‘Society benefits from short sellers’ — Gabriel Grego, CIO of Quintessential Capital
Gabriel Grego, managing partner and chief investment officer at Quintessential Capital, is known among investors for his devastating critiques of fraudulent companies. A former paratrooper in the Israeli Defence Force, Grego is on what he sees as a moral crusade to sniff out corporate corruption. He is adamant, he tells GlobalCapital, that activist short selling is a force for good in financial markets — and society as a whole.
Grego, who has been a stock picker for just over a decade, has two funds within Quintessential Capital. One, its flagship Capital Fund, is a long-short equity vehicle, focusing on value on the long side and activism on the short side. It returned 42% last year, Grego’s highest year on record. The other, the Pure Activist Fund, was founded in late 2018 and only deals in short activism.
Its short positions are focused on companies he believes to be total and utter frauds. For his firm to go public with a short position, Grego says, he has to be 100% sure of his stance.
This high threshold of certainty has bled into impeccable results. Roughly half of his targets have stopped trading soon after a Quintessential report, and most others have limped on as mere shadows of their former selves.
In 2015 Grego went after Globo, a software company and app maker listed on the London Stock Exchange that he said was booking fake invoices from fake shell companies as revenue. Just 12 hours after the report was published, the stock was suspended. 48 hours later the CEO and CFO resigned admitting the fraud.
His conviction comes from his obsessive level of research. Grego conducts deep due diligence on his targets. Most known in Europe, perhaps, was Folli Follie, the Greek listed jeweller that was found to have faked $1bn of sales in Asia.
Folli Follie claimed to have 930 shops, 240 of which were in China. Grego made a trip to China and toured its supposed stores, finding very little. He made roughly 600 telephone calls to explore his thesis that Folli Follie’s sales in Asia were a small fraction of what they claimed they were. He found the company’s filings in China said it had made $40m in revenue — small fry in comparison to the $1bn Folli Follie was claiming in Greece.
Quintessential’s last report was in April on Akazoo, a music streaming service listed on the Nasdaq. It was described by Grego as a “castle of cards”, and “just a tiny, loss-making company based in Greece with negligible user base and sales.”
He noticed that many of the addresses listed on its website as offices were no longer offices, and pointed out a critical distinction between earnings and cash flow. It delisted the month after.
Activist short sellers have come to be known as the unofficial police of equity markets. To some, this is an imperfect solution to an obvious problem of fraud. But to Grego, this is a great sign of market efficiency: providing incentives to root out the bad guys.
Grego told GlobalCapital that auditors are the most responsible party for covering up frauds, and unless the conflict of interest inherent in their business model is cleaned up, they will hinder rather than help attempts to minimise risks for shareholders.
GlobalCapital: What are the biggest tell-tale signs of a fraudulent company?
Grego: Well, two frauds are never identical to one another. If it were really easy to spot fraud and there were obvious red flags, people would understand very quickly what they are and no company would ever grow to be a large fraud.
Obviously there are no 100% indicators. There are things that tend to recur, but by themselves don't mean very much. It's like a court of law in that sometimes you have clues but each individual clue when taken on its own doesn't mean very much.
You need to look at the pattern. This is much more important than individual red flags.
With accounting fraud, there are usually discrepancies between cash flows in earnings and accounting earnings. You might see a company that keeps growing revenue and earnings very fast, but cash generation is negative. This happens year after year and is especially suspicious if it's occurring in an industry where this is not supposed to happen.
Certain industries are inherently cash absorbing — construction, mining or automotive for example. When they're healthy, companies in these sectors burn a lot of cash in investments. So, you would not necessarily expect to see a lot of cash flow generation when they're in a growth phase.
But if you're analysing a mature or semi-mature software business, for example, you would want to see a lot of cash generation. You don't need a lot of capex to get a software company in motion. If you see a software company that never shows cash because it all goes in M&A or in capital expenses, then you should be suspicious.
