Tuesday, May 16, 2017

UBS and Santander’s Role in Underwriting Employee Retirement System Bonds

By Craig McCann,PhD, CFA, Edward O'Neal, PhD, CVA and Susan Song, MA

We’ve written extensively about the UBS Puerto Rico Closed End Funds. These funds were concentrated in the riskiest subset of Puerto Rico municipal bonds – uninsured bonds with little or no market outside of the proprietary UBS funds. Our prior posts on Puerto Rico can be found by clicking here.

In this post we revisit the Employee Retirement System’s 2008 ERS Series B offering to highlight Santander’s role in this ill-fated deal. The Series B bonds were the second of three ERS offerings. The first, in January 2008, raised only $1.6 billion of the $4 billion contemplated for the 2008 A offering. In January 2008, the Retirement System still contemplated selling $4 billion more POBs.

The Offering Circular for the $1,058,634,613 2008 ERS Series B was published on May 28, 2008. See Figure 1. Notice that the underwriters were just UBS FSI of Puerto Rico, Santander and Popular down from the twelve underwriters who participated in the Series A offering.

Figure 1. Cropped 1st Page of ERS 2008 Series B Offering Circular (full document available here)
Something dramatic happened between January 29, 2008 when the 2008 Series A bonds were issued and May 28, 2008 when the 2008 Series B bonds were issued. The issuer and underwriters of the Series A bonds committed to finding a market outside of Puerto Rico for the Series B bonds. See Figure 2.

Figure 2. Excerpt from page 7 of ERS 2008A Offering Circular (full document available here)
Rather than only being sold in the non-Puerto Rican market place as promised four months earlier, the 2008 Series B ERS bonds would only be sold to Puerto Rican residents. See Figure 3.

Figure 3. Excerpt from page 7 of ERS 2008 Series B Offering Circular
There was no market outside of Puerto Rico for the ERS 2008B because the yields the Retirement System could pay on the bonds and hope to earn an interest arbitrage were insufficient to compensate for the risk of the bonds. This was material information about the riskiness of the ERS bonds for investors in the Series B bonds and holders of the Series A bonds but was not highlighted in offering circular.

Not only was there no market outside of Puerto Rico for the Series B bonds on the terms they were being offered, there was no market for the bonds on the island either. As we previously reported UBS bought 89% of the 2008 Series B ERS bonds into its proprietary funds. See Figure 4.

Figure 4. UBS Purchased 89% of ERS 2008B Bonds for Its Proprietary Funds
Recently we examined the holdings of Santander’s closed end funds and found something very interesting. Virtually all of the Series B bonds that were not bought into the UBS solely managed funds and funds co-managed with Popular were bought into the Santander funds. We are missing the holdings information for a few funds and so it is quite likely that 100% of the 2008 Series B bonds were bought into the funds controlled by the three underwriters – UBS, Popular and Santander. See Figure 5.

Figure 5. UBS, Popular and Santander Purchased at least 98% of ERS 2008B Bonds for Their Proprietary Funds
UBS, Santander and Popular paid about $99.20 on average for the bonds. UBS, Santander and Popular resold these bonds, which it paid the Employee Retirement System approximately $1,043,106,980 in the when-issued market to its proprietary mutual funds for $1,052,409,113. UBS, Santander and Popular charged its mutual fund investors approximately $9,000,000 markup over the price they paid the issuer in what was, economically at least, a riskless principal trade. This was a 0.80% markup on $1,052 million in institutional purchases.

Breen, Hollifield, and Schurhoff (2006), available by clicking here, find the average underwriting spread on municipal bonds is 0.8% and that more than half of this spread is provided to the brokerage firm as a sales credit or gross commission to motivate the sales force. They also find that a significant fraction of large trades are done below the reoffering price at the time of the offering. There were no retail brokers to compensate for selling these Series B bonds since they were bought by proprietary funds controlled by the underwriters directly from the underwriters yet UBS, Santander and Popular charged their mutual fund investors to whom they owed a fiduciary duty an additional $4.5 million over the average $4.5 million underwriter spread on this 2008 Series B which would have been roughly the average non-sales credit component of the spread. Thus UBS, Santander and Popular paid the Employee Retirement System millions of dollars less than they should have or UBS, Santander and Popular caused their mutual fund investors to pay millions of dollars too much – or both.

