The super-rich face challenges that the rest of us do not have to consider: yacht maintenance, selecting the right fleet of private jets, finding boarding schools for their offspring. Thanks to their roughly $6tn in combined family wealth, they now have to worry about Bill Hwang too.
Hwang has shot from relative obscurity to become the key figure in global markets over the past two weeks, as the implosion of his Archegos investment house has hammered a handful of stocks and punched multibillion-dollar holes out of Credit Suisse and Nomura.
The incident exposes poor risk management among a clutch of supposedly canny investment banks, charmed into providing lavish leverage for supercharging speculative bets by the protégé of Tiger Management — one of most respected hedge funds of all time.
But Hwang did not inflict this damage through a hedge fund of his own. Instead, it stems from his so-called family office — a vast pool of personal wealth. Regulators are already bristling; on Thursday, Dan Berkovitz at the US Commodity Futures Trading Commission said oversight of family offices “must be strengthened”, noting that they “can wreak havoc on our financial markets”.
In an era when wealth is becoming ever more concentrated, family offices are where these spectacular private fortunes are often managed. But people inside this rarefied, secretive world know that Hwang’s fall from grace means the boom times of light oversight are behind them.
“It’s going to get tighter for everyone now,” says a former family office executive, who did not wish to be named. “There is going to be greater scrutiny of margin lending, prime services, whether markets are orderly and other things we probably haven’t even thought of yet. I wouldn’t characterise the last few years as easy, but it has been a kind of golden age for family offices and we may be watching the end of that, or at least, a lot less freedom in how we approach the market.”
That golden age has brought a proliferation. In a report issued a year ago, business school Insead noted that the number of single family offices had grown by 38 per cent between 2017 and 2019, to reach more than 7,000. Assets under management stood at some $5.9tn in 2019, the report estimated. That compares with $3.6tn in the global hedge fund industry, according to HFR. Family offices are “growing faster than global wealth, and are increasingly common in all areas”, Insead added. Rich families are also placing a growing share of their wealth in these types of structures, it noted.
This is no small-time cottage industry. On average, they control assets worth $1.6bn apiece, according to another 2020 study by UBS, and a handful can stretch into hundreds of billions of dollars. Typically, each family office has two or three offices, often in hubs like Singapore, Luxembourg and London. Chief executives are paid something in the order of $335,000 a year, according to the Insead report.
But despite the size of these investment houses, family offices tend to operate below the regulatory radar. Unlike mainstream pension funds and investment managers catering to the masses, or more highbrow hedge funds, they do not manage external money. This means that they often answer to no one but the family — apart from standard anti-money laundering rules and sanctions compliance.
Unless they cross thresholds demanding transparency on the size of their stakes in public companies, or they choose to disclose investments, perhaps because of their philanthropic tinge, they do not reveal their bets. They rarely speak to the press and they do not provide updates on performance or holdings.
“If it’s their money, they can do what they want,” says Angelo Robles, founder and chief executive of the Family Office Association. “Just like the average person, why should they be disclosing things? But if they have ever taken any outside capital, they need to follow certain standards.”
Precisely how tight those standards are depends on each family office’s strategy. Even then, definitions become fuzzy.
“The big problem is, what is a family office?” says Bart Deconinck, founder of Zedra, which provides services to family offices. “It could be an entrepreneur selling a business who asks his bankers to invest the money, a multifamily office where families organise their affairs together, or a third party firm that manages the assets of family offices. Because there’s a lack of a decent definition there is no regulatory grip over it.”
In the US, the post-crisis Dodd-Frank Act dramatically tightened regulations for the financial industry. But the Securities and Exchange Commission in practice exempted family offices from its tougher rulebook on registration and disclosure — leaving it up to their own discretion.
Tyler Gellasch, a former SEC official and executive director of Healthy Markets, a financial reform group, argues this was a mistake, even though family offices might not have outside investors to harm. “Family offices can still do bad things . . . They can still hurt the overall market. ” he says. “We now have a clear example of someone exploiting the family office exemption and creating systemic risk.”
In his statement on Thursday, CFTC commissioner Berkovitz said other exemptions have opened the door to “convicted felons, market manipulators, and other financial market miscreants” to operate freely under family offices. “The information required would fit on a Post-it note, and the CFTC estimated the annual cost of the filing to be merely $28.50. In my view, there is no reasonable justification for such a policy,” he said.
