Laurus Capital is using money raised for new funds to cash out of an old one. How much are its holdings really worth?
The Laurus master fund was on a tear two years ago. The New York hedge fund had $1.8 billion under management and had reported 18% annual returns to investors so amazingly smooth that they included a single monthly loss in its six-plus years in existence. The problem Laurus faced was that many of its holdings were illiquid. To keep its streak alive, and its managers generously paid, it needed a buyer.
Enter the PSource Structured Debt fund. The closed-end fund raised $60 million on the London Stock Exchange in August 2007 and promptly used the entire sum to buy assets from Laurus. Say this for the PSource fund's investment managers: They knew what they were buying. That's because they were the same guys behind Laurus--brothers Eugene Grin, 51, and David Grin, 39. On the surface the Grins have achieved astonishing results at Laurus Capital Management. They've done it by funneling money into thinly traded penny stocks via private investments in public equity, otherwise known as Pipes.
This has proved a very profitable way to invest. For the Grins, at least. They have extracted tens of millions of dollars from Laurus Master since founding it in 2001. That includes management fees of 2% of assets a year, plus an average cut of 3.5% off the top of each of the dozens of new investments they arranged for Laurus. In addition, the Grins are entitled to a minimum 20% of reported profits (which they do not appear to have withdrawn). All told the brothers have amassed $88 million in deferred compensation, Laurus financial statements show.
Despite paying its managers top dollar, and the support of PSource, the Laurus Master Fund has run into serious problems. In fact, it is now being liquidated in the Cayman Islands, where its big feeder fund is domiciled, following a redemption request from Russell Investments, Laurus' largest investor. Laurus' problems, it would appear, have to do with the investments it made in a number of companies that later filed for bankruptcy protection. Another big Laurus holding is losing money hand over fist developing algae as a biofuel yet magically boasts a market value of $2.5 billion. None of this deterred the Grins from charging their funds $30 million for their services last year.
Russell, a unit of Northwestern Mutual Life, invested assets from its hedge-fund-of-funds in Laurus. It declines to comment, other than to say it is "a passive investor [and] has no decision-making authority."
Penny stocks--the informal, if not always literally accurate, description of shares in companies whose market values are completely disconnected from fundamentals like earnings and book value--are as old as Wall Street. What's new is how, over the past few years, they've been turbocharged by hedge funds operating through Pipes. A good question for investors: If that hedge fund you are in is invested in Pipes, is it really earning the return it's reporting? In that light, the Grins' claims of double-digit gains amid a flurry of trading among related parties in illiquid securities merit a close look.
As many investors have learned the hard way lately, reporting impressive returns is very different from realizing them. The way the Laurus Master Fund has cashed out of positions is by selling to related parties that the Grins control or have a hand in. They include PSource and the Valens group of hedge funds, which the Grins set up two years ago. Last year Laurus Master received $492 million from PSource and Valens for a basket of securities, many illiquid. That resulted in Laurus' booking a gain of $59 million above its cost basis for the securities, according to its financial statements, which were audited by Rothstein Kass. Also propping up reported returns in the Grins' various funds have been investments in PetroAlgae, a renewable energy outfit.
Eugene Grin is an old pro at the penny stock trade. He got into it at F.N. Wolf & Co., a boiler room that regulators shut down in 1994. Since Eugene and his brother started their own hedge fund in 2001, they have become two of the biggest penny stock investors of the decade. The Grins' hedge funds have pumped an estimated $850 million into nearly 250 companies, mostly via Pipes, according to Securities & Exchange Commission filings, court documents and PlacementTracker. Most of the money has gone into thinly traded public companies in exchange for secured notes that pay the Grins' funds interest, as well as warrants and options convertible into common shares. The converts often grant the Grins rights to buy stock below the prevailing market price.
Many of the Grins' biggest investments have not done so well. In September 2006 Laurus extended a $67 million line of credit to Puerto Luperon, which planned to build a tourist complex in the Dominican Republic. Puerto Luperon defaulted five months later and told Laurus it shut down operations. In an August 2007 deal the brothers bought a $12 million secured note from Incentra Solutions; the borrower wound up in bankruptcy court. 360 Global Wine is another major Laurus deal that produced a bankruptcy filing. (Laurus claims Incentra and 360 Global Wine restructured and became profitable.)
The Grins' valuations for secured notes sometimes seem optimistic. Laurus Master lent $71 million to Boom Drilling. Boom filed for bankruptcy protection in September 2008, but three months later, on Dec. 31, Laurus Master was still carrying the Boom Drilling debt on its books at a value of $70 million.
How can Laurus report the value of loans to bankrupts at close to 100 cents on the dollar? Because the loans are secured--that is, in a liquidation, Laurus would be entitled to whatever can be realized from the collateral. So Laurus says in a written statement supplied by its lawyer, Hillary Richard of Brune & Richard in New York. "Given that the [Laurus] Funds are usually the senior secured lender, they can preserve their economic interests during many restructurings," says her statement. She lists four Laurus debtors that filed for bankruptcy but still paid back the Laurus funds in full and says, "Such recovery has occurred on numerous other investments."
