Money Stuff: LeBron Bonds

Who should be making this loan?

When LeBron James signed up to lead the Los Angeles Lakers to NBA glory with a $154 million contract in 2018, it wasn’t the biggest deal he did that year.

Just months before he joined, a limited liability company he controls borrowed almost $300 million from a pair of Midwestern life insurers advised by an arm of Guggenheim Partners, according to insurance industry records reviewed by Bloomberg.

The previously unreported bonds, which are due in 2049, were structured to provide immediate cash to James and backed by a stream of future revenue tied to his earnings outside basketball such as a lifetime Nike Inc. sponsorship, people with knowledge of the matter said.

The burst of lending began before Guggenheim leader Mark Walter started acquiring the storied basketball team. In an abrupt turn this month, the billionaire mogul agreed to sell the Lakers amid a federal probe into parts of his business empire. There’s no indication that the loans to James have anything to do with those inquiries.

LeBron James is a guy. He has large and reasonably predictable future cash flows. You can put those cash flows into a box and issue bonds with a senior claim on them. James turns his future cash flows into $300 million upfront, and the bondholders get their $300 million back, with interest, over 30 years. Absolutely standard financial stuff, though applied to the cash flows of a guy rather than a corporation or shopping mall or data center.

Who are the right buyers for the LeBron bonds? They are quite long-term (30 years). They are, presumably, illiquid: $300 million is a lot for one guy to borrow, but it’s not a huge debt complex for the institutional credit markets, it’s a somewhat complex situation, his financials are not publicly disclosed, and there is unlikely to be a deep liquid secondary trading market in LeBron bonds. Nor is “loans to athletes backed by Nike sponsorships” a huge asset class, though Bloomberg notes that “athletes and artists are increasingly using future earnings like royalties and licensing deals to structure deals that help them unlock immediate capital.”

And so if James went to a bank and asked to borrow $300 million for 30 years, the bank might get nervous. Banks are funded by deposits, and making 30-year commitments to illiquid investments is not really the safest use of their money. Similarly, a bond mutual fund might have a hard time buying these bonds: Mutual fund customers can put money in or take it out at any time, so the funds might need to buy or sell their holdings, and small weird illiquid bespoke bonds are not ideal for that.

What you want instead is a buyer with its own long-term locked-up capital. Classically those buyers are endowments and pension funds, pools of money with predictable long-term liabilities. If you know you have to pay out pensions over 30 years, you can easily lock up some of your money in 30-year LeBron bonds. And because these bonds are illiquid — because they can’t easily be sold to retail investors or mutual funds or banks or hedge funds — they should pay a higher expected return than regular bonds, which should make them attractive to pensions.

One useful model is that the postmodern version of the “pension fund” is the “alternative asset manager investing the money of life-and-annuity insurance companies.” That is: A pension fund traditionally provides a steady predictable long-term stream of income to retirees, but the US has largely moved away from traditional defined-benefit pensions. But pension funds are great investors, with long time horizons and a willingness to buy weird illiquid stuff to achieve long-term returns, and so the modern financial industry misses them and wants to recreate them. Annuity companies basically sell private pensions — you give them money, they promise you a steady predictable long-term stream of income in retirement — and hand the money over to alternative asset managers, who invest it in weird illiquid stuff to achieve long-term returns.

This annoys people, because (1) the stuff is weird and illiquid and (2) the customers are ordinary retirees who can’t afford to lose money if the weird stuff doesn’t work out. You could argue, though, that it’s sort of inevitable:

• Weird illiquid stuff should pay more than ordinary liquid investment-grade bonds.
• Insurers who buy weird illiquid stuff should get higher returns than insurers who stick to ordinary bonds.
• Therefore they can offer cheaper life insurance or higher annuity payments.
• Therefore they can out-compete other insurers for customers.
• Therefore all annuity companies will eventually invest at least a large slug of their money in weird illiquid stuff.

You can take that argument too far: Insurers could do really risky stuff to earn high returns, out-compete safer insurers for customers, put lots of money into really risky stuff and then blow up, leaving the customers with nothing. It’s not like the customers are independently evaluating the insurers’ investments. The solution to this is basically regulation: Regulators are supposed to keep an eye on insurers and make sure that they invest in reasonably safe stuff, largely investment-grade credit instruments. But, with the right structure, a LeBron bond could be an investment-grade credit instrument, even if it’s a weird and illiquid one.

