Hedge Fund Feasts on Famine

Laurus made its name as a banker of last resort. Are its days of fat returns behind it?
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David and Eugene Grin built a major business for themselves selling last-ditch loans to troubled companies. But with returns slipping, some wonder if their Laurus Family of Funds can continue fattening itself at the bottom of Wall Street's food chain.

In just five years, Laurus has gone from being a blip in the $1 trillion hedge fund universe to one of the nation's largest investors in penny stocks. The Israeli emigres, who started in 2001 with less than $5 million in capital, now boast nearly $1 billion in assets.

The brothers Grin have also done well for their 300 or so investors. The New York-based fund's average annual return is just over 20%. In 2005, the hedge fund was up a more modest 8.5%. Still, that's more than double the gain in the

S&P 500

.

The secret to Laurus' rapid success has been its single-minded strategy of investing in collateralized convertible bonds, a financing transaction Laurus pioneered and has peddled to scores of struggling micro-cap companies that trade on the

OTC Bulletin Board

and unregulated

Pink Sheets

.

Laurus now ranks as one of the most active investors in the $17 billion-a-year market for Pipes, a Wall Street acronym (private investment in public equity) for deals in which companies sell fresh chunks of themselves even though they're already public. In 2005 alone, Laurus has provided more than $220 million in financing to 50 different small companies, according to PlacementTracker, a research firm.

Pipes are a popular financing vehicle for tiny, cash-strapped companies because they are a quick way to raise money. Hedge funds, meanwhile, are fond of Pipes because they usually get to buy shares at a discounted price and can quickly resell them.

Critics say that feature makes the Pipes market susceptible to abuse by unscrupulous short-sellers -- traders who place market bets that a stock will decline in price. That's one reason securities regulators have been investigating the Pipes market for nearly two years now and are beginning to bring enforcement actions against some of its players.

A Laurus deal, however, is not like most Pipes transactions. While other deals are designed to provide an early exit for hedge funds, Laurus aims to take a longer-term position in the companies to which it provides financing. Indeed, Laurus fancies itself as something of a neighborhood banker -- albeit in a sketchy neighborhood.

The unusual business strategy has set Laurus apart from other hedge funds in the Pipes market. It's also an approach that is fraught with added risk and leads some to wonder how long Laurus can keep posting strong returns, given that many of the penny stock companies it finances often are one step from bankruptcy.

On the surface, there's nothing particularly complex about a Laurus deal. In fact, almost every one is identical, except for the dollar value of the transaction and the term of the loan.

Laurus provides cash to a company in exchange for an interest-bearing bond that converts into stock when the price of the shares rises by about 10%. The loans, usually three years in duration, carry an interest rate that's as much as 3 percentage points over the prime lending rate. To protect itself against the possibility of a default on one of these notes, Laurus also requires a company to put up substantial assets as collateral to secure the bond. In many cases, the collateral used to secure the loan amounts to all of the company's assets.

In other words, if a company defaults on a Laurus deal, there's a good chance Laurus will own the company. Clients appear willing to take the risk, mainly because they have nowhere else to turn for financing.

On each deal, Laurus also books a "closing" payment and "due diligence fee" that can range anywhere from $100,000 to $300,000. It also acquires warrants to purchase shares in the future.

Laurus likes to describe its loans as a "win-win'' situation for the company and its shareholders because the fund says it has a vested interest in seeing a stock rise in value. Better yet, Laurus says, it has a policy of not shorting the shares of the companies to which it lends money.

In a traditional Pipes transactions, hedge funds often short the shares of the company on the expectation that a big influx of discounted shares into the market will further depress the price.

"We make money when the company's stock appreciates above our premium,'' says David Grin. "We make our money on the upside, not on the downside.''

This year, however, there's been a lot of downside to the stocks of the companies doing business with Laurus.

Of the 50 deals Laurus has financed through the first week of December, just 10 of the companies involved have seen an appreciation in their share prices, according to PlacementTracker. Shares of companies to whom Laurus has provided cash are trading down an average of 32%.

