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22 jul 2020

Wirecard – wildcard or systemic failure?

By now, you may have heard about the controversial collapse of Germany’s former fintech darling Wirecard. We’d like to give you a bit more insight into the situation and what it has meant for our ETFs.

Background

Wirecard AG is a payment service provider that entered the DAX 30 Index of Germany’s top 30 companies in September 2018, with a market cap of around €22.5bn at the time.

On its ascent to the top league of German industry, Wirecard had become a touted growth story, with clients including FedEx and Ikea. It gave a veneer of digitalisation to a DAX still dominated by traditional industry and consumer goods.

Less than two years later, Wirecard’s stock has fallen by 98%. This once multi-billion-euro company faces insolvency –  the first ever declared by a member of Germany’s main stock index. What went wrong?

Filing for insolvency

Wirecard filed for insolvency on 25th June after auditors from EY reported that they couldn’t find around €1.9bn on its balance sheet – which Wirecard then admitted probably did not exist.

This is a huge financial scandal and another major governance blow for the reputation of the DAX 30, following relatively hot on the heels of the emissions scandal which engulfed Volkswagen. Wirecard owes around €3.5bn to its creditors, who are unlikely to see that money again.

The scale of the crisis means this isn’t just a question of company fraud – it calls into question the apparatus of corporate governance and regulation, whether accounting issues are becoming systemic, and whether audit processes are being run as they should be. 

Financial Fallout

Germany’s financial watchdog BaFin has come under fire for perceived failures to investigate complaints against Wirecard. On 1st July, its president defended the agency’s actions to the Bundestag, saying that as Wirecard was labelled as a tech company, it was not fully under BaFin’s oversight.

Meanwhile, the behaviour of KPMG and EY – two of the world’s “big four” audit companies – is also under scrutiny. EY had been certifying Wirecard accounts since 2011 and could face significant compensation claims for its role in “wrongfooting” markets, having intimated as recently as May that it would have no problem in signing off 2019 accounts.

For now, Wirecard owes its banks as much as €1.75bn from a revolving credit facility and in September 2019 issued €500mn of bonds due in 2024. Banks and bondholders have been preparing for tussles with insolvency administrators by hiring an army of consultants, advisers and law firms.

It’s hard to say how much they’ll get back. The creditors’ position is weakened by the fact the debt is unsecured, meaning the loans are not backed up by assets. Wirecard had an investment-grade rating right up until the scandal erupted late last month and creditors often only demand collateral on borrowers with ‘junk’ ratings.

It was only downgraded on 20th June, so could the ratings agencies have acted sooner?

After all, there have been alerts of possible improprieties at the company since 2016. Notably, investigations carried out by two Financial Times journalists in the UK led to the publication of a very critical article in 2019. According to the FT, BaFin then started to investigate the paper “over allegations of market manipulation.”

Then what of extra-financial ratings agencies? Such an event is a perfect test, especially for agencies carrying out ESG ratings, to see how robust and useful their data really is.

Equity ratings

Wirecard was removed from MSCI indices through an “early deletion” process on 29th June. Bankruptcy is one of the few events which can trigger an immediate deletion. This is true for all “MSCI Standard” indexes, and for those of ESG-related products built on MSCI Standard parent indexes.

This means that these products will not have to wait until the next rebalancing (November) for a deletion based on downgraded controversy level and ESG rating.

Of course, investors will be asking whether this could have happened sooner.

In truth, MSCI did identify an issue regarding Wirecard’s accounting. But this was not enough to raise the controversy level to “Red flag” or “Orange flag”, which may have triggered a removal from its ESG-related indices at the very least. At the time of the event, Wirecard was rated with a “Yellow flag” meaning its controversy level was fairly low. More broadly, it held a “BBB” rating in MSCI’s ESG-scoring methodology – the median level – even after the downgrade of its accounting score to zero.

This highlights the critical role negative screening policies (exclusions, controversies exposure screening) can play and the differences between a selection or “best in class” approach in ESG versus a tilted approach (skewing weights but keeping everything after exclusion).

However, neither of these methods fully address the issue of ESG “compensation” or averaging, where a company which rates very poorly on one criterion can still be selected for index inclusion if its other scores are good. 

Lyxor portfolio positions

So where did Wirecard sit in our portfolios and what has happened to these positions in recent weeks? 

  • Our ESG Leaders and Trend Leaders ETFs (Europe Leaders and EMU Trend Leaders) filtered out Wirecard ahead of deletion – not based on its controversy score, but because its BBB ESG rating was insufficient to make it to the Top 50%. 
  • Our MSCI Climate change products (Europe and World) did still include Wirecard. These indices keep everything once baseline exclusions are made. If Climate products were ESG-screened to exclude the likes of Wirecard, they would have to remove anything up to BBB companies which is 50% of the market at least. 

  • Our DAX ESG ETF (currently available for investors in Germany and Austria) did not include Wirecard, after the Sustainalytics ratings used in the index ruled it out on grounds of governance, liquidity and free float. 