Another thing you tend to see is companies not using reputable auditors.
Changing auditors too frequently or at inflection points is also worrying. If a company’s accounting starts to get suspicious — for example, cash disappears or inventory becomes very large, or there are abnormally high levels of working capital — and at that moment the company changes auditors without a good reason, that’s a big red flag.
If regulation tightens for the auditing industry, and they have much more of a duty to uncover fraud and do additional due diligence, is that not an existential threat to activist short selling?
Auditors often leave before they really discover something very bad. They are not stupid. You start smelling issues much earlier than you see them, and unless auditors come across something that is clearly a serious anomaly, they don't have an incentive or an obligation to dig deeper.
A lot of frauds we uncover are multinational frauds. Typically, a company is domiciled in a certain country, but the actual fraud is taking place in some faraway place. The respectable auditor typically audits the parent company, and the subsidiaries are audited in their respective countries by a local accounting firm.
Subsidiaries are often audited by second or third rate auditors that nobody’s heard of. If a company is particularly ruthless they’ll find a one man shop in that specific developing country which doesn't mind signing anything as long as it's well remunerated. A particular problem is that typically these auditors don't have any downside — if they get caught, nothing happens in their country, they don’t get prosecuted.
What often happens is the more reputable auditor of the parent smells something wrong in the audited financials of the subsidiaries and asks to change the mandate so that the company uses them for foreign subsidiaries too.
In other words, if I'm a big auditor in Germany and I’m working with a parent company that has 70% of its revenue coming from subsidiaries in Asia and I see that something is fishy, I might ask the company ‘Hey, you guys, we are no longer going to sign off audits which come from Asia unless you use us in those countries, too.’
Of course, the auditor is putting the management in a difficult position because they know they may not be as compliant as the [local] unknown auditor is. So the company changes its auditor to one which doesn’t have these requirements.
This sort of thing is not obvious enough for the market to notice at face value. But this is exactly what happened when we uncovered Globo.
They changed auditors for the reason I mentioned. But the company made an official communication saying they were about to change auditor because the auditor was making unreasonable requests to audit much more expensively different subsidiaries.
The stock barely reacted; nobody gave a damn.
What about regulators? What methods can they employ to clean up fraud and corruption?
I don't think regulators will ever be able to change the equation dramatically. This is for two reasons: number one, the speed with which regulators move is very, very slow; second, you have thousands upon thousands of public companies around the world, especially in large, established financial markets, like London and New York. You cannot expect regulators to proactively uncover fraud to any significant degree – it just doesn't work like that.
To my knowledge the SEC or the FCA start investigating a company only after one of of our colleagues publicly declares a company to be a fraud, or if some newspaper writes a really strong investigative article.
The sheer manpower authorities must have to sniff out fraud is enormous and prohibitive
We specialise in international frauds, too, which have a leg in more than one country. Typically, financial authorities don't have jurisdiction in more than one place, and if a company is listed in the US but the fraud is being perpetrated in two or three countries, the SEC can’t easily conduct investigations abroad and it would be very, very hard and slow for them to get subpoena from a government like, say, Ecuador.
The auditors are the number one responsible party for a lot of frauds to occur. It doesn't matter how much you regulate them, or give them additional responsibility. What has to change is the conflict of interest. As long as these guys are paid by the very entities they audit, and as long as they're competing with other auditors, there will be a conflict of interest that will lead them to close an eye.
You cannot expect auditors to blow a whistle on the very people that pay them. Somebody made a statistic as to how frauds are uncovered, and the cases in which fraud is uncovered by auditors is less than 5%.
But fundamentally, fraud is one of the oldest human endeavours. I'm sure half a million years ago, when we used to live in caves as hunter gatherers, people were defrauding each other. It's part of human nature, you'll never get rid of it. If you tighten regulation, you might decrease the frequency in the place where you're regulating. But that will have the effect of changing the venue, not the behaviour.
So short activism is an ethical endeavour?