One of the few Laurus-funded companies to see a significant surge in its stock price in 2005 was

Naturade

(NRDC)

, a low-carb food manufacturer with less than $15 million in annual sales, whose own auditors say may not be able to continue as a going concern. Shares of Naturade, since obtaining $1 million in financing from Laurus in July, are up 75% to 21 cents.

More indicative of how the year went for companies that Laurus has funded is

BioDelivery Sciences

(BDSI) - Get Report

, a small biotech company that's trying to develop a new treatment for nausea and vomiting. In February, Laurus entered into a $2.5 million Pipe deal with the company and an additional $2.5 million financing deal in May. Since the first February financing, the company's shares have slid 22% to $2.50.

Or consider the case of

Epixtar

(EXPRE.OB)

, a financially strapped call-center operator that Laurus did a $6.2 million deal with in July. On Oct. 6, Epixtar filed for bankruptcy. Now Laurus is stuck in court trying to collect on the assets that the company posted to secure the deal.

This is not the first time Laurus has had to foreclose on one of it loans. Most notably, the hedge fund went to court last year to begin proceedings on the New York townhouse that

Penthouse

founder Bob Guccione inhabits. Penthouse International, the magazine's publisher, used the home as collateral for a $24 million loan from Laurus.

When Penthouse defaulted, Laurus moved to take possession of the townhouse and begin eviction proceedings against Guccione, who had a deal with the magazine company to live in the house rent-free through February 2006. Lawyers for Guccione say Laurus ultimately agreed to let the former Penthouse publisher stay in the townhouse through the term of his lease.

Laurus claims that fewer than 2% of the 160 deals it's done since 2001 have ended up in foreclosure. But some fear that the hedge fund could find itself spending a lot more time in court, especially if the economy sours and the companies it funds -- many of which already are on the edge -- go under.

Laurus' 2004 marketing brochure, a copy of which was obtained by

TheStreet.com

, shows that 73% of the firm's assets were invested in secured notes, 10% in cash, 4% in warrants to buy additional shares of company stock. The remaining 12% of the fund's assets were allocated to pending deals.

The fund's marketing material says the big audit firm KPMG performs a monthly analysis of Laurus' portfolio to make sure its loans are "being marked accurately and fairly.'' Valuation of bonds is always an important issue with a hedge fund that invests heavily in convertible notes.

Still, some see reason for concern. One Laurus investor, who didn't want to be identified, said this year's performance could be an indication that Laurus' strategy is faltering. There's a concern that with $1 billion in assets to manage, Laurus needs to move beyond simply being the banker of last resort to the penny stock set, if it's to keep growing.

Such concerns have led some potential investors to take a pass on the company.

"We just decided it wasn't a strategy we wanted to be involved with,'' says Robert Keck, a managing member with the 6800 Capital Group, a so-called fund of funds that invests its clients' money in a wide range of hedge funds.

Keck, who met with the Grins before deciding not to invest in Laurus, said the brothers described their fund as "filling a need'' that commercial banks don't want to do.

In many ways, Laurus is a hedge fund in name only. Its midtown Manhattan offices are set up more like a commercial finance firm than a trading shop. In fact, the 60-employee fund has more lawyers and investment bankers on its staff than traders.

The fund also employs a team of 10 analysts whose main job is to vet the companies Laurus is considering financing.

Grin says the large analyst staff helps insure that Laurus doesn't enter into too many risky deals. He says the funds' goal is to minimize foreclosures.

He dismisses talk that Laurus' strategy can't succeed during an economic downturn. Grin notes that the fund opened its door just before the Sept. 11 terror attacks and managed to flourish throughout the last recession.

Grin says a bigger obstacle to Laurus' growth is the general aversion institutional investors have toward the Pipes market. He believes that is changing, although he declines to discuss the hedge fund's investors.

To increase its palatability to institutions, Grin recently registered the fund with the

Securities and Exchange Commission

. Unlike other hedge funds that are finding ways to avoid the new registration requirement, he says being "transparent'' is one way to gain investor confidence.

Still, 2006 is shaping up as a pivotal year for Laurus. With $1 billion in assets, it's now one of the bigger hedge funds in the nation. The question is whether it will continue feasting on a diet of skimpy companies.