I’ve started subscribing to a newsletter called “Money Stuff”, written by Bloomberg contributor Matt Levine (pictured above). Levine falls within the “Opinion” half of Bloomberg’s media operation; this gives him license to report on current events in finance with a degree of flippancy that is equal parts funny and disturbing. The funny part is that billions of dollars are sloshing around in our great financial system and much of that movement can’t really be explained satisfactorily, even by the people doing the moving. That’s also the disturbing part.
One episode that Levine took particular interest in is that of Greensill Capital.
I don’t have any particular insight into the collapse of Greensill Capital, but I must say that I admire Greensill, from a safe distance, for its commitment to the weird shuffling of money. What Greensill does—did, maybe—is “supply chain finance.”
(See, it’s funny because it doesn’t make sense.)
Big companies buy stuff from smaller companies, and have to pay for the stuff within, say, 90 days after delivery. Greensill pays the suppliers, say, 30 days after delivery, but at a discount; the big company now owes the payment to Greensill. It pays the full amount, to Greensill, 90 days after delivery. Greensill has effectively loaned money to the big company; the difference between the discounted price that Greensill pays and the full price it receives is effectively interest on that loan. Greensill would package these loans into notes that it would sell to investors, including some funds run by Credit Suisse Group AG and others run by GAM Investments.
The old “bundling of safe loans into lucrative investments” —- what could go wrong?
First, it’s not obvious that this is anything more than an accounting trick:
[B]ig companies sometimes like to borrow money to meet their working-capital needs. Supply chain finance is arguably preferable to other ways of borrowing the money—like having a revolving credit agreement—because it doesn’t show up on the big company’s balance sheet as debt; it shows up as “accounts payable.” When the big company owes the money to the supplier, it’s an account payable; when Greensill pays off the supplier, it buys the receivable, and the big company still owes an account payable to Greensill.
A basic dumb rule of thumb for big companies is that investors (1) do not like debt (ooh, scary debt), but (2) love accounts payable (ooh, you’re so powerful and so efficient with your cash, you can get your suppliers to wait a long time for payment so you can hang on to your cash). So transforming “debt” into “accounts payable” is a good accounting trick; it makes a company look more valuable, without actually changing anything of substance.[1] Good accounting tricks are worth money, to big companies, and Greensill could profitably sell this trick.
One thing I’ve always found confusing about finance is the multitude of ways to describe the concept of a loan. Selling a bond, of course, is equivalent to being lent money, but the former has much more pizzazz than the latter. The same goes for “accounts payable”. Companies can sell accounts payable to raise cash, and then use that cash to do something else. Which, when you think about it, is somewhat strange, because the accounts payable represents a loan, and why wouldn’t a company want to use its cash to pay off that very loan? As Levine explains, this is another example of the “weird shuffling of money” that characterizes so many finance stories these days. From the accounting perspective, it might be better to have a combination of debt (“accounts payable”) and cash (which can be used for “an investment”) than neither. In fact, Vodafone, one of Greensill Capital’s partners, sold ~$1 billion of its accounts payable and used the proceeds to invest in Greensill’s “Supply Chain Finance Fund.” It’s so breathtakingly dumb that I marvel at the people being paid millions of dollars to do this.
Greensill’s story later took an even more bizarre turn. Greensill worked with one company called Bluestone, which mines metallurgical coal and sells it to steel producers. Obviously, there is a need for “supply-chain finance”, because Bluestone would like to be paid more quickly than their customers are willing to pay them. That’s where Greensill comes in. But, curiously, Greensill’s business with Bluestone extended well beyond Bluestone’s actual customers:
But the money did not all go to financing receivables. Much of it went to financing “prospective receivables” from “prospective buyers.” That is, there would be some steel company that did not buy coal from Bluestone, and Bluestone and Greensill would agree that probably it should and some day it would, and they would figure that, well, if it did buy coal from Bluestone, it would probably buy like $15 million worth, and so Greensill would lend Bluestone that $15 million. And then Greensill would eventually collect the $15 million from the steel producer, if and when it did buy coal from Bluestone. This sounds a little like I’m kidding but I’m absolutely not.
(See, it’s once again funny because it doesn’t make sense.)
And here we get to the nub of the Greensill story. Financial innovation is, in theory, a good thing. Companies can take on less risk, get better lending terms, smooth out their balance sheets, etc. But what passes for financial innovation these days doesn’t actually do any of that. It should instead be viewed as a sophisticated example of fraud. One party is making money by doing the other party dirty. It’s a zero-sum game, and the “innovation” involves finding the sucker.
