Market View – The tragedy, destiny and endgame of Abraaj Capital
F. Scott Fitzgerald, the literary king of Jazz Age New York, and the author of the Great Gatsby, wrote “there are no second acts in American life”. The traumatic events of the past month prove there are no second acts in emerging markets private equity either. Abraaj Capital, once a global private equity colossus founded in Dubai, filed for liquidation in the Cayman Islands after pressure from creditors that included Kuwait’s pension fund and a major Wall Street distressed debt fund.
Abraaj’s financial meltdown was as swift as it was brutal. A decade ago, an Abraaj partner boosted to me that the firm was worth $1 billion in an IPO and the GCC’s top family offices were invited to invest in its holding company at two or even three times book value. As CIO of a major family office, I preferred to invest in the New York listed shares of Blackstone Group, which manages $345 billion in assets and has global standards of governance and investment best practices. A decade later, Abraaj Capital’s alpha males, the Gulf’s own Great Gatsbys, violated the sacrosanct trust of investors like Bill Gates and the World Bank by “comingling” funds without their consent or knowledge. In other words, Abraaj used the money entrusted by investors in its global healthcare fund to finance its own business.
A Deloitte’s audit later found that $95 million was “comingled” from another Abraaj fund. At that point, I knew the firm was doomed as a viable manager of institutional investor funds in global capital markets. Several close friends in the Gulf will see their entire equity stakes or unsecured debt to Abraaj wiped out while the firm’s managed funds will see dramatic falls in NAV at a time of distress in emerging markets. I cannot see how the firm escapes punitive fines from the US Justice Department (the US taxpayer keeps the World Bank and IFC afloat) or regulators in all the other markets where Abraaj had offices – Dubai, London, Cairo, Istanbul, Nairobi etc. A tsunami of lawsuits and counter-suits is now inevitable. Abraaj’s shareholders and fund investors are the crème de la crème of the Middle East’s financial elite – pension funds, family offices, sovereign wealth funds, merchant dynasties, royal offices, public companies (note Air Arabia shares were slammed due to its $336 million Abraaj exposure). This is just the tip of the iceberg. It is probable that $3 – 4 billion in Gulf financial wealth would be decimated in the de facto bankruptcy of Abraaj Capital.
I am still amazed at how “comingling” on such an epic scale could have happened at Abraaj Capital without the knowledge of its regulators, auditors, board of directors, compliance officers and fund administrators? KPMG, Abraaj’s auditor, is also auditor for dozens of regulated firms in the DIFC. Arif Naqvi, Abraaj’s founder, gave wonderful speeches on governance and transparency and the potential of emerging markets (which he rebranded as growth markets). Yet how could Abraaj’s own governance have been so dismal that hundreds of millions of dollars from the world’s most elite investors could be misused in so cynical and brazen a manner, even if there was no fraud or embezzlement. Abraaj’s leadership team had degrees from the LSE, Harvard, Georgetown and, yes, Wharton and decades of experience in the world’s top banks, management consulting companies and public corporations. Surely they know that “comingling” investor funds is a crime – I repeat, a crime – for a regulated fund manager. What could have led to such a colossal act of corporate self-destruction and a violation of investor trust? How could executives who spoke so passionately about governance and transparency at Davos be guilty of such a colossal failure of governance and basic client ethics?
Dozens of Abraaj deal makers, partners and analysts have lost their jobs. The firm will be remembered for the surreal flameout of its death, not the money making windfall of its birth and adolescence. I lived and profited from some of Abraaj’s famous deals – Aramex, Air Arabia, the Dana Gas IPO, EFG Hermes in the time of Hassan and Yasser. Why did it have to end this way? If ever there was a Sophoclean tragedy in emerging markets finance, this is surely it.
Colony Capital, a $43 billion US fund whose founder is a close friend of Donald Trump will buy Abraaj’s Funds in Africa, Latin America, Turkey and the Maghreb. Significantly, the Karachi Electricity asset is not included in the Colony Capital deal. Why?