Archegos may prove to be an isolated blow-up that does not create a wider ripple through the financial system. So far, the losses have not kicked off a destabilising domino effect of damage across banks and other investors. But they could have done, points out Mark Sobel, US chair of the think-tank OMFIF and a four-decade senior US Treasury official. He played an instrumental role in the global post-2008 regulatory overhaul, and feels this is an area that was left out at the time.
“Archegos raises fundamental questions about the adequacy of bank risk management and regulatory oversight of the interactions between banks and non-banks,” he argues. “Prime brokers as a whole — even if not individually per se — were obviously providing large-scale lending to Archegos and leverage got out of hand. Did banks or regulators appreciate and know this?”
Riskier than hedge funds
The knotty issue facing the broader financial system, as Archegos illustrates, is that family offices are not created equal.
Many are cautious, seeking only to preserve the wealth they have amassed. Some, however, demonstrate all the speculative aggression typically associated with the most cut-throat hedge fund. Hwang’s Archegos falls into that camp. The banks involved are now investigating whether Hwang misled them, concealing positions held with other banks to rack up vast amounts of leverage in concentrated bets that unravelled alarmingly fast.
“This is not a family office. Most of them are very risk-averse. But it’s also not a hedge fund either,” says Patrick Ghali, a hedge fund and family office consultant at Sussex Partners. “Even hedge funds don’t leverage themselves to this degree. If a hedge fund ran this kind of risk it would not be able to raise capital.”
For some, the freedom to place bets too spicy for clients to tolerate is the allure of the family office.
Risk-taking is a key reason that billionaire Michael Platt decided in 2015 to convert his hedge fund BlueCrest into a family office, claiming that demands by institutional investors for lower-risk products had constrained his bets. The firm has since then chalked up several years of gains of 50 per cent or more.
Louis Bacon’s Moore Capital, which cited a “challenging business model” in late 2019 when it told investors it was closing its flagship hedge fund to external money, made one of the biggest profits of his career last year, helped by a newfound ability to take more risk. Both Moore and BlueCrest still file plenty of regulatory disclosures, however, unlike Archegos.
In the case of Hwang, speculative fervour mixed with high leverage and poor risk management formed a uniquely combustible combination. By using the specialist services of investment banks’ prime brokerage divisions — typically service providers for hedge funds — it was able to place vast bets on stock prices on margin.
It is not uncommon for family offices to have prime brokers; some have several. However some bankers in this area are puzzled over why Archegos was allowed in to the club, especially with its backing from Hwang, who admitted securities fraud while at Tiger Asia less than a decade ago.
One such banker pointed to a long-running legal tussle between Deutsche Bank and Sebastian Holdings, an investment fund run by billionaire financier Alexander Vik. SHI sued the bank for $8bn in 2008 over issues relating to margin calls stemming from trades with its prime brokerage division. The judge ended up ruling in favour of the bank in 2013, and some proceedings are still under way. The episode served to remind banks that clients, even those from cuddly-sounding family offices, often have sharp elbows.
“After that, most banks decided that a family office could not be considered an institutional player,” the former banker says. “We had to treat them like private clients.” That meant higher trading costs, more controls and less leverage.
But the Archegos drama suggests that banks, hungry for lucrative clients, have allowed that restriction to slip for many family offices.
Banks are likely to tighten up the leverage they offer to family offices and other speculative accounts after this embarrassing slip-up, either independently or under orders from regulators.
“There is never just one cockroach,” warns Andrea Cicione, head of strategy at research house TS Lombard. “If all this sounds familiar, it is because of the similarities with the beginning of the global financial crisis, when two hedge funds . . . had to be bailed out by their sponsor, Bear Stearns, following margin calls they could not meet.”
He adds: “To be absolutely clear, we are not calling [another financial crisis] here — there simply is not enough evidence to conclude that Archegos is anything more than an isolated case.” Nonetheless, he says, the case for greater transparency or tighter capital requirements for banks offering this kind of leverage warrants close attention.
For Deconinck at Zedra, the family offices most likely to disrupt markets are those in the mould of Archegos. “The dangerous guys are the ex-hedge fund guys and a certain type of investment banker,” he says. “People who come out of this industry have always made money this way.”
Additional reporting by Leo Lewis in Tokyo
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