Archegos: Leverage and the Abandonment of Fundamentals
The spectacular collapse of Archegos Capital at the end of March captivated financial markets as details slowly emerged of the demise of this little-known market participant. Much has been written about the specifics of the collapse and how it occurred. However, it is wrong to view the collapse of Archegos as a peculiarity unique to a highly leveraged trading of derivatives. In fact, Archegos can in many ways be seen as a parable for asset markets more widely over the past two decades and particularly over the past few years.
A 2018 Mckinsey Global Institute report found that corporate debt had grown by approximately 250% between 2000 and 2017 and the Covid pandemic has driven more debt growth in many companies. High and growing debt levels need not be an issue if they are supporting corresponding growth in productive activity. However, corporate debt growth has far outstripped growth in productive activity. The result of this is that on average firms are less able to with stand shocks and are increasingly dependent on rolling over these higher levels of debt. Further, a broader increase in debt levels in the global economy has increased the available funds to invest, driving down yields. To generate returns in this climate, increasingly investments have been made not on the basis of underlying fundamentals, but on the expectation of value appreciation as others think along similar lines. This shift has turned some asset classes into classic bubbles with returns only generated by others buying in. This divorce of prices from the underlying business is now evident in many of the stocks in which Archegos was heavily invested. Furthermore, it is now apparent that its own purchases of stocks such as Viacom, enabled by growing leverage, were significant drivers behind the stock’s growth.
One of the most notable features of such an investment model, especially when heavily reliant on leverage, is the speed of the potential downfall. Indeed, any market where participants rely heavily on leverage are exposed to sharp corrections if lenders become wary of lending against an asset for fear of its value depreciating significantly or uncertainty about future cashflows. This has been the case over the past year in the UK retail sector where NatWest had extended more than 500m pounds in loans backed by shopping centres, primarily to private equity funds. The hit to cashflow at these centres has put hundreds of millions of pounds of these loans in default and it is becoming apparent as the assets are disposed of that NatWest was having a significant impact supporting the market. Without them lending to potential purchasers, and with other banks unkeen to get involved in a troubled sector, values of the assets have crashed, leaving NatWest facing the prospect of significant losses.
Around the world regulators and market watchers are concerned by the ever-growing valuations in many asset classes. In January, legendary investor and GMO co-founder Jeremy Grantham wrote that he believes the current bubble will go down in history as one of the greats, alongside the South Sea Bubble and that of 1929. However, what is evident is the difficulty in deleveraging markets without triggering a collapse in asset prices and existential risks to the broader economy given the extent of the high valuations. In a small way, this was discovered by the investment banks as they sought to manage their exit from Archegos’s positions. Soon they realised that there were significant losses to be realised and scrambled not to be the one who did so. Several articles were written questioning why buyers yesterday at the elevated price were not buyers today at a steep discount, however, these fail to recognise these purchasers were buying not based upon the fundamentals of the firm, but on the expectation of the stock’s appreciation of value. Very rapidly this appreciation narrative changed, and what people were willing to pay changed with it.
At a national level, China has been struggling with this issue for several years. More than any other major economy China reflated post 2008 with incredible amounts of debt. Unsurprisingly, much of this flowed into markets, be that stock exchanges or urban property. Over the past few years China has increasingly tried to address this dependence on debt. However, they have been struggled to balance their desire to rein in speculative activity with their concern about the implications of the massive losses which many would incur if credit tightened rapidly. So far, their policy has broadly been to try and limit further growth in leverage and speculation, avoiding sharp write downs in values caused by a rapid deleveraging, and hoping that slowly improving fundamentals of the assets, or perhaps inflation, will begin to justify the lofty prices which have been attached to many assets.
It is easy to view the collapse at Archegos as the fault of a few fee hungry decision makers. However, such a view fails to appreciate the extent of similar models of investment and risk across the world and across markets. As will have become painfully clear to other Viacom shareholders who had bought stock at elevated prices, collapse of this edifice of debt is fast and brutal. It must be considered, however, that whilst pockets of this sort of destruction may continue to occur, contagion would likely attract a sweeping and comprehensive monetary and fiscal response. On this premise, the only route back to values which reflect the fundamental value of these assets in terms of growth and income is a prolonged level of significant inflation.