DCG Unchained
This past week I sat down with Ram Ahluwalia to discuss DCG and Genesis on Laura Shin’s popular podcast Unchained. We outline what happened, debate how things will play out and highlight lessons from the debacle.
It’s an engaging conversation. Ram and I challenge each other’s thinking. Here is a quick take:
Listen to the episode on Spotify and Apple Podcasts. Watch it on YouTube. It’s full of insights.
This article is a brief follow up to the podcast and my deep dive DCG’s Downfall. I correct a mistake. I explain how DCG borrowed $1.1 billion from Genesis and absorbed Genesis’ 3AC exposure. I highlight new information that has surfaced. I tweak my proposed Genesis prepackaged restructuring plan.
The correction
On the Unchained podcast I stated that 47% of Genesis loan portfolio as of June 30, 2022 was exposed to 3AC. The statement is incorrect and misleading. I apologize for my mistake. Thanks to Ryan Selkis for pointing it out. I quickly corrected myself.
The 47% reference is incorrect because part and perhaps all of the $2.3 billion loan Genesis extended to 3AC was off of Genesis’ balance sheet by June 30, 2022. I missed that in the GBTC Q2’22 10Q filing.
The 35 million shares of GBTC Genesis received during the three months ended June 30, 2022 was worth $533 million upon receipt (35m shares x $14.98 GBTC price). Genesis also received $103 million of additional collateral from 3AC (per 3AC bankruptcy filing) in the form of Grayscale Ethereum Trust shares and AVAX and Near tokens. The total liquidated collateral was at least $636 million ($533m + $103m). The 3AC bankruptcy filing also suggests $1 billion of the Genesis loan to 3AC was unsecured.
We cannot correctly infer how much exposure Genesis had in its loan book to 3AC as of June 30, 2022. We do not know how much of the loan was still outstanding, if any. We do not know how Genesis defines its $4.9 billion active loans.
Even if we could determine Genesis’ 3AC exposure relative to its overall loan portfolio, it would be misleading. Ram Ahluwalia explained that in times of stress lenders’ loan portfolio gets concentrated in its poorest performing loans. When a lender calls back its loans, well capitalized borrowers are able to repay and the weak ones are not. The lender, in this case Genesis, is left with a portfolio of its bad loans. As a result, the percentage of bad loans to total loans is inflated.
The conclusion remains the same. Genesis had a large exposure to 3AC. 3AC’s implosion put a $2.3 billion hole in Genesis’ balance sheet. The hole potentially made Genesis insolvent. Genesis’ insolvency forced DCG to rescue it. DCG rescued Genesis by absorbing the $2.3 billion 3AC bankruptcy claim.
The degree of Genesis reckless loan underwriting is debatable. It is not as bad as I originally characterized it. But it’s still bad enough for it to wind up in this dire situation.
The $1.1 billion Genesis lent to DCG
Genesis lent $1.1 billion to DCG. This loan was likely issued in June 2022. A 10 year term is typical. The timing coincides with the 3AC collapse. The big question is:
How did Genesis loan $1.1 billion to DCG?
My theory is that Genesis sold its $2.3 billion 3AC bankruptcy claim to DCG in exchange for $1.1 billion to be paid in 2032. No money changed hands as part of this transaction. It’s an accounting trick to make Genesis look solvent. 3AC implodes creating a potential $2.3 billion loss for Genesis. The potential loss could make Genesis insolvent. Genesis sells that $2.3 billion claim to DCG for $1.1 billion to be paid in 2032. That’s the promissory note. That’s how DCG ends up owing $1.1 billion to Genesis. That’s how Genesis swaps a “bad asset,” the 3AC bankruptcy claim, for a “good asset,” a loan to DCG. This transaction is why DCG, and not Genesis, is on the 3AC bankruptcy creditor committee. The $1.1 billion value is derived by the potential value of 3AC bankruptcy claim and the amount that makes Genesis solvent. I suspect it was driven more by the latter than the former.
DCG and Genesis executed this shady accounting transaction because they're run by the same people. It's moving a loss from one entity to another. The terms of this transaction are not public. I suspect an independent counterpart would not have agreed to this transaction.
Restructuring process update
There are three key updates since I wrote DCG’s Downfall. They are:
Timing: Genesis CEO stated in a letter to shareholders on December 7 that he “anticipates it will take additional weeks rather than days” to reach an agreement. That timing is consistent with my prior view.
The biggest driver of the timeline is the $575 million loan Genesis made to DCG that is due in May 2023. DCG is not in a position to repay or refinance the loan. When that happens, the borrower usually makes concessions in exchange for the lender to extend the maturity. That will be difficult to do in this case. The $575 million loan is one of the largest assets on Genesis’ balance sheet. Genesis creditors will prevent any form of preferential treatment of the loan, including an extension. I suspect DCG, Genesis and its creditors will come to an agreement inside of Q1’23.
Negotiations: Genesis creditor, Gemini, has hired the reputable restructuring law firm Kirkland Elis. Genesis has hired restructuring bankers Moelis & Co. Gemini is negotiating a deal with Genesis and DCG.