In the case of Greensill, it found, in Bluestone, a company that was willing to accept short-term loans for receivables it didn’t have and would never have. When Bluestone was, unsurprisingly, unable to pay, Greensill rolled the loans over and the cycle continued. Levine reports that Greensill accrued hundreds of millions of dollars of interest on these short-term loans with a total principal of ~$850 million. Obviously Bluestone should have known better (and, I should mention, this story has come out primarily because Bluestone filed a lawsuit against Greensill). But, on the other hand, I do have a small amount of sympathy for the Bluestone executives who were impressed by the idea of “supply chain finance” and “prospective receivables” and thought that the great minds of Wall Street might be helping them for a change. (In the least surprising turn of events, the scam eventually unraveled, and Greensill filed for bankruptcy. The investors who took the losses? — that would be Softbank, the luminaries behind WeWork.)
In recent weeks, Levine has devoted his newsletter to topics such as non-fungible tokens (NFTs), GameStop, Archegos, and so on. These are all “funny” in the same way that the story of Greensill is funny: someone eventually bears enormous losses, but, in the meantime, wheeeeee! (It reminds me of one of my favorite quotes about the financial crisis, from Citigroup head Chuck Prince: “As long as the music is playing, you’ve got to get up and dance. We’re still dancing.”)
One topic I find particularly interesting is that of special purpose acquisition companies, or “SPACs”. Here’s Levine’s explanation:
A SPAC raises money from investors in a “blank check” initial public offering, puts the money in a pot, and goes out and looks for a private company to merge with. In the merger, the target private company gets the money in the pot and the SPAC shareholders get shares in the new combined company; the result is that the target company has raised cash and gone public through the merger. It is an alternative to an IPO that can offer more speed and certainty and perhaps even a better price.
We have talked about SPACs before, but I have somehow neglected to express appreciation for the clever and elegant bit of financial engineering at the heart of the SPAC structure. Here’s how a SPAC works:
- You give me $10.
- I put your $10 in a pool with a bunch of other people’s $10, held in a trust account at a bank.
- I give you back one share in the pool (representing $10 of money in the pool), and one-quarter of a warrant to buy another share for $11.50. (The combination of the share and part of a warrant is sometimes called a “unit.”)
- I try to find a company to take public within two years.
- If I fail, I give you back your $10 with interest.
- If I succeed, I merge the pool with the company, giving the company the money in the pool and giving you and your fellow shareholders shares (and warrants) in the new combined company. Also I get a bunch of shares and warrants in the combined company, as a reward for my work.
- When I do this, I give you the choice to either (a) let your money ride and take a share in the new company or (b) get your $10 back, with interest.
SPACs are so hot right now that even the New York Times’s Style section reported on how money men are trying to find celebrities (Serena Williams, Paul Ryan, Jay-Z, etc.) to woo investors for their SPACs. To reiterate: people who know next to nothing about investing are being paid lots of money to persuade other people to invest in a newfangled financial product. This is probably as good a sign as any that things are not entirely aboveboard.
One thing that might puzzle you after reading Levine’s description is that the SPAC sounds like free money from the perspective of the investor. I give someone $10 to take a company public. If they fail, I get my $10 back with interest. If they succeed, I either get a share in the company, or I can get my $10 back, again with interest. If I am rational and able to assess that company’s value, I will accept the share only if it is worth more than $10. Ergo, I am guaranteed to make money. And if I am guaranteed to make money, then who exactly is losing it? Or is this one of those unicorn-like examples of financial innovation where all parties benefit?
What is actually happening is not too surprising, but is yet another example of how the usual assumptions of markets — investors are rational and capable of assessing risk/reward — are invariably never true. Here’s the summary from a Harvard Law School article entitled, “A Sober Look at SPACs”
In a nutshell, we find:
- Although SPACs issue shares for roughly $10 and value their shares at $10 when they merge, by the time of the merger the median SPAC holds cash of just $6.67 per share.
- The dilution embedded in SPACs constitutes a cost roughly twice as high as the cost generally attributed to SPACs, even by SPAC skeptics.
- When commentators say SPACs are a cheap way to go public, they are right, but only because SPAC investors are bearing the cost, which is an unsustainable situation.
- Although some SPACs with high-quality sponsors do better than others, SPAC investors that hold shares at the time of a SPAC’s merger see post-merger share prices drop on average by a third or more.
To summarize, financial innovators have once again found the suckers, and they are us. An investor who should be guaranteed at least $10 often winds up with only two-thirds of that, largely because of the complexity embedded in the structure of SPACs (which leads to massive dilution) and the corresponding difficulty in evaluating exactly how much a share is worth.
The funniest part, at least to me, is the claim that SPACs are “unsustainable” because its investors are losing money. This deeply misunderstands the nature of the financial industry. The point is not to help others make money. The point is to do so for oneself. So long as the supply of suckers is renewable, the remaining problems of “sustainability,” I think, solve themselves.
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