If people really want to be serious about containing fraud the answer is to support and encourage short activism and the sceptics. It's a beautiful way that capitalism provides incentives to police the market. We have very clear incentives to identify, investigate and expose fraud. It's a very elegant way of containing the problem and it doesn't cost the taxpayer a penny.
In the US this is being done. The SEC has been remarkably benign to short sellers, and has been quite prompt in investigating their claims. That’s how you contain fraud.
But you have the exact opposite in places like Germany. They actually cater to their national fraud champions, and act as mafia bosses that go out and persecute everybody that speaks out. That sends a horrible message that fraud will be tolerated and whistleblowing will not, so you are going to get more of the former and less of the latter
There are many frauds in Germany. The behaviour of Bafin has been inexcusable. I've been investigating Wirecard since 2015, and I've seen the whole thing unfold. We had most of the information prior to its collapse, and the only reason we did not publish a terminal activist short report on Wirecard was we saw the behaviour of the regulators. We thought, OK, not only might you not have the desired effect because the regulators will come out and say it is not true, but also you run a risk of a criminal investigation from the prosecutors. Their behaviour was inexcusable and hopefully somebody will pay for it dearly.
BaFin chose not to comment in response to questions from GlobalCapital for this article.
What do you think are the most insightful methods out there for activist short sellers, and how do you initially find a target?
It depends who the short seller is. There’s no perfect recipe.
The way we work at Quintessential is like this: we get a lead on a company suspected in behaving in a criminal way — that could be through some kind of whistle blower, a frustrated competitor, or another fund which doesn’t have the capability to pursue an investigation or the stomach to start an activist campaign, which usually comes with a lot of scrutiny and media attention and abuse from the target company.
When you know you're fighting to put the company out of business, those executives will be fighting for their survival too, and they will throw everything they have at you. It's a very different skill than, say, fundamental value investing, where all you have to do is read a balance sheet and an income statement.
The best ideas typically come from either other short sellers or other investors. But sometimes we also use some software screens that kind of flag what we believe are anomalies like the ones we spoke about before; discrepancies between cash flow and earnings or changing auditors or similar. Then we look more closely and check if there is fire besides the smoke.
And once you've located a prospective target?
Once we locate a target we come up with a thesis. It's a scientific method, exactly the same as if you're doing physics research.
Say for example the theory is that Folli Follie might be faking revenue, by way of issuing fake invoices. OK, what does the good physicist do after coming up with a theory that’s internally coherent? First, he devises a set of experiments to find out more to observe what's going on.
Second, he sees whether his theory makes good predictions. For example, If the company is a retailer faking revenue, either it's exaggerating the number of shops it has or it's exaggerating the number of sales per shop.
So we devise a way to find out which it is.
It helps coming up with a bunch of questions whose answers will confirm or disprove the thesis. And then the trick is you find every possible legal and ethical way to come up with an answer to those questions.
Those ways can be anything. It can be a site visit, or speaking to a former employee, or talking to a competitor. Then at the end of the day, you put all the information you got together and see all of the answers. And if all the answers collimate to the same point, then your prediction looks correct.
Quite frequently you must develop a thesis that you're somewhat certain about, but not certain enough to actually issue a report publicly.
Unfortunately, we can waste a lot of time on a company that doesn’t reach our threshold — the conviction we need — in order to go public.
I look for overlapping signs. I think that’s one thing that makes us different from many other short sellers out there. If I find only one indicator, it doesn't cut it. I want to see 10 or 20 pieces of information which are all coherent with each other, and all push in the same direction.
We’ve never gone out publicly on a campaign which we were wrong on. Of course, if you come up with 100 allegations, maybe one out of 100 turns out to be incorrect, statistically speaking. And it's possible you get a detail wrong in good faith, of course, but so far we have never got pieces completely wrong.
If we still have some doubts right before publishing, we ask the company. The behaviour of that company when we ask those damning questions is very revealing.