Macro Ideas – The emerging markets meltdown has begun
I had argued that emerging markets faced a financial meltdown in successive columns, most recently since my visit to the sceptered isle in mid-May. Unfortunately, the macro logic of my conviction has not changed even as I see an emerging market meltdown is happening in real time. Why?
One, the US Dollar Index bottomed at 88 three months ago. It is now 95. King Dollar has returned with a vengeance, a scenario that is a disaster for emerging market currencies from the Brazil real to the Indian rupee, the Turkish lira to the Pakistani rupee, the Argentine peso to the Mexican peso. There are four major reason for the US dollar’s resurgence. The political centre was annihilated in Italy by a far left-far right populist coalition, Chancellor Merkel faces the twilight of her political career in Germany, Eurozone industrial production data has slumped while the ECB dare not shrink its balance sheet in September.
Two, the Volatility Index was 25 in March as the financial markets considered the threat of Trump’s EU steel and aluminium tariffs. Yet the tariff tension has escalated into a full scale global trade war with the EU, Canada and Mexico but the Volatility Index is just above 13 despite the recent turmoil in global equities. A global trade war is simply not priced into volatility or asset valuations despite the ursine fireworks on Wall Street last week. This means downside risk in emerging markets will continue to rise this summer.
Three, I cannot forget that the 2013 and 2015 – early 2016 emerging markets meltdowns were both preceded by a money market squeeze in Shanghai and a mini-devaluation of the Chinese yuan that sent shock waves across the world. The Middle Kingdom was hunky dory three months ago, as Wall Street bought the “Xi Jingping put” on Chinese growth, financial stability and commodities demand with a vengeance. This was the reason bank strategists dissed the woes of the Turkish lira or the Argentine peso as “idiosyncratic”. To be polite, this is bull manure. Contagion in emerging markets is now unmistakable. Even the Indian rupee trades at 68.70 as I write, a telltale sign of debt distress and fear in emerging markets Shanghai plunged by 4% after the Dragon Boat holiday. If Trump really threatens to impose tariffs on $200 billion of Chinese goods, Beijing could well retaliate by reducing its purchase of US Treasuries or even a major Chinese devaluation. This will be the July 1997 (Thai baht triggers the Asian flu) or 2001 moment (Argentine default, Turkish banking crisis) moment for Asia and emerging markets. The MSCI emerging markets index has now declined for six successive days, a bearish scenario omen. The impact on the semiconductor business on a US-Chinese trade war is an argument to short Taiwan. King Dollar, higher US rates and a liquidity squeeze in the Chinese property markets means short Hong Kong. Lower Chinese growth and commodity appetite is Armageddon for Southeast Asian equity markets.
Four, the political scene in emerging markets is toxic. A far left firebrand Lopez Obrador will be the next President of Mexico in the July elections, thanks to Mexican disgust with Trump’s Gringolandia. There is no real hope for the center-right President Michel Temer in the Brazilian election in October. President Erdogan has threatened global ratings agencies and foreign banks once his AKP wins reelection in Turkey. The BJP has faced setbacks in several Indian states (notably Karnataka) and the pro-business PMLN in Pakistan reels from the disqualification of Nawaz Sharif.
Five, Trump’s tariffs and retaliation by the EU, Canada, China and Mexico will broaden to consumer goods. This means higher inflation and lower consumer purchasing power to the West, a disaster scenario for emerging markets. Note that more than 50% of Turkish manufactured exports are destined for the EU, where stagflation means another major lira crisis. Turkey’s $250 billion consumer banking time bomb has only one endgame – a deep recession.
Six, the Powell Fed is forced by Trump’s fiscal stimulus to raise interest rates and shrink its balance sheet. This means a trillion dollar hit to the global liquidity pump at the precise moment US funding needs accelerates to at least $600 billion. Property is the kiss of death in a debt deflation credit cycle. Good bye, goldilocks!
