By Nell Mackenzie

LONDON (Reuters) – Well-known activist short-selling hedge funds expect to find more companies squeezed by tough economic conditions in 2023, potentially increasing instances where balance-sheet sinkholes are hidden.

Some $321 billion worth of U.S. and European speculative-grade debt is due for refinancing over the next 12-14 months. Defaults may double in 2023, if interest rates and corporate borrowing costs rise further, S&P Global Ratings reckons.

GRAPHIC: The US has the lion’s share of risky debt to refinance in 2023

Activist short sellers cross over into forensic accounting when they go beyond reading balance-sheet statements and scour footnotes and subsidiary findings to uncover if every line item mentioned is true and cash flows match.

Hedge fund Muddy Waters on Wednesday said it was shorting Vivion Investments, suspecting the real estate investment firm’s portfolios were overvalued. The company responded with a statement on its website on Wednesday saying Muddy Waters’ report contained numerous factual inaccuracies and said it would respond in further detail next week.

Here are what some prominent short sellers say about how they use forensic accounting, lessons they have learned and what they expect in 2023.


*Size: $245m AUM

*Famous positions: NMC Healthcare, Burford Capital, Vivion

*Top tip: Do the numbers add up?

Since the 2007-2008 global financial crisis, companies have pushed aggressive accounting to its limits, said Muddy Waters CEO Carson Block. Most of the companies he investigates have not done anything illegal, but have exaggerated their value.

“Things are just out of control. People are milking the system,” he said, adding that he expects even more aggressive accounting and fraud in 2023.

“There’s a lot of low coupon debt to be refinanced,” Block said. He was referring to companies that borrowed at low interest rates over the last 10 years, but now face higher coupons on repayments as rates rise.

GRAPHIC: High risk debt to refinance

Block said that low borrowing costs had encouraged fraud because any increase in earnings, real or exaggerated, would have a large effect on the company valuation, its stock price and the amount of financing available.

“If you were a stock scammer with a $50 million fraud ten years ago, it would be a huge number. Today the typical fraud is more like $100 million,” Block said.

Clues that led to Muddy Waters’ most recent short included an in-person visit to the property sites of real estate investment company, Vivion, to find out if their rental properties were as valuable as the company said. One they found was “vacant and derelict,” Muddy Waters’ report about the company said. Vivion said it would respond with a further statement and that this picture was not accurate.


*Service: Subscription-based research

*Famous research tip: Wirecard

*Top tip: It pays to pay a visit

Mark Hiley, the director and founder of the Analyst, is not a short seller, but his company sells ideas to short sellers who subscribe to his research.

He was among a handful of outspoken critics pointing to wrongdoing at payments firm Wirecard in what proved to be one of Europe’s biggest fraud scandals.

His firm recently did a research project on the 2023 picture for European corporations and Hiley concluded: “If you double interest costs, a lot of companies will spend their entire earnings before tax just on that.”

In coming years, British accountants could be required, under recent government proposals, to look for fraud at companies they audit.

One result could be detailed disclaimers where auditors try to protect themselves by disclosing what they have not checked out. This would be the perfect place to start looking for signs of potential fraud, Hiley said.

Sometimes, going through paperwork is not enough.

Hiley said he had already dug through paperwork to see if the assets on the balance sheet of a German logistics company he was investigating truly existed. After watching a factory tour on social media, he sent someone to visit the site.

“It was basically a shed in a forest. On YouTube, it had looked like a whiz-bang logistics facility with 500 trucks parked outside,” he said.


*Size: $90m

*Famous positions: Wirecard, Civitas, Boohoo

*Top tip: A short matters only if the shareholders care

The secret to uncovering the perfect short is that shareholders need to care about your findings, said Matthew Earl, the hedge fund manager behind Shadowfall.

If investors think the company will ultimately do well, they might overlook aggressive accounting, he added.

In more serious cases of fraud, no one may believe the findings at first. German authorities initially tried to prosecute Earl over his short on Wirecard. Two years later, the government apologised. “It was complete vindication,” said Earl.

Tighter monetary conditions and less readily available debt means investors will likely scrutinise company cash generation in 2023, Earl said.

He added that most fraud was not premeditated but the result of a decision that spiraled out of control.

“There’ll be an incentive by management of the company to paper over cracks,” Earl said.

(Reporting by Nell Mackenzie in London; Editing by Dhara Ranasinghe and Matthew Lewis)