This is the basic story behind the rise of private credit. The Financial Times describes the situation:

Historically low interest rates were weighing on life insurance and annuity providers [after 2008], making it hard for them to earn enough on investments to meet future commitments to policyholders.

The difference between what insurers could earn holding staid, high-quality corporate and government bonds and what they owed policyholders had crumpled, making their traditional business model all but obsolete. …

“You cannot run an insurance company successfully and profitably if your only access is what exists in the public market,” Marc Rowan, Apollo’s chief executive, told an industry conference last year.

One other thing to notice about the LeBron bonds, though, is that LeBron James is very famous and cool. People want to hang out with him. People want his autograph. Nike wants to pay him hundreds of millions of dollars to be associated with him. This should, you might think, lower the expected return of the LeBron bonds. Like, the interest rate on the LeBron bonds should, theoretically, be something like:

• the 30-year risk-free rate, plus
• some credit spread reflecting the riskiness of the expected cash flows, plus
• some additional premium reflecting the illiquidity of the bonds, minus
• some discount reflecting the fact that it’s LeBron James and people want to go around saying “oh yeah LeBron owes me money.”

But there is a sort of market segmentation problem: 

1. The people who think LeBron James is cool and want to be associated with him are essentially people, individuals, and it’s hard to get individual investors to lock up their money for 30 years.
2. The people who want to lock up their money for 30 years to earn an illiquidity premium are essentially pension funds and annuities, and their goal is to maximize economic returns, not to hang out with LeBron James.

If the LeBron bonds were priced with a discount reflecting James’s coolness, pensions and quasi-pensions wouldn’t rationally buy them: The pension fund doesn’t derive any benefit from that coolness.

But in the real world, there are principal-agent problems. Somebody derives a coolness benefit from lending annuity money to LeBron James. Somebody — not a dispersed pool of retail annuity buyers, but a person — is sourcing and negotiating this loan on behalf of a life insurer. That person is handing James a big check and shaking his hand and saying “pleasure doing business with you,” and is having more fun than the person handing over a similar-sized check for a pool of auto-loan receivables. Does this lower James’s borrowing cost, at the expense of the life insurance firm? Man I have no idea; just something to think about.

Mark Walter has been in the news a lot recently, and not because of the LeBron bonds. Walter is the co-founder and chief executive officer of Guggenheim Partners, an alternative asset manager, and a pioneer in the business of acquiring insurance companies to provide capital to private investments. [1] He also has a personal holding company, TWG Global, which owns among other things (1) shares of Guggenheim, (2) two life-and-annuity insurance companies, Delaware Life Insurance Co. and Clear Spring Life and Annuity Co. and (3) stakes in the Los Angeles Dodgers, the Los Angeles Lakers and Chelsea FC. The US Securities and Exchange Commission and federal prosecutors are looking into those insurance companies, which apparently loaned money to Walter’s other businesses without disclosing it. Bloomberg News reports:

Prosecutors and regulators are examining how his insurers failed to disclose that loans they made were channeled to his other pursuits. After receiving subpoenas, those insurers disclosed more than $20 billion of loans that should have been labeled as affiliated transactions, but weren’t. …

It’s not illegal for an insurance company to lend money to a related party. But capital rules pressure life insurers to hold mostly investment-grade credit, and it can be difficult to get insurance regulators to accept an investment-grade stamp on a related-party deal.

So the insurers apparently loaned money to nominal third parties, which then loaned it back to Walter affiliates:

In recent years, Walter’s insurance companies loaned more than $1 billion to newly formed LLCs set up as subsidiaries of [Scott] Szykowny’s small trading firm, Hudson Trading, Bloomberg reported this month, citing people familiar with the matter.  …

It was a great deal for Szykowny: By lending the money out to Walter’s businesses at a higher interest rate than he borrowed, he collected a spread while putting little or none of his own money at risk, those people said.

Eventually the insurers reclassified the loans, and there does not seem to be any allegation that they have not performed; TWG is buying some of them back and replacing them with unaffiliated assets. At a high level, this stuff is directionally fine:

• Walter is a successful alternative asset manager.
• The insurance companies have long-term predictable liabilities and should invest in illiquid alternative assets.
• Everyone else is doing it: Lots of other alternative managers have their own insurance companies that invest in affiliated transactions, because good alternative asset managers should be making investment decisions for insurance companies.