  • Two of our new Thematic ETFs did hold Wirecard given its relevance as a key European fintech player: Digital Economy and Disruptive Technology. That’s because exclusions in these MSCI thematic indices are limited to CCC rated. Excluding BBB-rated companies would make the universe too narrow.

  • In our corporate bond ESG ETFs, our chosen indices only select companies rated with an MSCI ESG Rating of BBB and above (which differs from the Top 50% methodology). Wirecard could therefore have been selected however it had no issuance outstanding in excess of the €1bn threshold we have in place – so it was not included. 

Additional information

Weight of Wirecard as of 29/05/2020 (last end of month date preceding the event), in Lyxor products including ESG criteria in the index methodology (ESG based selection or ESG filter) and including Wirecard:

MSCI EMU Climate Change
0.34% vs. 0.31% in MSCI EMU i.e. overweight 0.03%

MSCI World Climate Change
0.03% vs. 0.03% in MSCI World

MSCI ACWI IMI Disruptive Technology ESG Filtered
0.60%

MSCI ACWI IMI Digital Economy ESG Filtered
0.67%

Risk Warning

This document is for the exclusive use of investors acting on their own account and categorised either as “Eligible Counterparties” or “Professional Clients” within the meaning of Markets in Financial Instruments Directive 2014/65/EU. These products comply with the UCITS Directive (2009/65/EC). Société Générale and Lyxor International Asset Management (LIAM) recommend that investors read carefully the “investment risks” section of the product’s documentation (prospectus and KIID). The prospectus and KIID are available free of charge on www.lyxoretf.com, and upon request to client-services-etf@lyxor.com.

Except for the United-Kingdom, where this communication is issued in the UK by Lyxor Asset Management UK LLP, which is authorized and regulated by the Financial Conduct Authority in the UK under Registration Number 435658, this communication is issued by Lyxor International Asset Management (LIAM), a French management company authorized by the Autorité des marchés financiers and placed under the regulations of the UCITS (2014/91/EU) and AIFM (2011/61/EU) Directives. Société Générale is a French credit institution (bank) authorised by the Autorité de contrôle prudentiel et de résolution (the French Prudential Control Authority).

The products mentioned are the object of market-making contracts, the purpose of which is to ensure the liquidity of the products on the London Stock Exchange, assuming normal market conditions and normally functioning computer systems. Units of a specific UCITS ETF managed by an asset manager and purchased on the secondary market cannot usually be sold directly back to the asset manager itself. Investors must buy and sell units on a secondary market with the assistance of an intermediary (e.g. a stockbroker) and may incur fees for doing so. In addition, investors may pay more than the current net asset value when buying units and may receive less than the current net asset value when selling them. Updated composition of the product’s investment portfolio is available on www.lyxoretf.com. In addition, the indicative net asset value is published on the Reuters and Bloomberg pages of the product, and might also be mentioned on the websites of the stock exchanges where the product is listed.

Prior to investing in the product, investors should seek independent financial, tax, accounting and legal advice. It is each investor’s responsibility to ascertain that it is authorised to subscribe, or invest into this product. This document is of a commercial nature and not of a regulatory nature. This material is of a commercial nature and not a regulatory nature. This document does not constitute an offer, or an invitation to make an offer, from Société Générale, Lyxor Asset Management (together with its affiliates, Lyxor AM) or any of their respective subsidiaries to purchase or sell the product referred to herein.

Research disclaimer

Lyxor International Asset Management (“LIAM”) or its employees may have or maintain business relationships with companies covered in its research reports. As a result, investors should be aware that LIAM and its employees may have a conflict of interest that could affect the objectivity of this report. Investors should consider this report as only a single factor in making their investment decision. Please see appendix at the end of this report for the analyst(s) certification(s), important disclosures and disclaimers. Alternatively, visit our global research disclosure website www.lyxoretf.com/compliance.

Conflicts of interest 

This research contains the views, opinions and recommendations of Lyxor International Asset Management (“LIAM”) Cross Asset and ETF research analysts and/or strategists. To the extent that this research contains trade ideas based on macro views of economic market conditions or relative value, it may differ from the fundamental Cross Asset and ETF Research opinions and recommendations contained in Cross Asset and ETF Research sector or company research reports and from the views and opinions of other departments of LIAM and its affiliates. Lyxor Cross Asset and ETF research analysts and/or strategists routinely consult with LIAM sales and portfolio management personnel regarding market information including, but not limited to, pricing, spread levels and trading activity of ETFs tracking equity, fixed income and commodity indices. Trading desks may trade, or have traded, as principal on the basis of the research analyst(s) views and reports. Lyxor has mandatory research policies and procedures that are reasonably designed to (i) ensure that purported facts in research reports are based on reliable information and (ii) to prevent improper selective or tiered dissemination of research reports. In addition, research analysts receive compensation based, in part, on the quality and accuracy of their analysis, client feedback, competitive factors and LIAM’s total revenues including revenues from management fees and investment advisory fees and distribution fees.

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