What is the typical response from a company in that situation?
Well the typical response to damning questions is not responding. Typically the company would be very forthcoming as long as the questions are benign. But the moment you start asking the scary questions, very often they just stop answering. That, to us, is an incredible sign of guilt.
How often does a risky situation actually become dangerous in your fieldwork?
So with Folli Follie, it was very benign. The difficulty was not in physical danger, it was more just patience because it was a lot of shops to check in on.
But we did other campaigns where problematic subsidiaries were in developing countries, in South America and in the Caribbean. One case was in Colombia, one in Jamaica and another in Argentina.
Those are places where if you're going and taking photographs and doing undercover work, you need to plan it very, very well if you want to do it safely.
I'm a relatively risk averse person, I’m never reckless. I really enjoy my work. I want to do it for a long time. I'm doing well financially and if I need to be awake at night knowing I'm doing something that might get me shot, there is no point doing it.
Even when it's something relatively benign, like going outside a warehouse and taking a few photographs, you have to think much more than you would normally think. About the time, what you’re going to say, how many people are going with you, etc.
It's not a good idea to just show up at a place and take a photograph.
How do you deal with the backlash from the public, the company or its shareholders?
If you scrutinise the campaigns we’ve done you’ll see we're very picky.
We want to be 100% certain. We make sure we go after companies that behave illegally and unethically.
Our success rate in itself creates a lot of goodwill over time. After you do the first one, the second, third and fourth one and they're all frauds and your theses end up being validated, then the public starts to support you.
By now, the public that follows us, and also certain press and many of our colleagues, they know we only go after situations like that, and that usually neutralises a lot of the usual bad will you have from the public when a short seller acts.
Some other colleagues go after anything, you know, every Tuesday and Thursday they come up with a different target. And it's not necessarily a fraud. Sometimes it's just a weak business model or bad upcoming earnings report or some kind of temporary thing like that.
I try to drill in every time, both in the press and in my own reports, that what we do is a very ethical activity. And yes, we definitely have a conflict of interest and like everybody, we need to make a living and earn money.
But everybody works for money. If you’re a cop or a regulator, or work at a charity, you make money for it.
But beyond making it clear we have a conflict of interest, I personally believe this is a moral activity because what we're doing is looking for the bad guys and bad companies, and we're trying as hard as we can to put an end to them.
And why is that good for society as a whole? The current investors obviously get burnt. If you're holding shares after we present our thesis, you're going to lose all your money, especially if you don't sell at the first possibility.
But the type of fraud we go after is accounting fraud. It’s a situation where a company’s pretending to grow and sell when it’s actually not. The only way they can perpetrate that is if they keep tapping financial markets for more and more money.
Companies have costs to justify and they need to either issue a lot of debt or stocks or a combination of the two. It will get exponentially more serious because the only way they can do it all the time is by faking very high growth rates, which means that they will have to borrow more and more and faster and faster.
That implies more and more people are going to be sucked in as investors or credit holders. And because of the inherent instability of the Ponzi scheme, eventually the whole structure will collapse, whether it's us or a regulator or internal forces that collapse the whole structure.
A recession may come and the company's unable to draw from financial markets and receivables don’t turn into cash because they are fake. I could point out several suspected frauds that collapsed and the collapse was blamed on the financial crisis or a recession, when in fact it was a fraud.
Our intervention prevents a smaller fraud becoming an enormous fraud and we save a lot of potential investors from buying into it and losing all their money. So in the grand scheme of things, society as a whole benefits from short sellers.
Our work acts as a deterrent. If you are a fraudulent CEO and you only have to worry about the SEC or the regulator, the chances of getting caught in any given year is low. But if the CEO knows there are short sellers out there looking for frauds all the time, they may change or think twice.
To be clear, if there is a fraud and I know it's occurring, I will find it. It’s just a matter of time. If we don’t do something, it’s because we haven’t found the target. If we find it, we will publish.