Gemini is likely the largest Genesis creditor: The FT disclosed that Genesis held $900 million of Gemini deposits. Genesis had $4.9 billion and $2.8 billion active loans on June 30, 2022 and September 30, 2022 respectively. Those loans are assets on Genesis’ balance sheet. The accompanying liabilities, of likely similar size, are the deposits from Gemini and others and potentially loans to third parties. Given the estimated size of Genesis’ liabilities, it stands to believe that $900 million from Gemini makes it the largest creditor.
Updated restructuring plan
I think a prepackaged restructuring remains the best option for all parties. It ensures all DCG businesses can continue operating. It leads to the highest possible value for DCG. The largest asset on Genesis balance sheet are the loans it made to DCG. Enforcing on those assets brings DCG into Genesis’ restructuring. So the greater the value of DCG, the higher the likelihood Genesis creditors get made whole. This clip highlights my thinking.
The plan I laid out in DCG’s Downfall needs a tweak to accommodate Gemini. The size of Gemini’s creditor claim is problematic. Gemini is the agent acting on behalf of the retail depositors. The retail depositors are the creditors, not Gemini. Retail depositors likely need to be made whole as part of the restructuring plan. The majority of Gemini’s retail clients are probably non-accredited investors. A restructuring including a debt for equity swap, as I previously suggested, necessitates a private investment. Private investments cannot be offered to non-accredited investors.
A two tier prepackaged plan could solve the Gemini complication. One creditor group consisting of Gemini depositors would be made whole. The other creditor group would agree to have their capital returned later in kind and/or equity in DCG.
The $900 million of Gemini depositors could be made whole through a combination cash equity injection and the Winklevoss twins. The cash equity injection from DCG would be funded by raising equity and/or monetizing assets in its portfolio. The Winklevoss’ own Gemini. They are worth a combined $6 billion. They may want to preserve Gemini’s brand and participate in a potentially lucrative transaction. If they bought out Gemini depositors, the twins would become a Genesis creditors. Unlike Gemini retail depositors, the twins could participate in the Genesis and DCG restructuring.
There is more pertinent information that we do not know, than we do know. For example, the state of Genesis’ balance sheet and various creditor terms. Reconstructing what happened and a path forward is akin to putting together a puzzle. But in this case, critical puzzle pieces are missing and we do not know what the final picture looks like.
Nonetheless, I think it is safe to assume that Genesis has $2.8 billion of liabilities. I infer this based on Genesis’ loan book, which had $2.8 billion of loans outstanding as of September 30, 2022. Genesis has three businesses. A trading, custody and lending business. The lending business is where the problem is. The lending business is the one that lent $2.3 billion to 3AC and $1.6 billion to DCG. For the purposes of simplicity I lump them all together. In reality, they’re probably all separate. The nature of the custody and trading business is such that they don’t have substantial assets, which likely means no material liabilities.
The visual below illustrates the mechanics of a potential restructuring. Starting with Genesis’ balance sheet. There are an estimated $2.8 billion of assets, of which $1.125 billion are loans made to third parties. My working assumption is that those are good loans that will be repaid in time. If they are not, Genesis is in a more difficult position to restructure. The good loans will fund creditors once repaid. On the liabilities side, there are $900 million of Gemini depositors. They will be made whole from a $500 million cash equity infusion from DCG and $400 million funding from the Winklevoss’. There are $1.9 billion of other creditors on the balance sheet. In this plan, the total creditors are owed $2.3 billion ($1.9 other creditors + $0.4b Winklevoss). Creditors are repaid in time with the $1.125 billion of “good” loans and $612 million of Grayscale profits. I estimate Grayscale will generate $612 million of profits over the next 3 years based on annualizing its Q3’22 revenue and an estimated 75% margin. Creditors are left with a $563 million shortfall. In exchange for absorbing the shortfall and not getting their deposits back immediately, this second class of Genesis creditors would get an equity stake in DCG.
Genesis’s lending business would not have capital to originate news loans. In time, it could source new capital to continue its loan business. Alternatively, Genesis could shut down its lending and keep operating its trading and custody businesses.
This plan requires:
DCG to raise $500 million through raising equity and/or selling an asset other than Grayscale.
Winklevoss’ to buyout $400 million worth of Gemini depositors.
Genesis creditors agree to own a certain percentage of DCG.
Those are three big terms to negotiate. It will take time. It will only work if DCG takes a massive haircut to its prior $10 billion valuation. My back of the envelope math in DCG’s Downfall suggested DCG could be worth ~$2 billion. But DCG has ~$2 billion of debt. There is virtually no equity value of DCG. New equity partners and creditors could end up owning nearly all of the restructured business.
The Winklevoss’ have a path to owning a large stake of a restructured DCG and merge it with their Gemini business. It’s a way for them to become one of the largest players in crypto. An unexpected white knight.
In reality, it will be more complicated than my simplistic example. Genesis balance sheet and its various creditor agreements, all of which are private, will inform the terms of the restructuring.
The parties involved will continue to work throughout the holidays. You can probably tune back in to DCG in the new year.
When estimating Greyscale's profits how do you factor in ETF conversion possibility? For example if we get a new administration in 2024 election and Gensler is out couldn't that pave the way to ETF and cut those profits?