Since the emergence of “Modern Portfolio Theory” and the “Capital Asset Pricing Model” in the late 1960s, institutional investors have taken a quantitatively driven approach to portfolio construction, looking to create portfolio diversification and obtain better risk-adjusted returns by balancing their asset-class exposures. This journey has seen several important advancements in thinking about how to optimally achieve desired results.
Funds that want to take the total portfolio approach first need to get the total portfolio view. To do that they not only need data – and lots of it – but a rock-solid understanding of exactly how they’re going to use it.
Wirecard’s spectacular collapse: a lesson in due diligence
by Greg Bright
In one of the most stunning corporate failures in recent years, the big German payments fintech company Wirecard AG went into liquidation late last month and is now subject to fraud investigations, including money laundering and even dealing in the armaments trade. It is the first DAX 30 index stock – Germany’s equivalent of the Dow Jones Industrial Index – to go into liquidation. Castle Hall, the world’s largest specialist due diligence firm, says there were four main themes or warning signs.
Castle Hall, which has offices in five countries including Australia, produced a short white paper on the Wirecard story early this month (July 6). Wirecard was a high-flying company and the prestigious symbol of corporate Germany’s pivot to fintech. It was a “darling of the EU technology industry”, the paper says, with a market capitalisation of €25 billion (A$40.6 billion) when it joined the index. It symbolised replacing old-economy Commerzbank payments with a new-economy fintech system. While Castle Hall identified four main warning signs of the collapse, it says the most obvious lesson for investors is the one they should always remember: “if it looks too good to be true, it probably is”. With Wirecard, the four main themes were:
Audit failure
- The ‘Financial Times’ (FT) newspaper had been raising uncomfortable questions about Wirecard since 2015, based on the limited publicly available information, compared with what the auditor, in this case EY, could see. On June 25 this year it produced the killer blow, saying: there were “clear indications that this was an elaborate and sophisticated fraud, involving multiple parties around the world in different institutions, with a deliberate aim of deception”. The FT said, though, “even the most robust audit procedures may not uncover this kind of fraud”.
In the following day’s newspaper it detailed failings in the audit system: “EY failed for more than three years to request crucial account information from a Singapore bank where Wirecard claimed it had up to €1billion (A$1.6 billion) in cash – a routine audit procedure that could have uncovered the vast fraud at the German payments group… At the time, Wirecard held assets in Singapore, before moving them to the Philippines.
Castle Hall says: “If this is true – and, as alleged, EY did rely on indirect confirmation of cash balances and documents given to them by Wirecard themselves – then this is an audit failure that, in our view, could reach the level of Enron. It is imperative for any auditor to independently confirm cash balances direct with the banking institution. This must especially be the case in a situation where there clearly is rumour and uncertainty around the company: cash should have been the number one audit risk when EY were planning their engagement. We reserve judgement until more facts emerge. However, in Castle Hall’s diligence work, we have seen other examples where auditors apparently accept documents given to them by the asset manager as audit “evidence”, notably in private market strategies.”
Quality of business operations
- Wirecard seems to have been ineffective in its own internal controls. In late 2019, KPMG was hired to complete a forensic examination of Wirecard’s accounting. The KPMG report had revealed a “complex process” and “missing paperwork”. The paper says: “Once more, it is quite staggering that a DAX 30 public company was apparently relying on third party spreadsheets with little to no underlying detail to book millions of dollars of revenue. It is also alarming that, based on these FT reports, EY were seemingly prepared to continue to audit underlying account records with this alleged lack of detail or support for material revenue.”
For its due diligence on asset managers, Castle Hall says it needs to assess whether the manager has an appropriate accounting system and an adequately staffed backoffice with a qualified COO or CFO. It also strongly supports the appointment of a third-party administrator whose fees are paid for by the fund’s investors, to create a higher level of control and investor protection.
The common sense ‘smell’ test
- For investors, there must always be a question of whether a strategy seems plausible and, especially, an understanding of what it is that allows a certain manager to report superior performance to other experienced, top tier asset managers. Investors should always understand the source and drivers of outperformance and be comfortable that it is simply not too good to be true.
Exactly how did Wirecard make its money? It seems that a key part of the firm’s business was working with acquirors who held banking licences in various countries where Wirecard itself was not regulated as a financial entity. Wirecard then stepped “behind” the acquirors to process the credit card transactions passed through. However, even though these acquirors were third-party companies (assuming they did actually exist), Wirecard appears to have, in essence consolidated their revenues 100 per cent as if they were wholly owned.
The cult of the CEO
- Markus Braun became CEO of Wirecard in 2002. Braun was the dominant face of the company, and a shining tech billionaire. The FT reported: “Mr Braun, a former management consultant, cloaked himself in a formality that stood out in the casual atmosphere of a technology company. He secluded himself on a floor where key card access was only available to senior management, their assistants, and the team that dealt with high-risk payments processing for online gambling.” Similarly, the Wall Street Journal reported: “Markus Braun was the self-styled visionary behind German payments giant Wirecard AG. An instantly recognizable fixture at tech conferences, recently adopting Steve Jobs-style black turtlenecks, Mr Braun became known for grand predictions about the future of payments, big data and artificial intelligence”.
The Castle Hall paper says: “[The late] Steve Jobs shows us that visionary companies have visionary leaders: but, equally, an effective business will have a broad executive management team. Following this point, in asset management, it is always important to consider the depth of both the investment and business management teams – although we recognize that, especially for smaller asset managers, there may be no succession plan as the manager is wholly dependent on the founding principal to remain in business.”
