and the industry’s chronic over-capacity for available business will gradually abate. This seems more hope than likely experience in the absence of some other radical catalyst. Capital will flow to where it perceives that sound non-correlated returns may be obtained- and the ILS market is one of them.

Furthermore, and somewhat ironically, a rising rate environment is likely to drive up reinsurers’ own cost of capital, as investors seek higher returns in that sector. This may give some impetus to a firmer holding of the line on necessary rate increases, but still only creates a “zero sum outcome.”

What reinsurers really need are premium revenues that are non-commoditized and offer strong, non-correlated returns when compared with CAT lines. Some think they have found that in covering “cyber” risks. However, given the inherent difficulties in modelling and setting boundaries to both the nature and the quantum of the constantly-mutating threats, we suspect that some are likely to be suddenly and severely disabused of that expectation.

At Awbury, our focus on underwriting bespoke, value-added credit, economic and financial risks readily provides a more attractive risk/reward scenario, which has generated significant returns for our partners since inception 7 years ago- a situation which we believe is both sustainable and scalable through careful risk selection across a wide range of opportunities.

One should always look well beyond the price and simple rate on line, and instead focus on the long-term risks and value of any (re)insurance business line. That is something we do every day.

Call us.

The Awbury Team

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CRE Can be Really Expensive for Lenders (and Investors)…

As we enter what may well be the late stages of the current economic cycle (with uncertainty exacerbated by looming trade wars and Brexit), we read with interest a recent report entitled somewhat provocatively “The CRE Lending Black Hole”, published by the UK’s Property Industry Alliance Debt Group.

The thesis of this document is that (in the context of the UK), if Commercial Real Estate (CRE) lenders (and investors for that matter) properly analyzed the complete “through the cycle” realised profitability of their CRE lending, they would begin to comprehend that, as the title suggests, it has recently been something of a “black hole”; because all the profits they believed they would make and had booked were negated (and more) by the losses from subsequent write-downs and write-offs. It is important to note that the particular period on which the report focused was 1992-2008; for which the authors calculated that write-offs (GBP 19.3BN) exceeded gross profits (GBP 7BN) by almost 200%- and this ignores losses from equity real estate investments.

We are sure that there will be those who quibble with the numbers and challenge the methodologies used (which are carefully explained). However, the difference between supposed profit and realized loss is simply too great to be dismissed. Furthermore, the authors argue that latent losses were potentially much greater at the bottom of the cycle, with lenders being “rescued” from even worse write-offs by being able to “hang on” and wait for values to recover as the economic recovery took hold. Nevertheless, it needs to be pointed out that the particular time period documented encompassed what was the worst downturn in several generations, and so was something of an “outlier”.

So, why did all this happen? What behaviours were major contributory factors? Could it happen again? Is this just a UK phenomenon?

To the first point, the report makes it clear that the 1992-2008 cycle was a more extreme version of previous ones; which, anecdotally, tend to result in a “crash” roughly mid-way through the second decade of expansion. While not participants, some of the Awbury Team have been around long enough to remember the crash of 1974- not as bad, but one that left scars and caused a secondary banking crisis. As in many other areas of the financial industry, it does seem that memories fade, and those still around, who do remember can seem like Cassandras, and too easily ignored.

In terms of behaviour, as the infamous Chuck Prince quote from 2007 makes clear, no-one likes to leave the party while everyone else is still dancing. Internal and external pressures from peers and competitors mean that one needs significant fortitude to decide that actually now would be a very good time to leave, just as it seems that everything is building to the peak. In fact, one should have left some time before. In addition, each sophisticated lending organization is convinced that its policies and procedures, coupled with the quality of its risk management and governance mean that it will be able to “get out” before it is too late. They are almost invariably wrong.

Since the Great Financial Crisis, the amount and quality of capital held by traditional CRE lenders has increased significantly, regulators are more vigilant, and such key metrics as Loan to Value Ratios (LTVs) more conservative. However, there are signs that valuations are stretched in a number of sectors, while the retrenchment of banks has led to much CRE lending now being undertaken by non-bank actors, which are less transparent to the markets. While many, if not most, are experienced and use much less overall leverage, nevertheless, the concern has to be that there are pockets of vulnerability that could trigger a down-cycle.

As the report makes clear, all its data are from the UK. However, one only has to look at experience in the US, Spain, Sweden, Japan- one could go on- to realize that the experience in the UK is hardly unique.

As students of financial history, the Awbury Team believes that a critical component of managing risk successfully is avoiding succumbing to “market groupthink”; being willing to take a contrarian view and, if necessary, walk away from transactions where, no matter how tempting the economics may be, the risk/reward ratio is skewed to the downside, with too many things having to go right. Avoidance of loss and ruin is essential.

Investors may not fully appreciate the losses that can offset profits in CRE; and outcomes measured depend upon the timeframes chosen. Trying to time a market is inherently dangerous (and not just in CRE!). Investors and lenders need to model for the fact that cycles turn; and that, to avoid being forced to liquidate in a hostile environment, one must maintain sufficient flexibility and robust liquidity until markets recover.

The report, while seeking to prove a point, does still provide a salutary example of why “this time round” it is rarely different; and that behaviours need to change if the inherent CRE “boom to bust” cycle is ever to be broken.

The Awbury Team

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Integration is a good thing…until it isn’t…

Much is made these days of the risk of “cyber-attacks” on individuals, businesses and governments, with cyber insurance being one of the few growth areas in the (re)insurance industry. This is as it should be, because even the disclosed events (and the majority are likely not disclosed) show how damaging such attacks can be.

