H2O Asset Management carried out hundreds of millions of euros of trades in illiquid bonds in the year before regulators froze its funds, shuffling its exposure to this troublesome debt through a loose network of minor brokerages.
The counterparties are unusual for a €22bn investment firm. They include entities with links to Lars Windhorst, the controversial German businessman that H2O’s portfolio of hard-to-sell bonds are all tied to. There is also a small lossmaking British merchant bank and a mysterious company, “Merit Capital”, that H2O refuses to identify.
H2O initiated these trades, known as “buy and sell back” transactions, in the wake of a Financial Times investigation in June 2019, which revealed that the fund manager held more than €1bn in bonds linked to Mr Windhorst, a flamboyant financier with a history of legal trouble.
The ensuing furore led panicked investors to yank billions of euros from H2O’s funds, while the asset manager was forced to write down the value of the troublesome securities by 60 per cent, it said this week.
Yet H2O was able to reassure its clients about the bonds’ liquidity several days after the FT’s initial report, when it announced that it had managed to sell a large portion of these typically thinly traded securities.
It has now emerged that this sale never actually closed and the asset manager was stuck holding bonds many investors had deemed toxic. But H2O this month revealed it had found an artful solution: “restructure” the abortive disposal into “buy and sell back” transactions.
In these types of trades, asset managers typically take on high-quality and liquid securities, such as government bonds, in exchange for providing short-term loans to their original owner, which buys them back at a later date.
In H2O’s case, entering into these agreements allowed it to reclassify some of the troublesome illiquid bonds outside its main portfolio holdings. Crucially, this meant that these securities were outside the scope of a 10 per cent cap on unlisted investments that applies to open-ended funds.
Matthew Clark, an analyst at Mediobanca, described this approach to fund accounting as “creative”.
Yet H2O breached other rules with these trades. In September 2019, H2O’s Adagio fund breached a risk limit on trades with a single counterparty stemming from transactions with Shard Capital, a small London brokerage, whose founder James Lewis has had a close working relationship with Mr Windhorst for more than a decade.
Shard Capital declined to comment on its role in these trades, but previously told the FT that it acted “under instruction as an execution-only broker”. The ultimate counterparty was not made public.
By the end of 2019, H2O’s flagship MultiBonds fund had €680m of “buy and sell back” transactions outstanding, representing 13.5 per cent of its net assets. These trades were split across three financial institutions — Shard, Merit Capital and Brandon Hill Capital.
Although its trades with each of the three firms were just below a 5 per cent cap on exposure to a single counterparty, H2O still ended up breaching risk limits, which it said was because Brandon Hill was late settling a trade.
Brandon Hill, based in London, describes itself as a “natural resources merchant bank”. The firm, which has no notable record in bond trading and primarily helps small mining companies raise equity funding, made a loss according to its last published accounts for 2018 and its auditor flagged potential doubt about its ability to continue as a going concern. Brandon Hill maintains a business relationship with Shard Capital, according to its website.
Brandon Hill told the FT it acted as “an agent only” in transactions with H2O and “at all times” within “regulated permissions” set by the Financial Conduct Authority.
Merit Capital is more mysterious. MultiBonds’ audited annual accounts refer to a Merit Capital in the UK. Yet there is no business with that name incorporated in the UK, nor does any such company hold a licence with the country’s financial regulator.
People familiar with trading in the Windhorst-linked bonds said they understood the filings referred to Merit Capital in Belgium, a small wealth management firm, whose chairman Henry Gabay is a longtime associate of Mr Windhorst.
Mr Gabay was arrested in late June as part of a German investigation into the “cum-ex” tax arbitration scandal. He was released on bail and has not been charged with any crime. He told the FT that he had offered his “full assistance” to the German authorities in their inquiries and reiterated that he had “no role in any tax fraud or any dividend arbitrage trading”.
Mr Gabay’s Duet Group acquired the then-struggling Merit Capital in 2018 from a group of shareholders including Jan Tops, a former Olympic gold medal winning equestrian, whose showjumping business Mr Windhorst recently invested in.
Funds managed by both Merit and Duet have also previously invested in bonds or stocks related to the German financier.
But Mr Gabay denied Merit was involved with the trades. “Merit Capital incorporated in Belgium has not traded with H2O,” the Swiss-Turkish financier told the Financial Times, when asked about these fund filings.
On his relationship with Mr Windhorst, Mr Gabay said that his Duet Group has done business with more than 1,000 entities. “I have been in finance since 1992 and do have a very large network,” he added.
H2O Asset Management did not respond to repeated requests for clarification on the counterparty’s identity.
Accounts for H2O’s MultiBonds fund show that billions of euros worth of Windhorst-related bonds flowed in and out of the fund over the course of 2019. Four of the top 10 portfolio movements were in securities linked to the German financier — accounting for about €2.9bn worth of both purchases and sales.
“Trading of Lars Windhorst-related private securities accounted for just 5.4 per cent of H2O MultiBonds’ total transaction volume in 2019,” H2O said.
The fund manager added that all of its counterparties are “vetted and preapproved by H2O’s compliance, risk and broker selection departments”. “H2O has acted in line with all rules and regulatory requirements concerning counterparties,” the investment firm said.
A spokesperson for Lars Windhorst said: “We are not aware of these transactions and they are not our concern.”
Mr Clark, the Mediobanca analyst, said: “I fear the seriousness of the deficiencies being revealed at H2O are still under-appreciated.”