As we have said before, the most interesting non-public documents in the Puerto Rico municipal bond fund saga will likely be the internal emails and memos at UBS, Santander and Popular and the communications between UBS, Santander and Popular and the Retirement System as they realize that there was no market for the 2008 Series B bonds and the 2008 Series A promise that the Series B bonds will not be sold on the island had to be abandoned. Someone should be looking into this.

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Tuesday, April 25, 2017

Puerto Rico Municipal Bond Returns and Sunspots

By Craig McCann,PhD, CFA and Susan Song, FRM

Introduction

Economists use a statistical procedure called regression analysis to determine whether there is a relationship between economic variables. For example, a labor economist might use regression analysis to determine whether there is a relationship between salaries and education after controlling for differences in job tenure and geographic region. An antitrust economist might use regression analysis to determine whether an attempted collusion in the airline industry effected prices after controlling for other possible explanations for changes in prices such as the cost of jet fuel. Financial economists use regression analysis to determine the relationship between the returns to shares in publicly traded company stock and the returns to baskets of shares of other publicly traded companies.

The simplest regression analysis is called ordinary least squares (OLS) because it determines the parameters of an estimated linear equation relating the variables by minimizing the sum of the squared differences between the observed values of the dependent variable (salaries, ticket prices and stock returns in our examples) and the independent or explanatory variables (education and tenure, dummy variable for before and after the attempted collusion and jet fuel prices, and stock index returns in our examples). The difference between observed values and predicted values for different values of the explanatory variable are called error terms or residuals.

OLS requires the following five key assumptions to hold for the regression results to be valid.

Two kinds of data

Successful application of regression analysis must recognize potential problems with the data being analyzed to ensure that faulty inferences are not drawn from naïve application of a valid technique to problematic data.

Data sets include observations on a list of variables. In our labor example the data set might contain 2016 salaries, level of formal education, years with current employer and years as a CPA for 5,000 individual CPAs in New York. Each individual CPA’s set of values comprise an observation and our hypothetical dataset contains 5,000 such observations. This data set is a cross sectional data set because all the observations are taken at approximately the same point in time. The variation in this example data set is across individual CPAs.

Time series data on the other hand is a set of observations in which the variation in observations is across time. For example, an analyst might use OLS to determine whether the yields on Treasury bonds are related to mortgage interest rates using a dataset that contains observations on Treasury yields and benchmark mortgage interest rates at each month end for a 10-year period (120 observations). The variation in this dataset is across time from one month to the next and the data.1

Sunspots and GNP

There are pervasive challenges applying regression analysis to time series data. An analyst who is not knowledgeable about basic statistics could conclude that two completely unrelated series are closely related by failing to test for serial correlation. This problem is especially acute in time series data where time trends and other omitted variables are likely to cause time series to move together even when there is no independent relationship between the variables. Fortunately, there are ways of drawing valid inferences from times series data with regression analysis which can be found in almost any introductory econometrics textbooks and are well-known to any competent analyst.

A classic example of faulty potential inferences drawn from time series data is GNP and sunspots. See Charles I. Plosser and G. William Schwert’s “Money, Income, and Sunspots: Measuring Economic Relationships and the Effects of Differencing” Journal of Monetary Economics (1978) 637-660 available here. Also see C.W.J Granger and P. Newbold, “Spurious Regressions in Econometrics” Journal of Econometrics 2 (1974) 111-120 available here.

Simplifying Plosser and Schwert’s example, imagine accumulating the sunspots observed each year into a running total. Such a series would increase each year by the number of sunspots observed that year. GNP also increases over time. Regressing GNP on cumulative sunspots generates a high R-squared and a significant t-statistic on cumulative sunspots even though GNP and sunspots are obviously unrelated. The analyst could avoid a possible embarrassing mistake by noting the residuals are positively correlated as evidenced by the DW statistic and make the correct transformation of the GNP and sunspots variables. This is a famous example because the regression of levels on levels is so obviously wrong and because regressing first differences (annual changes in GNP and sunspots) demonstrates that GNP and sunspots are unrelated other than by virtue of both having a positive time trend.

