Covenant Lite #27: Yield Chasing at its Worst: Private Credit's Fallen Stars (Part 3 of 3)
A three-part series on what can go wrong in private credit
In this third installment of our Fallen Stars series, we journey from the distant echoes of the Great Financial Crisis (GFC) covered in Part 1, through the reckless post-crisis asset gathering we unpacked in Part 2, and finally arrive at the most recent—and perhaps most jaw-dropping—implosion in our lineup: H2O Asset Management’s 2020 liquidity meltdown.
The H2O saga, involving a tangled web of private debt investments with controversial German financier Lars Windhorst, showcases vividly how unchecked growth ambitions, liquidity mismatches, and weak governance can turn even high-performing funds into cautionary tales almost overnight.
Before we jump into H2O’s saga, here’s a quick refresher on what the earlier episodes taught us:
Part 1: Allied Capital, American Capital Strategies, and Carlyle Capital Corporation fell victim to bad liability structures, financing themselves with short-term, mark-to-market leverage while investing in illiquid (and, over time, increasingly risky) direct loans. When the GFC hit and many of their risky bets began defaulting, the firms could no longer mask losses—and were ultimately forced to wind down or be taken over.
Part 2: Fifth Street Finance, Medley Capital, and Direct Lending Investments imploded in the post-crisis era, succumbing to misaligned incentives that fueled reckless growth as company management was paid to grow AUM, not protect it, which encouraged riskier loans and looser credit standards over time. Ultimately, the funds were forced to deal with reality due to higher defaults and investor redemptions, leading to their demise.
Today, we’ll explore how H2O—named ironically after liquidity itself—plunged headfirst into similar pitfalls. As you’ll see, H2O was undone by a combination of the traps that felled the firms in Parts 1 and 2—both a bad liability structure and misaligned incentives that fueled reckless growth.
Beginnings: A Tempting Opportunity (2015–2017)
H2O Asset Management began as a superstar within the European fixed-income world. Founded in 2010, the London-based boutique quickly grew into a giant, drawing investors attracted to its macro-driven global bond strategies and double-digit returns.
In 2015, H2O’s charismatic founder and CEO, Bruno Crastes, along with CIO Vincent Chailley, crossed paths with Lars Windhorst—a financier with a compelling story but a checkered past. Windhorst’s holding company (initially called Sapinda, later Tennor) needed capital, offering privately-placed bonds and promissory notes paying tantalizing yields of 10-13% in a near-zero-rate environment.
Windhorst’s holding company was a sprawling, eclectic mix of high-profile, cash-intensive trophy assets, each with plenty of glamour but perpetually thirsty for capital. At its core was luxury fashion brand La Perla, a storied Italian lingerie house undergoing a difficult turnaround.
Alongside that was an ambitious but financially strained stake in Bundesliga football club Hertha BSC, whose costly dreams of new stadiums and Champions League aspirations were proving harder to fund than expected. Tennor also held an interest in a troubled German shipyard, Flensburger Schiffbau-Gesellschaft, which stumbled from one liquidity crisis to the next, as well as speculative stakes in the mining firm Petropavlovsk, Dutch esports giant Team Liquid, and various real estate and tech startups awaiting IPO miracles.
Together, these businesses formed a capital-consuming patchwork, where glamorous stories and optimistic forecasts masked persistent cash-flow holes—holes that needed a large, consistent source of investor capital to fill.
Despite initial skepticism about Windhorst—whose past included bankruptcies and fraud allegations—H2O’s CEO, Crastes, was soon charmed. Lavish hospitality, including private jet rides, yacht vacations in the Mediterranean, and high-end dining in London, blurred the lines between friendship and fiduciary responsibility. In 2015, Crastes enthusiastically told Windhorst their partnership felt “like family.”
Within two years, H2O had quietly amassed hundreds of millions in private placements tied directly to Windhorst’s businesses, turning speculative private debt into core holdings in supposedly liquid daily-dealing UCITS funds.
The Good Years: Yield Masking Risk (2017–2019)
Between 2017 and early 2019, H2O’s funds appeared unstoppable. Annual returns of over 30% in some flagship products attracted inflows from institutional and retail investors alike, catapulting H2O to the top of European asset-management rankings. Assets swelled to €31 billion across the H2O platform from ~€10 billion when they began investing in Windhorst entities.
Behind the scenes, Windhorst’s instruments became H2O’s secret weapon. The high-yield, privately-placed debt—initially small positions tucked discreetly into its higher-octane funds like Allegro and MultiBonds—grew rapidly, ballooning into nearly €1.6 billion across multiple strategies by mid-2019.
From a governance and incentives standpoint, multiple factors encouraged H2O to keep expanding these bets. First, the firm’s performance was stellar—the Allegro and MultiBonds funds, for example, regularly topped performance league tables. These outsized returns translated into lucrative performance fees and helped double the firm’s profits to over $500 million that year (Link).
The Windhorst deals, while illiquid, often carried double-digit coupon rates or came with equity-kicker upside, contributing to the strong returns (at least on paper) as long as they were valued optimistically. H2O charged its usual management fees on the full NAV of the funds—including those hard-to-value securities—giving it little short-term incentive to liquidate them and shrink the NAV.