Of particular concern are systems and networks which provide essential services, such as power grids, or air traffic control systems. Yet there are also under-appreciated risks in industries in which there is clear competition, with no obvious monopoly characteristics; one example being the oil and gas business.

Earlier in the year Marsh published a Briefing entitled “Could Energy Industry Dynamics Be Creating an Impending Cyber Storm?”- a headline which should have been guaranteed to catch attention. Not surprisingly, the article highlighted the fact that 76% of executives surveyed believed that Business Interruption (BI) would be the most dangerous cyber loss scenario. Of course, one of the issues the (re)insurance market faces is how to categorize a particular event and which particular policy(ies) should answer- the so-called “hidden cyber” dilemma. Conversely, risk managers may find out that the coverage they thought they had is not there, or capped at much lower levels than expected. Causation and attribution may not always be self-evident in, say, the failure in a well-head pump.

That aside, a key issue that remains to be tested is the extent to which unexpected links and dependencies may show up as the result of a cyber-attack. One targeted at a particular O&G business may have a broad impact because of the fact that, for example, cost-cutting as a result of the 2014-2016 industry downturn has led to supply chains becoming more integrated, with fewer alternative suppliers and greater standardization. Might disruption that flowed from an attack on one oil major’s operations cascade through its supply chain and through that into the operations of other producers? At what point might the digital equivalents of firebreaks stem the attack? Do they even exist?

The benefits of closer and more extensive integration are significant, so it is highly unlikely that the threat of a cyber-attack will reverse that process. However, the ever-expanding “Internet of Things” (IoT) means that more and more components of a business’ critical infrastructure are inter-connected, such that the potential consequences of an effective cyber-attack also increase in magnitude.

Paradoxically, all this means that effective risk management may well need to re-consider the creation of redundancies in systems (compare how civil aircraft are designed) and supply chains in order not to suffer a catastrophic business failure- in essence “buying insurance” that the failure of one link or supplier can be contained, isolated and addressed. It is all very well seeking to be the most efficient and low-cost producer, but that should not come at the expense of potentially embedding the risk of ruin within the overall systems architecture.

Awbury does not write cyber-risk (and has no intention of doing so). However, one has to look beyond obvious first-order effects; and we believe that it is essential that we continue to study and learn more about the threats to otherwise robust and high-quality businesses, let alone to those with less capacity to withstand material disruption to their operations.

The Awbury Team

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A little malfeasance with that mille feuille…?

We wrote recently about the malfeasance that apparently occurred at jeweller Folli Follie; and how it eventually became clear that certain numbers simply did not make sense once tested.

Now comes another example, replete with irony and the potential for slapstick (of the pie-in-face variety) in the form of the near-collapse of publicly-quoted, UK-based café chain Patisserie Valerie (PV), whose original Soho premises some of the Awbury Team can remember visiting more decades ago than they care to remember!

To summarize recent events: on October 10, the company’s directors asked for PVs shares to be suspended, as they had discovered “potentially fraudulent accounting irregularities” in the company’s accounts. Subsequently, the CFO (who had been at the company since 2006) was arrested and bailed by the UK’s Serious Fraud Office, while the company’s major shareholder and Chairman, Luke Johnson, provided emergency loans to keep the business solvent. The Board has since called an emergency shareholders’ meeting for November 1 to approve a “rescue rights issue”, failing the success of which it warns the company may well go into administration.

One delicious irony is that Mr. Johnson, who is an experienced businessman and well-respected entrepreneur, had (a week before the news on PV broke) published an article in the UK’s Times newspaper entitled “A business beginner’s guide to tried and tested swindles”. If it were not true, who could make it up?!

While much remains to be revealed about what exactly caused PV’s near-failure, certain known facts do beg the question about corporate governance and the vigilance of the company’s auditors, Grant Thornton.

For example:

– On September 14 (i.e., almost 4 weeks before the Board’s actions), HMRC had filed a petition in the High Court in London to wind up PV’s key operating subsidiary for a significant unpaid tax bill (since apparently settled)
– The company had reported net cash in its balance sheet of c. GBP 28MM as at the end of its half-year in March 2018. However, it turned out that in fact it had 2 “secret” lines of credit at HSBC and Barclays on which it had borrowed some GBP 10MM, implying that a reported net cash position of GBP 28MM had somehow become a net borrowing positon of GBP 10MM, a “hole” of GBP 38MM, and this for a business that reportedly turns over c. GBP 120MM a year
– Same store sales were almost identical on an annualized basis for the past 5 years at c. GBP 600,000 per store
– Significant sales of shares acquired under incentive schemes were recently made by, amongst other, the now-suspended CFO. Some of the awards made had apparently not been disclosed

The Board professed (and there is absolutely no reason to disbelieve its members) that it was unaware of the HMRC petition and cash shortfall. However, this makes any outside observer wonder what sort of controls, checks and balances were in place to monitor the company’s financial and tax positions; and how, in a fairly unsophisticated business, with rapid turnover and minimal inventory or receivables, no-one, including its Board, bankers and accountants thought to verify its systems were fit for purpose. Was this negligence, or the consequence of a sophisticated and long-standing fraud?

Of course, as always, it is easy to perceive issues with benefit of hindsight and when one is looking for them (such as the remarkably consistent same store sales levels), but the fact that the HMRC had pressed matters to the point of taking the extreme step of filing its petition (and no-one on the Board professed to know), or that there was an almost GBP 40MM “hole” in the company’s cash position does strain credulity.

At Awbury, we “collect” such examples as a reminder that one should always assess key factors for credibility before making any material decision; and we look forward to learning more about what happened, how and why.

The Awbury Team

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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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