As Granger and Newbold in 1974 and Plosser and Schwert in 1978 made clear, the issue raised by time series data is not whether the variables should be measured as levels or as changes in levels, i.e. first differences of levels, but whether the resulting error terms are uncorrelated or not. If the error terms are correlated some remedial measure such as first differencing the variables must be taken or else the conclusions drawn from the regression analysis are not valid.

It is exceedingly hard to miss serial correlation in error terms since statistical packages automatically produce the Durbin-Watson (DW) statistic which tests for serial correlation of the error terms.2

The DW statistic ranges from 0 to 4; DW = 0 means the error terms are perfectly positively correlated, DW = 4 means the error terms are perfectly negatively correlated and DW = 2 means the error terms are uncorrelated.3 Statistical tables provide critical values for the DW statistic which would allow us to conclude at a given confidence level that the error terms are correlated, uncorrelated or of an indeterminate relationship.

Sunspots and GNP Revisited: Puerto Rico Municipal Bond Returns

Our recent research into Puerto Rico municipal bond returns provides an example of the potential for finding an unreliable relationship in time series data which can be avoided by paying attention to what the DW statistic tells us about serial correlation in the error terms.

In Figure 1, We plot the S&P Puerto Rico Municipal Total Return Index (SAPIPR) and the S&P Investment Grade Municipal Total Return Index (SAPIINV) both set equal to 100 on January 29, 1999. We also plot the cumulative sunspots observed from January 1, 1982 normalized to equal 100 on January 29, 1999 when our total return data starts.4

As we expect from a fixed income total return index, there is a strong upward trend in both the Puerto Rico and USA series. There is a drop in both indexes in 2008, 2010 and 2013. Each time the drop in the Puerto Rico is larger than the drop in the USA series. The drop in Puerto Rico municipal bond prices in 2013 was especially dramatic and persistent.

Figure 1. S&P’s Puerto Rico and Mainland Municipal Total Return Indexes


Figure 1 might tempt an unsophisticated analyst to run an OLS regression on these two total return index level data series from January 29, 1999 to December 31, 2007 to support a belief that Puerto Rico municipal bond returns are highly correlated with mainland municipal bond returns. The results of that regression run in Excel are reported in Tables 1.

Table 1. OLS Regression of Puerto Rico Total Return Index on USA Total Return Index





The R-squared statistic = 0.9995 and t-statistic = 2,159 on the explanatory variable are red flags that there is something wrong with this regression.5 As Granger and Newbold and Plosser and Schwert foretold, there is an extreme positive serial correlation problem with this regression. The correlation between adjacent residuals is 0.99 (should be near 0 on a scale from -1 to +1) and the DW statistic is 0.02 (should be near 2 on a scale from 0 to 4). Figure 2 plots the residuals on lagged residuals from the regression of S&P Puerto Rico Municipal Total Return Index level and the S&P Investment Grade Municipal Total Return Index level. This plot clearly shows the high correlation amongst adjacent error terms.

Figure 2. Residuals from Table 1 Regression Plotted Against Lagged Residuals


To see how silly it would be to defend the regression reported in Table 1 consider a regression of the Puerto Rico Municipal Bond Total Return on the Cumulative Sunspots variable plotted in Figure 1. Obviously Puerto Rico municipal bond returns are unrelated to sunspot activity yet the regression yields an R-Squared of 0.93 and a t-statistic on the Cumulative Sunspots of 177.8. See Table 2.

Table 2. OLS Regression of Puerto Rico Total Return Index on Cumulative Sunspots Since 1982



An analyst who accepts or defends the regression results reported in Table 1 would likely also accept and defend the nonsensical results in Table 2. The correlation coefficient for adjacent residuals from the regression in Table 2 is 0.997 and the DW statistic is 0.0054 demonstrating that the residuals are nearly perfectly positively correlated and the regression results therefore unreliable. Figure 3 is a residual plot for the Puerto Rico municipal bond total returns levels on cumulative sunspots. It looks very similar to Figure 2 because both regressions suffer from severe serial autocorrelation.