Currencies – Anatomy of a free fall in the British pound sterling
Sterling’s plunge against the US dollar since its April high of 1.4376 has been epic in both scale and swiftness. Cable trades at 1.3263 as I write. What went so terribly wrong for the currency of Her Majesty’s sceptered isle in the spring of 2018?
One, King Dollar. The US-China trade war and an inter-continental emerging market currency crisis led to a global safe haven bid in the US dollar. The US Dollar Index bottomed at 88 and has now surged to 95.
Two, relative central bank monetary policies. The Federal Reserve has raised its Fed Funds rate twice in 2018 while a first quarter economic slowdown and disappointing UK data forced the Bank of England to abandon its earlier hawkishness on interest rate policy and not raise the base rate in its May MPC conclave. The logic of relative data, central bank rhetoric and US Treasury-British gilt yield spreads screamed short sterling once cable fell below 1.40.
Three, Theresa May’s Tory Cabinet faces bitter divisions over Brexit (the customs union, the Irish border) and lacks a stable parliamentary majority in Westminster. This toxic political debate is reminiscent of Mrs. Thatcher’s cabinet in 1989 or John Major’s revolving door in Downing Street in mid-1996 – in short, a green light to short sterling as the Tories head for either regiside or election defeat.
Four, divisions within and among European governments have raised the political risk of Brexit negotiations with the UK. A populist – far right coalition in Italy, a new Socialist government in Spain, a political challenge to Chancellor Merkel from her own CDU/CSU coalition is not exactly a formula for a successful endgame to Brexit even after March 2019. This is obviously negative for sterling.
Five, even international politics and offshore capital flows militate against sterling strength. Relations between the EU and Washington have deteriorated since Trump’s G-7 debacle in Quebec – and Britain has the ultimate special relationship with the US. The corruption crackdown in China, tighter sanctions on Russia, the oil price crash in the Gulf and devaluations in West Africa have sharply reduced offshore capital flows to the London property markets. Prime London has fallen and Battersea/Nine Elms is a leveraged disaster for investors.
Sterling has historically punched above its weight in the foreign exchange market due to the legacy of the British Empire, North Sea oil, the Thatcher era privatisation and London’s role as the epicenter of the Euromarkets, derivatives and asset securitisation. Yet the past decade has witnessed the most traumatic trade weighted devaluation of sterling (2.10 in November 2007 1.3263 now) in the history of modern Britain. This devaluation has been greater in scale than Black Wednesday in 1992, Harold Wilson’s “pound in your pocket” debacle of 1968 and Ramsay MacDonald’s decision to exit the gold standard in 1931. However, this does not mean that sterling is a no brainer buy, even at these admittedly optically cheap levels.
I believe a sustainable sterling rally needs multiple catalysts – an inflation overshoot or strong data momentum that forces Governor Carney to hike rates in August (dream on) and November, a less toxic milieu in Westminster, tangible progress in the Brexit Chinese water torture, a tacit acknowledgement of emerging market contagion by the Powell Fed and a sag in King Dollar. Am I confident in these potentially bullish catalysts for sterling? Absolutely not. The old adage “the trend is your friend until the trend comes to an end” sadly holds true for sterling until the smoke signals from Threadneedle Street resurrect the battered sterling bulls once again. This could well happen if the pound falls below the November 2017 lows of 1.26, when the Old Lady panicked on inflation and began to jawbone cable higher to 1.36. The currency gnomes in London do not expect such a policy U-turn in August.
The Bank of England minutes lifted sterling as three members of the MPC dissented in favour of a base rate rise. Yet clashes at the EU summit in Brussels could well reverse cable’s two big figure gain on the “hawkish hold” message from Threadneedle Street. I need to see a successful test of 1.3340 to cover sterling shorts. This will be the proof of the pudding for a trend reversal to 1.3480. If not, I can only repeat the old warning – caveat emptor!