While saying it hardly ever suffers losses from bankruptcies, Laurus claims to have struck gold pretty often, too. Among eight deals it says have been profitable are a $50 million investment in telecom outfit 180 Connect and a $49 million one in publisher Penthouse International.
Another bit of heritage the Grins share with penny stock touts of yore are brushes with criminals. Five years ago Laurus Master Fund became a creditor to Thomas Equipment, a Canadian maker of skid-steer loaders that eventually came to owe the hedge fund $73 million, SEC filings show. Laurus' partner in the deal was Frank P. Crivello, who pleaded guilty a decade earlier to a felony charge of misleading a lender. Thomas' operating units filed for insolvency proceedings in Canada, and Laurus assigned its debt in Thomas to Valens, SEC filings show. Laurus lent $6 million to
With this as its legacy, Laurus Master Fund ceased raising money in May 2007. The Grins promptly set up and began sucking outside money into their Valens hedge funds. Valens holds $725 million in assets, according to documents prepared by Amber Partners, an investment consulting firm.
The Grins began working around the same time with Soondra Appavoo, a managing director of PSource Capital, which itself is a unit of the Punter Southall Group in the U.K. Appavoo says he'd met Laurus exec Dennis Pollack at a London hedge fund conference and shortly thereafter flew to New York to meet the Grins. They hatched a plan to form the PSource Structured Debt fund for the purpose of buying assets from Laurus--a fact fully disclosed to investors. As part of the deal, it was also agreed that Laurus Capital Management would manage the PSource fund's investments. Translation: The Grins are on both sides of the negotiating table.
Despite the related-party nature of such transactions, the bankruptcies and the elbow-rubbing with crooks, the Grins sent their investors an e-mail message this February that claimed the Laurus Master Fund had posted an average annual return since 2001 of 12.2%, notwithstanding a disastrous 2008, in which it lost 22%.
The question remains of just how much of that value the Grins' funds will be able to realize if their money hose runs dry and they are forced to sell assets to arm's-length outsiders. Last year Laurus Master Fund unloaded mostly illiquid securities it was carrying at a cost basis of $300 million onto Valens Offshore Fund for a $54 million profit. Valens U.S. Fund paid another $88 million for Laurus assets the same year. Valens, meanwhile, suspended redemptions by its own investors late last year. It says it will begin permitting them by Sept. 30.
Meanwhile, Laurus and Valens investors aren't likely to take much comfort from the hedge funds' financial statements that say "the ultimate amount of proceeds that might have been paid had a third party been involved could differ and might have been materially higher or lower." Attorney Richard, in a written statement, says: Laurus did not profit from the sales; "there was nothing improper about these transactions, which were fully and transparently disclosed to investors and rigorously audited."
The PSource fund, the third leg of the investment stool, has raised $125 million to buy assets from Laurus Master Fund and Valens. While it's true that the Grins manage investments for both Laurus and PSource, all their transactions are overseen by outsiders, including an independent board of directors and a valuation consultant, says Appavoo. The transactions are between a "willing buyer and willing seller," he insists.
If all this weren't murky enough, the Valens funds and PSource also last year bought minority interests valued at $188 million in four special-purpose entities originally set up by Laurus Master Fund. These outfits house investments made by Laurus Master Fund, its financial statements declare.
Then there is the amusingly effervescent PetroAlgae. The Melbourne, Fla. company aims to harvest oil from algae and claims its "production will be scalable and highly prolific," thanks to "proprietary algae strains."
PetroAlgae started trading on the otc Bulletin Board in December 2008 through a reverse merger with a public shell. It has no revenue and has lost $34 million since its inception. Yet in July it was changing hands at $40 per share, bestowing on it a $4 billion market value. A mere 1% of PetroAlgae's 104 million shares float freely; the rest are owned by the Laurus Master Fund, the Valens funds and PSource. The stock's run-up came on average daily volume of 2,555 shares between December and August.
"From a business perspective I don't understand it," says Robert Walsh, chief executive of Aurora Biofuels, a rival algae entrepreneur.
As of Dec. 31 Laurus Master Fund was carrying its stake in PetroAlgae at $352 million. That means PetroAlgae accounted for 54% of the Laurus Master Fund's net assets, its audited financials show. The cost basis for that stake was listed at $28.7 million. The Valens Offshore Fund booked the cost of its PetroAlgae stake at $23.4 million as of Dec. 31 and was carrying it on its books at $90 million. That represented 17.9% of its net assets. Laurus says its valuations are reviewed by outsiders and that PetroAlgae is carried "at a very significant discount to market value."
"PetroAlgae is recognized by respected sources, including Biofuels Digest and Greener Dawn Research," Laurus says through its attorney. Whether it grows into a moneymaking enterprise or not, PetroAlgae is already cultivating plenty of green for the Grins, thanks to the fees they charge on the net asset values of each of their funds.
At the PSource fund, PetroAlgae currently makes up 34% of assets, helping drive an average annual return of 11.9% since its launch two years ago.
"It's a good thing to have a good stock," says PSource's Appavoo. "It [PetroAlgae] has signed up a very major transaction in China. It's going to be in time a full Nasdaq company."
It would seem that Appavoo still has some selling to do. The PSource fund's London Stock Exchange-listed shares are trading at a 42% discount to their purported net asset value.