Figure 3. Residuals from Table 2 Regression Plotted Against Lagged Residuals



With near perfect positive serial autocorrelation like exhibited in Figure 2 and Figure 3 the standard fix is to run the regression on the first differences of the variables. The results of a regression of first differences in the Puerto Rico Municipal Bond Total Return Index and the Cumulative Sunspots are reported in Table 3. The R-Squared drops to 0 and the t-statistic on the Sunspots variable is not statistically significant at standard confidence levels. This is what we expect since Puerto Rico municipal bond returns cannot be related to sunspot activity. The correlation coefficient for adjacent residuals from the regression in Table 3 is -0.020 and the DW statistic is 2.039 demonstrating that the residuals are uncorrelated and the regression statistics therefore likely reliable.6

Table 3. OLS Regression of Puerto Rico Total Return Index on Daily Sunspots



Returning to the more serious question of the relationship between the returns on Puerto Rican municipal bonds and the returns on mainland municipal bonds; as we saw in Table 1, the adjacent residuals are nearly perfectly correlated and so the careful analyst would run the regression on the first differences in the two total return index level variables. Table 4 reports the results of such a regression. The correlation coefficient of adjacent residuals is now 0.069 (instead of 0.99) and the DW statistic is 1.862 (instead of 0.02). The R-squared is still quite high and the statistic on the mainland variable is still implausibly high at 317 but the results in Table 4 make more sense than the results in Table 1.

Table 4. OLS Regression of Daily Changes in Puerto Rico Total Return Index on Daily Changes in USA Total Return Index





Take a Closer Look at the Data

There is a second major data problem that would cause the error terms to still be correlated. The index levels from 1999 to mid-2006 are only reported monthly. Our hypothetical hapless analyst has filled in all the missing days from 1999 to mid-2006 with the last value for both total return series and treated each day as having a new, independent observation instead of 20 identical observations.

Running OLS regressions on first differences of this “fake” data will still generate serially correlated errors since the error term every day but once a month during the period from January 1999 to August 2006 will equal the previous day’s error term. The correlation coefficient and DW statistics reported above don’t fully reflect the positive serial correlation because once a month there is a large reversal in error term. In fact, continuing to difference the variables a second time, a third time and so on as suggested by Plosser and Schwert won’t fix this data problem. Even without looking at the DW statistic, the analyst would know by looking at the residuals from both the levels and differences regressions, the data from January 1999 to August 2006 is not daily data and can’t be used as daily data.

There are other serious problems with analyzing this data and interpreting the results, but the lesson for today is simply: like any good undergraduate student, check the residuals for serial correlation.

_________________________________________

1 Panel data includes both cross-sectional variation and times series properties. For instance, a data set containing observations on salaries, level of formal education, years with current employer and years as a CPA for 5,000 CPAs over a 10 year period would be a panel data set.
2 A simple discussion of serial correlation can be found in any introductory econometrics textbook - even Econometrics for Dummies, Chapter 12.
3 Except for very small samples the DW statistic is equal to two times the difference between one and the correlation coefficient between adjacent error terms. That is DW=2×(1-ρ). If the error terms are perfectly positively correlated, ρ = 1 and DW = 0. If the error terms are perfectly negatively correlated, ρ = -1 and DW = 4. If the error terms are uncorrelated, ρ = 0 and DW = 2.
4 Source: WDC-SILSO, Royal Observatory of Belgium, Brussels. Downloaded at http://www.sidc.be/silso/datafiles.
5 T-statistics greater than 2.00 – not 2,000 – are usually considered to be statistically significant (more properly are statistically significant at the 5% confidence level). The R-squared statistic requires skeptical interpretation in every case and as reported in Table 1 at 0.999 is, literally, unbelievable.
6 This is too strong a statement since there could be other reasons why regression results might not be reliable but at least the error terms are uncorrelated which is a necessary assumption for the application of OLS to be valid.

Thursday, April 13, 2017

Non-Traded REIT Conflicts Run Amok: VRM I, VRM II and MVP, MVP II

By Craig McCann and Regina Meng

Introduction

SLCG has written extensively about pervasive conflicts of interest in non-traded REITs arising because a non-traded REIT’s sponsor, advisor, selling agents, and major suppliers are often affiliated entities that benefit more from creating the non-traded REIT than from running the REIT profitably. Our blog posts can be found by clicking here. SLCG economists have also published peer-reviewed articles on non-traded REITs, including An Empirical Analysis of Non-Traded REITsi available here.