But the lack of disclosure is bad, and seems to mean that the insurers had too little regulatory capital; they need more risk-based capital against affiliated loans (which these were) than against unaffiliated investment-grade ones (which is what they said these were). And the lending to affiliates through non-affiliates looks pretty weird.

Also, though, he does own a lot of sports teams. Fewer, now: This month, Walter sold the Lakers to raise money. I have not seen any suggestion that the Delaware Life loans were, like, “they loaned Mark Walter $6 billion to buy the Lakers.” But money is fungible, and Walter selling the Lakers to raise money to restructure some of his insurance companies’ investments suggests something in a vaguely related direction. My Bloomberg Opinion colleague Paul Davies writes: “Watching the rapid unwinding of ties between Mark Walter, his investment firm and its insurance companies has me asking: Why were the customers financing his trophy assets?”

And don’t the LeBron bonds suggest an answer? Life insurance customers should be financing strange illiquid assets, because they are best suited to hold that risk. But if you’re a guy with the discretion to invest billions of dollars of insurance-company money into whatever strange illiquid assets you think are the best, and if no one is keeping an eye on you, you might end up picking the ones you think are the coolest instead.

The Archegos situation was, roughly:

1. Archegos Capital Management, Bill Hwang’s family office, borrowed a lot of money from several banks to buy about a dozen stocks.
2. Archegos bought a lot of those stocks, often becoming the biggest holder of those stocks and buying large chunks of the daily volume.
3. Those stocks went up a lot, largely because of Archegos’s concentrated buying.
4. This gave Archegos big mark-to-market profits, which it used to borrow more money to buy more of the stocks.
5. Eventually the stocks started going down, Archegos got some margin calls, and it couldn’t meet them.
6. Its banks got together to discuss an organized unwind of the trade, in which they would seize the underlying stocks and work together to sell them in an orderly fashion that wouldn’t spook the market.
7. But then they didn’t, and raced to sell them instead, leading to collapses in the prices of the stocks.
8. At the end, Archegos was worth $0 and several of its lenders had lost billions of dollars, though others did fine.

There are some obvious similarities to the situation at Situational Awareness last month:

1. Situational Awareness LP, Leopold Aschenbrenner’s artificial intelligence-focused hedge fund, borrowed a lot of money from several banks to buy large positions in some AI stocks. 
2. Situational Awareness bought a lot of those stocks, becoming for instance a cornerstone investor in SK Hynix Inc.’s US offering last month.
3. Those stocks went up a lot while Situational Awareness was buying them.
4. This gave Situational Awareness big mark-to-market profits, and it does look like it used those profits to borrow more money to buy more of the stocks. 
5. Eventually the stocks started going down, Situational Awareness got some margin calls, it met them for a while, but the pressure built.
6. Situational Awareness and, one assumes, its banks discussed an organized unwind of the trade, in which it would sell some of the underlying stocks in an orderly fashion that wouldn’t spook the market.
7. That worked: Situational Awareness sold most of its public stock positions to Citadel last month in a block trade at a discount. 
8. At the end, Situational Awareness continues in operation, seems to be up for the year despite the drawdown, and can easily raise more money. Citadel has worked out of most of its Situational Awareness positions, apparently at a profit. None of its lenders lost any money.

The end of this story — Steps 7 and 8 — is very different from the end of the Archegos story. But the Archegos story was quite bad! Hwang went to prison for market manipulation and deceiving his banks, and several banks were quite embarrassed and lost billions. You might reasonably ask questions like “how close was this to Archegos?” and “did the banks just get lucky here?” And the New York Times reports:

The Securities and Exchange Commission recently sent subpoenas to banks that handled the hedge fund’s calamitous trading and that fed it borrowed money to supersize its bets, according to three people briefed on the outreach who were not permitted to discuss it publicly.

The subpoenas asked for details on the timing of Situational Awareness’s trades and for its communications with lenders about the money it was borrowing, also known as “leverage,” two of those people said. The subpoenas additionally warned the banks to preserve any information regarding the San Francisco hedge fund.

The S.E.C. oversees financial markets with an eye toward protecting small investors, and has brought civil cases regularly against investment firms that produced large losses. Any investigation into Situational Awareness would be at its earliest stages, and it’s no guarantee that it would lead to fines or other punishment. The hedge fund has not been accused of wrongdoing.

