Via Wolf Street

 “Valuation uncertainties.” And the trail of the Windhorst bonds.

By Nick Corbishley, for WOLF STREET:

H2O Asset Management — a UK-based highly-leveraged hedge fund, majority-owned by French investment bank Natixis — just gated a series of its funds due to illiquidity of its holdings. On Friday evening, France’s chief market regulator, Autorité des marchés financiers (AMF), instructed the firm to close three of its funds due to “valuation uncertainties” resulting from their exposure to unlisted securities linked to the controversial German financier Lars Windhorst.

Besides the three funds indicated by AMF, H2O closed another five funds containing holdings of similarly illiquid assets, with the result that roughly half of the asset management firm’s entire portfolio of assets — €21.7 billion, according to the company’s website — is now under wraps. Trapped investors cannot access their funds, and will be unable to do so for at least the next four weeks, during which time the company will try to sell off the illiquid assets.

Natixis — itself owned by Groupe BPCE, France’s second largest banking group — insists that whatever happens at H2O will have “no financial impact” on its own balance sheet or income statement. Natixis has enough problems of its own to deal with, having suffered significant trading losses in the second quarter as stocks derivatives bets went awry.

In 2015, H20 began purchasing non-rated corporate private placements. They included bonds issued by companies backed by the German entrepreneur Lars Windhorst, who in 2009 had received a suspended prison sentence for breach of trust. After leaving a trail of bankrupt companies, stiffed investors, and unpaid debts, Windhorst was accused by the German financial daily Handelsblatt of “greed, boundlessness and immoral behavior.”

But H2O couldn’t get enough of Windhorst’s bonds and other illiquid assets. By June 2019, the fund’s unlisted holdings accounted for almost 10% of total assets under management. As FT Alphaville reported at the time, they included a €500 million bond issued by Chain Finance, a vehicle that Mr Windhorst used in 2017 to settle outstanding lawsuits and repay existing debts. Nonetheless, €383 million of the €500 million issued ended up in six of H20’s funds, all of which offered investors the prospect of daily withdrawals.

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When the true nature of these private securities were revealed, Morning Star decided to downgrade its rating of the fund. And many of the fund’s investors rushed for the exits. In the space of just over a week, €8 billion — around 30% of the total money parked in the fund — fled the fund.

A sudden surge in outflows can be fatal for an open-end mutual fund with large holdings of illiquid assets. When investors take their money out, the fund has to use up its remaining cash and then has to sell assets in the portfolio to raise money to meet the redemptions. If the assets in question are thinly traded bonds, they can take months or even longer to sell, particularly in a downturn. This gives rise to a “mismatch in liquidity” between what the fund offers to its investors (daily liquidity) and what the fund holds (largely illiquid assets).

But even as billions of euros fled H2O, new money was apparently coming in, said the firm’s CEO Bruno Crastes, who vowed not to shut the fund’s doors, as Neil Woodford had done months earlier with his Woodford Equity Income fund. H2O, Crastes said, would “never” take action to prevent investors from redeeming their assets. But that is precisely what it did on Friday, albeit at the regulator’s request.

According to H2O’s own account, the gating of the eight funds was necessary in order to sift out the privately listed assets and place them in what it calls “side pockets,” while creating new funds to house the other assets, which will be apportioned to existing investors. H2O will then try to complete the sale of the privately listed assets — at a sharp discount — to a Luxembourg-based consortium of investors called Evergreen Funding, which was assembled by none other than Lars Windhorst himself.

These dealings have a strong whiff of fish about them. France’s financial regulator has already flagged “valuation uncertainties” at H2O because of the significant exposure of three of its funds to Windhorst’s securities.

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To buy back his portfolio of bonds from H2O, Windhorst managed to persuade two German business magnates — the fashion retailer Friedrich Knapp and the health care entrepreneur Ulrich Marseille — to pony up around €500 million for a €1.25 billion high-yield bond issued by a Windhorst vehicle, reports Bloomberg. With the newly raised funds, Windhorst, who himself apparently invested about €400 million in the bond, will buy back his own bonds at sharply reduced prices and H2O — or more specifically, its investors — will eat the losses.

Once Windhurst’s bonds have been sold back to Windhorst, the remaining liquid assets placed into new UCITS that comply with the EU’s liquidity rules (Undertakings for the Collective Investment in Transferable Securities are mutual funds that can be sold across the EU). These UCITS will then be reopened and everything will be hunky dory, investors are being told.

But big questions still remain about the state of H2O’s financial health. And there are also concerns that the four-week gating period could be extended, as happened with UK open-end property funds that were gated in March and remain shuttered to this day.

During the massive market sell-off in March, as the virus crisis battered financial markets, two of H2O’s flagship funds — the H2O Multibonds and H2O Allegro funds, housing €4.9 billion and €1.5 billion of assets respectively — slumped 50% in just four weeks, according to Morningstar, which placed the fund under review for the second time in less than a year over concerns about what it called “extreme losses” and “rampant risk taking”. According to the French daily Les Echos, one fund had collapsed by 80%.

“The extent of the recent derailment is alarming,” said Matias Möttölä, associate director for multi-asset and alternatives manager research at Morningstar, during the crash. “These risks come on top of the issues raised in 2019 regarding the fund’s exposure to illiquid bonds that were revealed by the Financial Times.”

H20 responded to the allegations by squarely rejecting them while issuing an apology to investors on the fund’s outsized losses:

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“On behalf of the whole H2O team, we would first like to extend to you and to your clients our sincere apologies for our risk-adjusted losses, which have been particularly significant since early last week… If 2008 was a liquidity crisis, 2011, a volatility crisis and 2016, a convexity crisis, 2020 is a combination of the three previous shocks.”

In its apology, the fund also admitted that during the sell-off in March many of its hedges had not worked out as planned. To compound matters, Blackstone Group dropped H2O as advisor of one of the investment giant’s major funds.

Yet even as the value of its holdings plunged, its hedges went awry and one of its major clients cancelled its contract, H2O still clung to one hope: that central banks would step in and save the day by re-pumping the prices of the high-risk asset classes it likes to hold, such as junk bonds. “Even though the end of the tunnel is not visible yet, the lights have been turned on by central banks and governments,” H2O said in March.

Six months on, central banks and governments have more than delivered. Many asset classes have regained their previous value, in spite of the damage in the real economy. But even this unprecedented bailout still wasn’t enough to solve H2O’s problems, given the gating of the funds on Friday evening. By Nick Corbishley, for WOLF STREET.

As so often, this started well before Covid, but Covid is speeding up the process. Read... Office Towers in Hong Kong Battered from All Directions: Big Haircuts for Investors amid Falling Rents and Rising Vacancies

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