A collection of real-estate funds under common control based in Las Vegas, NV epitomize the worst of non-traded REIT abuses. The real estate funds (Vestin Realty Mortgage I, Vestin Realty Mortgage II, MVP REIT I, and MVP REIT II) are under the common control of Michael Shustek and, indirectly, Lance Bradford. The abuses include selling loans to related parties in non-arms length transactions, transferring liabilities to public investors through non-arms length transactions, and transferring property among related entities at less than arms length.

VRM I, VRM II, MVP REIT I, and MVP REIT II illustrate the perils of non-traded REITs in which control persons can direct transactions for their benefit with little or no regard for the harm they cause retail investors.

The extreme disregard shown by control persons for investors in these registered investments also highlights the potential risks associated with proposals to allow easier sale of unregistered investments to retail investors.

Mr. Shustek Reaped $1.6 Million by Purchasing a Loan from VRM II

In November 2014, Vestin Realty Mortgage II (VRM II) sold a $7.45 million loan due in January 2015 to its CEO, Mr. Shustek, for $3 million, plus 50% of whatever Mr. Shustek collected from the borrower beyond $3.0 million (after expenses).ii In January 2015, just two months after VRM II sold the loan to Mr. Shustek, the borrower paid back the loan and VRM II received an additional $1.6 million per the agreement. That means Mr. Shustek received at least $6.2 million from the borrower and kept at least $1.6 million for himself ($3.0 million + 2 * $1.6 million = $6.2 million).

Publicly available documents do not indicate whether VRM II conducted any due diligence to confirm that the transaction was fair to VRM II shareholders. However, Mr. Shustek’s large windfall in two months, the myriad conflicts of interest, and the existence of other potential abuses of his power to control VRM II raise questions about the legitimacy of this loan transaction. The transaction stands out not only because it is an apparent abuse of his power, but also because of its size. In December 2014, VRM II only had $28.9 million of net assets, meaning the transfer of at least $1.6 million from VRM II to Mr. Shustek was a significant loss for VRM II investors.iii

The Influence and Control of Mr. Shustek and Mr. Bradford

Mr. Shustek controls multiple companies, including the Vestin Mortgage, LLC, Vestin Realty Mortgage I (VRM I) and Vestin Realty Mortgage II (VRM II). Mr. Shustek also owns MVP REIT’s sponsor, and one of MVP REIT’s two selling agents. Figure 1 presents a simplified organizational chart of Mr. Shustek’s influence over the related entities.

Figure 1. Mr. Shustek’s Influence.iv Solid lines indicate ownership; dashed lines indicate non-ownership roles with significant influence.

 

Mr. Bradford controls multiple companies, including L.L. Bradford (an accounting firm) and several holding companies, which transact with companies controlled by Mr. Shustek. Figure 2 presents a simplified organizational chart of Mr. Bradford’s influence over the relevant entities.

Figure 2. Mr. Bradford’s Influence.v Solid lines indicate ownership; dashed lines indicate non-ownership roles with significant influence.



Mr. Shustek and Mr. Bradford are also affiliated in ways that do not show up on the organizational charts. For example, Mr. Bradford was the President of MVP REIT (2016)vi, a managing officer of MVP Realty Advisors (1999-2005)vii, and an officer of Vestin Mortgage (1999-2005)viii. L.L. Bradford also provides accounting services to VRM I, VRM II, and MVP REIT.ix The questionable nature of Mr. Shustek’s and Mr. Bradford’s dealings is alluded to in a February 2016 article by a Las Vegas newspaper.x

Mr. Shustek Passed Between $4.5 Million and $17.4 Million in Costs on to VRM I and II