We’ll see what they turn up, maybe, but I think the answer is: This was not particularly close to Archegos. 

The biggest bad thing about Archegos is that, by being the biggest buyer of his stocks for a long time, Hwang manipulated their prices up. Aspects of this are mysterious to me — for one thing, I have no idea what his endgame was; for another thing, the evidence of manipulative intent was a little thin — but it seems likely that the value of Archegos’s portfolio was inflated by Archegos’s own frenzied buying, and also that Archegos did not have much of a fundamental reason for buying so much at those prices.

Situational Awareness also clearly had an impact on the prices of its portfolio. It was a big buyer of its stocks, but Aschenbrenner was also an influential and widely followed AI investor, and the stuff that he bought went up in part because he bought it. Also, when he was selling stuff in July to meet margin calls, the stuff went down, presumably because of his selling (and the momentum traders who magnified it). But the context is that Situational Awareness was buying lots of AI stocks in a giant AI boom; it seems silly to think that, like, SK Hynix was up because of Situational Awareness’s buying. Also Situational Awareness had pretty well-documented, fundamental, non-manipulative reasons for buying AI stocks hand over fist. There’s a whole manifesto. 

A related … bad? weird? … thing about Archegos is that, as its stocks’ values soared, it kept borrowing more money to plow back into the same positions. This drove me crazy at the time; I wrote:

One thing about margin lending is that if you borrow money to buy stocks, and your stocks go up, you automatically deleverage. If you use $15 of your own money and borrow $85 from your broker to buy $100 worth of stock, you have 85% leverage; if the stock then goes up to $200, you are down to 42.5% leverage. You still owe your broker $85, but now you have $200 worth of stock. If the stock then falls by 25% to $150, that’s fine: You are still in the black, and your broker still has ample security for its loan.

The incredible thing about Bill Hwang is that he made enormous levered bets on risky stocks, and those bets worked out perfectly and made him immensely wealthy in the course of a year or two, and he seems to have plowed every cent of it back into increasing those levered bets.

This was a mistake not just by Archegos, but also by its lenders: Lending Archegos 80% of the value of its stocks at the beginning of the trade is one thing, but lending it 80% of the value of the stocks after they had doubled in price is much worse. If they fall back to their original price, the loan is underwater!

There were some suggestions that Situational Awareness did something similar, and I wrote a few weeks ago: “Isn’t it a little weird that Aschenbrenner was up 1,000% in two years and still running at something like 4x leverage? … ‘Our bets have paid off lavishly, so we need to borrow ever more money to keep on the same level of leverage’: What, no, why?” 

But in fact it seems like Situational Awareness did lower its borrowing as it made money: Its lenders understood that, as Situational Awareness’s stocks shot up, they couldn’t keep lending the same percentage of their value. International Financing Review reports that “banks’ prime brokerage units passed their sternest test since the collapse of Archegos Capital Management in 2021 as they successfully navigated the dramatic fall from grace of AI-focused hedge fund Situational Awareness in late July”:

Dynamic margining practices automatically delevered Situational Awareness’s portfolio as AI share prices soared earlier in the year, sources said. That mechanically lowered the loan-to-value of banks' financing facilities giving them a greater cushion against potential losses.

Prime brokers also ensured they had additional protection on top of collecting large sums of margin as AI stocks started to slide. Chief among these protections was recourse to both Situational Awareness’s public and private investments including its prized Anthropic stake, sources said, meaning banks could always seize and liquidate those holdings if worst came to worst.

Such practices have been industry standard for years among the top lenders. However, several firms have also been updating models and risk protocols in recent years specifically to deal with the emergence of concentrated AI funds, sources said. 

 “There was never any risk of a credit loss,” said the senior bank trader. “[There was] adequate margin, the LTV was low and [there was] recourse to Anthropic.”

As hedge-fund blowups go, the Situational Awareness one looks pretty benign. Situational Awareness took money from investors who could afford to lose it, and invested it in accordance with its well-understood mandate, which was basically “get super long AI.” It borrowed some money from banks to do this, but the banks understood the risk and properly managed it. Situational Awareness made tons of money while its get-super-long-AI thesis was working, for basically good and correct fundamental reasons; then it lost much (not all!) of that money back when that thesis stopped working (temporarily?). Its blowup probably did further bring down the prices of its stocks — there was some contagion — but that was managed reasonably well; the sale to Citadel prevented a disorderly liquidation. Sometimes hedge funds lose money in suspicious ways, but sometimes they just lose money in regular ways.