In addition, H2O’s risk/reward models may have perversely favored these holdings: since they were marked infrequently, they showed low daily volatility and did not “consume” as much of the funds’ risk budget as, say, volatile trading positions. This allowed H2O’s portfolio managers (who were often paid based on fund performance and size) to gear up the portfolios further, enhancing returns (and fees) in good times.
But cracks were forming beneath the surface. Internally, CIO Vincent Chailley grew uneasy at the scale of the Windhorst exposure. Throughout 2018, he emailed Crastes with escalating concerns—at one point noting that Windhorst was essentially “leveraging himself on our balance sheet” and even charging personal expenses (private jets, luxury hotels) to the companies H2O invested in (Link).
By late 2018, Chailley calculated that H2O’s funds were far exceeding regulatory limits: UCITS rules cap illiquid investments at 10% of a portfolio, yet H2O’s Windhorst holdings had grown to over €1.5 billion—roughly 15% of the relevant funds by his estimate, vs. about €1 billion allowed (Link). He warned that continuing would “breach the level of illiquid exposure allowed by the rules” (Link).
In May 2019, as Windhorst invited Bruno Crastes to join Tennor’s new advisory board, Chailley’s alarms reached a crescendo. He told Windhorst directly that H2O “could not proceed” with a new bond purchase because they were beyond the legal illiquidity threshold (Link).
By June 2019, H2O had transformed into a stealthy, high-risk lender to Windhorst’s holding empire, all while investors still believed their money remained safe and liquid.
The Crisis: Reality Strikes Hard (2019–2020)
In June 2019, the Financial Times published a bombshell investigation, exposing H2O’s outsized exposure to Windhorst’s illiquid securities and highlighting clear conflicts of interest (Link). Within days, investors panicked, pulling billions from H2O’s funds. Morningstar suspended ratings, triggering further redemptions. The facade cracked fast: investors who’d believed their funds were liquid suddenly realized H2O had little way to sell these opaque, privately-held securities.
Under pressure, H2O faced impossible choices. Selling liquid assets to meet redemptions meant illiquid Windhorst notes ballooned as a percentage of the remaining holdings, worsening the mismatch. Still, management promised transparency and liquidity, hoping markets would calm.
But the pandemic-driven liquidity crunch of March 2020 magnified problems further. By August 2020, regulators stepped in decisively: France’s AMF and the UK’s FCA forced H2O to halt investor redemptions across multiple funds. H2O segregated €1.6 billion of Windhorst-linked instruments into side-pocket vehicles (Depth SP, Allegro SP, etc.), freezing investors’ money indefinitely.
The FCA’s investigation concluded that H2O conducted little to no fundamental analysis on many Windhorst deals—in one example, only 7 out of 24 investments had any recorded business analysis performed. H2O basically entrusted Windhorst’s word and the aura of a savvy dealmaker, despite his checkered past.
The promise of daily liquidity was shattered, and investors now owned illiquid stakes in a speculative credit portfolio whose values remained deeply uncertain.
Aftermath (2020–2024)
The years following the freeze became a slow-motion cleanup operation:
Partial Recoveries: Windhorst made intermittent repayments; H2O gradually returned some funds, though often at deep discounts.
Regulatory Penalties: In late 2022, the French regulator (AMF) proposed an unprecedented €75 million fine and a 10-year industry ban for CEO Bruno Crastes, citing profound breaches of duty and conflicts of interest. The UK’s FCA settled in 2023 by mandating a €250 million restitution to investors rather than imposing an additional fine.
Operational Downsizing: H2O announced it would shutter its UK-regulated activities by late 2024, focusing on a smaller European footprint.
Investors, who once saw H2O as a trusted steward of their capital, faced substantial losses and protracted recoveries. The affair underscored brutally how quickly private credit optimism could collapse under illiquidity and weak governance.
Bottom Line: Private Credit’s Recurring Traps
H2O’s downfall wasn’t solely about Windhorst’s controversial background; rather, it echoed themes we saw in Parts 1 and 2 of this series: leverage, hidden illiquidity, conflicts of interest, aggressive underwriting, and human psychology blinded by performance and flattery.
Similar to the firms profiled in Part 1 (Allied Capital, American Capital Strategies, and Carlyle Capital Corporation), H2O relied on a bad liability structure for investing in private credit. Unlike those examples, it wasn’t mark-to-market debt that was their undoing but rather the inherent mismatch between its supposedly liquid UCITS structure and a portfolio that became increasingly concentrated in privately-placed securities impossible to quickly liquidate.
Similar to the cautionary cases we examined in Part 2 (Fifth Street Finance, Medley Capital, and Direct Lending Investments) H2O prioritized aggressive growth, chasing yield into increasingly speculative investments while ignoring mounting signs of credit stress. In each scenario, management’s aggressive pursuit of performance and inflows overwhelmed prudent risk management, until reality abruptly intervened.
As investors today pour record sums into private credit, confident in the asset class’s resilience, the H2O saga serves as a reminder that vigilance—around liquidity, transparency, and incentives—is essential.
History doesn’t exactly repeat, but it seems to rhyme—and investors who learn the rhythms of private credit’s past might just avoid becoming the subject of its next cautionary verse.
That’s the hope, anyway.
Covenant Lite