When Mr. Shustek created MVP REIT, he structured the advisory agreement so MVP Realty Advisors would pay the upfront selling commissions and offering and organizational costs. MVP Realty Advisors would then be recover its costs through acquisition fees and asset management fees. When MVP REIT began raising capital in September 2012, Mr. Shustek owned 60% of MVP Realty Advisors through MVP Capital Partners. By December 2013, MVP REIT had only raised $25.5 million of capital, suggesting the advisory agreement was going to be a negative net present value investment. By December 2013 VRM II had lent and written off approximately $6.1 million to MVP Realty Advisors. In December 2013, Mr. Shustek gave his 60% interest in MVP Realty Advisors to VRM I and VRM II. Subsequently, VRM I and VRM II loaned MVP Realty Advisors $4.5 million and an additional $6.8 million, respectively.xi The loans were written off as uncollectable in the same quarter they were issued. VRM II might have loaned MVP Realty Advisors the additional $6.8 million anyway, as VRM II was already a 40% owner. However, the $4.5 million from VRM I would likely have come from Mr. Shustek if he had retained his interest. In effect, Mr. Shustek saved at least $4.5 million by passing his 60% interest in MVP Realty Advisors on to VRM I and VRM II.

Despite owing $17.4 million to VRM I and VRM II, MVP Realty Advisors waived $6.9 million of fee revenue and expense reimbursements from MVP REIT by June 30, 2014.xii Thus, it appears VRM I and VRM II could have avoided some uncertainty about being repaid by just requiring MVP REIT to pay its bills. Both the near-immediate impairment of large loans to MVP Realty Advisors and the waived revenue from MVP REIT raise questions about conflicts of interest and abuses of power at VRM I and VRM II.

The Shustek/Bradford Real Estate Funds

Vestin Realty Mortgage I (Previously Vestin Fund I and DM Mortgage Investors)

Vestin Realty Mortgage I (VRM I) began as DM Mortgage Investors. On March 17, 2000, DM Mortgage Investors registered up to 100,000,000 shares at $1 per share, later amended to be up to 10,000,000 shares at $10 per share. The registration statement is available by clicking here. On June 29, 2001, DM Mortgage Investors changed its name to Vestin Fund I. All Vestin Fund I’s SEC filings can be accessed by clicking here. Vestin Fund I converted to Vestin Realty Trust I, quickly changed its name to Vestin Realty Mortgage I (VRM I) and began trading on the Nasdaq Capital Market on June 1, 2006, under the ticker VRTA. All VRM I’s SEC filings can be accessed by clicking here. In March 2012, VRM I ceased being a REIT, but continued trading on the Nasdaq.

Mr. Shustek was the President and CEO of Vestin Realty Mortgage I and its predecessors DM Mortgage Investors and Vestin Fund I. He was also the CEO and majority shareholder of Sunderland Corporation, which became Vestin Group, and which owned the Manager.

The Sunderland Corporation / Vestin Group route to becoming a publicly traded company is an interesting story. A shell company, Sunderland Acquisition Corporation, was registered by a Washington, DC lawyer on or about April 20, 1999. Mr. Shustek and Mr. Bradford are not mentioned in the registration statement which is available by clicking here. Two weeks later, Sunderland Acquisition Corporation acquired Capsource, Del Mar Mortgage and Del Mar Holdings, changed its name to Sunderland Corporation and shortly thereafter to Vestin Group. Mr. Shustek was the majority owner and Mr. Bradford was CFO.

Mr. Bradford functioned as the CFO of DM Mortgage Investors/Vestin Fund I.xiii He was also an executive of Sunderland Corporation. Mr. Bradford’s accounting firm provided services to VRM I and its predecessors.xiv

VRM I was always a very small REIT. Its market capitalization never reached $50 million. At the end of 2015, VRM I deregistered with the SEC and moved from the Nasdaq to the OTC Bulletin Board. VRM I’s total return from inception to April 11, 2017 was -83.5%. During this same time period the total return to the FTSE Mortgage REIT Index was +11%. See Figure 3.

Figure 3. Vestin Realty Mortgage I (VRM I) Total Return



We have identified MVP I and MVP II’s capital raise periods in Figure 3. These non-traded REITs discussed below were controlled by Mr. Shustek. Any brokerage firm considering selling either MVP I or MVP II, could have seen that investors in Mr. Shustek’s VRM I had fared very badly both in absolute terms and relative to a more diverse set of mortgage REITs.