If you went to a bank and asked for a loan against your shares of a ball bearings company, the bank would probably think about the value of your ball-bearings shares, and their volatility, and how long it would take to liquidate them. If you owned half a day’s volume of a large profitable public ball bearings company whose stock traded a lot with very little volatility, the bank would probably lend you a large portion of the market value of the shares. If you owned 60% of a small unprofitable private ball bearings company, the bank would probably lend you a lot less. For one thing, it would be hard for the bank to assess the value of your shares: Sure you could point to financial statements and funding rounds, but the market price of the stock is uncertain. For another thing, if you don’t pay back the loan and the bank needs to seize and sell your collateral, how could it sell it? It can’t just pound the stock out on the exchange; it would need to find a private buyer, an uncertain and risky process.

And there are various intermediate states. A newly public company will probably be more volatile than one that has been public for years; also, your shares in a newly public company might be subject to lockup restrictions that make it harder for the bank to sell them if you run into trouble.

And so if you own locked-up shares in a highly volatile, unprofitable, newly public company, you might expect banks to be reluctant to lend you money secured by those shares.

But you don’t own shares in a ball bearings company, do you? And if you own shares in a volatile, unprofitable, newly public giant frontier AI lab, banks will do anything for you. The Financial Times reports:

JPMorgan Chase is relaxing its approach to lending money against shares held by employees and early investors in companies that have recently gone public, as the US bank seeks to win clients from emerging tech giants.

JPMorgan’s typical policy is not to accept as collateral shares in a company that has gone public within the past 135 days. However, it told bankers ahead of SpaceX’s blockbuster initial public offering in June that it would lend against shares in Elon Musk’s rocket and AI company sooner, according to people familiar with the matter.

Bankers inside JPMorgan expect the lender to have a similar approach when Anthropic, the maker of the Claude chatbot, goes public, though no final decision has been made. JPMorgan earned $75mn from its role on the SpaceX listing.

JPMorgan’s move underscores the efforts asset managers are making to win business from the huge wealth being generated by the AI boom.

One point here is that, when trillions of dollars of AI wealth are being created, wealth managers need to compete to manage it, and you need to take some risk to be in the game.

The other point is that the risk here is, like, “we lend money to AI employees secured by their shares, they default in the next few months, we have to seize their shares and sell them, and the market for them has dried up.” I think it is quite rational for banks to think that that risk is very low — perhaps not for newly public companies in general, but for giant AI labs in particular.

Also, though, I wrote a few weeks ago about a margin loan to SoftBank secured by its stake in OpenAI:

“Borrowing against OpenAI to buy more OpenAI” is a decent description of the global economy right now. If OpenAI’s valuation collapses, then the banks that gave SoftBank this margin loan will be in bad trouble, but so will all the other banks. Might as well also do the margin loan.

“Ooh, if SpaceX and Anthropic collapse, we’ll lose some money on our private-wealth margin loans to early employees,” sure, but really that would be the least of your problems.

Broadcom Credit Risk Soars on Mega AI Debt Financing Backstops. Mexico Bonds Trade Like Junk After $130 Billion Bailout of Pemex. SoftBank Plans Record Retail Bond Issuance Amid AI Push. Thoma Bravo Conceded 40 Deal Sweeteners as Debt Talks Heat Up. Private Equity Finds New Way to Ride Out Cash Crunch. Private equity growth funds attract record first-half inflows as sector rebounds. OpenAI Claims Its New Chips Can Outperform Nvidia Processors in Tests. First Brands forced into liquidation by bankruptcy court. Bitcoin Tops $80,000 as Bullish Mood Returns to Crypto Market. Deutsche banker charged with embezzling €600,000 from wealthy clients. Lego invests in software-enabled bricks and other products to power growth run. A Billionaire CEO, a Hamptons Town and the Endless Fight Over a Seafood Shack. Scientists who turned to OnlyFans to fund marmot research receive crypto boost.

If you'd like to get Money Stuff in handy email form, right in your inbox, please subscribe at this link. Or you can subscribe to Money Stuff and other great Bloomberg newsletters here. Thanks!