Vestin Realty Mortgage II (Previously Vestin Fund II)

Vestin Fund II registered up to 50 million shares at $10 per share on December 21, 2000. Vestin Fund II’s registration statement is available by clicking here. All Vestin Fund II’s SEC filings can be accessed by clicking here. In May 2005, Vestin Fund II announced plans to convert to Vestin Realty Trust II. Instead, in March 2006, Vestin Fund II merged into newly formed VRM II and in June 2006 VRM II began trading on the Nasdaq as VRTB. At the end of March 2017, VRM II deregistered with the SEC and moved from the Nasdaq to the OTC market.xv VRM II’s SEC filing (available by clicking here) began in 2005 and Vestin Fund II deregistered in 2006.

Michael Shustek is the President and CEO of VRM II.xvi Lance Bradford functioned as the CFO of VRM II’s predecessor, Vestin Fund II.xvii Mr. Bradford’s accounting firm provided services to VRM II and its predecessors.xviii

VRM II’s maximum market capitalization was approximately $240 million. VRM II’s total return from inception on May 1, 2006 to April 11, 2017 was -93%. During this same time period the total return to the FTSE Mortgage REIT Index was +13%. See Figure 4.

Figure 4. Vestin Realty Mortgage II (VRM II) Total Return



We have identified MVP I and MVP II’s capital raise periods in Figure 4. Again, any brokerage firm considering selling either MVP I or MVP II, could have seen that investors in Mr. Shustek’s VRM II had fared very badly both in absolute terms and relative to a more diverse set of mortgage REITs.

Figure 3 and Figure 4 don’t capture the full extent of investor losses due to Mr. Shustek’s VRM I and VRM II programs. VRM II had raised over $300 million net of redemptions before becoming Vestin Realty Mortgage II in 2006. Had those net amounts raised from investors been invested in a diversified portfolio of REITs proxied for by Vanguard’s VGSIX fund, the investments would have been worth approximately $600 million when the VRM II shares were worth $180 million. Thereafter, the VGSIX shares that could have been purchased with the net amounts paid for Vestin Fund II / VRM II shares would have grown to be worth $1.233 billion while the VRM II shares are worth $0.012 billion. That is, the VRM II program has cost REIT investors $1.221 billion. See Figure 5.

Figure 5. Vestin Fund II / Vestin Realty Mortgage II (VRM II) Total Return
 
MVP REIT

MVP REIT is a non-traded REIT sponsored by MVP Capital Partners, LLC and advised by MVP Realty Advisors, LLC. MVP Capital Partners, LLC became owned by VRM I and VRM II. MVP REIT’s SEC filings are available by clicking here.

During three years of fundraising starting in September 2012, MVP REIT issued only $77 million of stock, or 14% of its proposed $500 million offering. Most of the $77 million in MVP REIT shares were issued to SERE Holdings controlled by Mr. Bradford in exchange for interests in six buildings. SERE Holdings then appears to have sold the shares to investors through a brokerage firm owned by Mr. Shustek.

MVP REIT II

MVP REIT II is a second non-traded REIT from MVP Capital Partners. It was registered in September 2015 and sought to raise up to $550 million in a one year period. As of September 30, 2016, the REIT had only raised $45 million, or 9% of its maximum offering amount. The Board of Directors extended the close of offering from October 1, 2016, to December 31, 2016, and announced $50 million preferred stock offering after the closing date of common shares offering was determined.

MVP REIT II’s SEC filings are available by clicking here.

Entities Affiliated with Mr. Shustek and Mr. Bradford Repeatedly Bought and Sold the Same Properties from Each Other.

Between June 2013 and May 2016, entities affiliated with Mr. Shustek and Mr. Bradford bought and sold the same six buildings from each other on three separate occasions.xix As of May 2016, the net result of the repeated sales was a $9.2 million loss for VRM I and VRM II, plus commissions and closing costs.xx

The First Sale

Between June 2013 and November 2013, SERE Holdings, of which Mr. Bradford was the managing member, sold Wolfpack Properties, LLC; Building C, LLC; Building A, LLC; Devonshire, LLC; SE Properties, LLC; and ExecuSuites, LLC to MVP REIT for $55.1 million (see Table 1).xxi Each LLC was a holding company for a single property. As part of the transactions, MVP REIT paid $1.7 million in acquisition fees to MVP Realty Advisors, a subsidiary of VRM II.xxii

Table 1. Summary of the Transactions in Round 1



MVP REIT paid SERE Holdings for the buildings by issuing 2.2 million shares of common stock valued at $19.5 million and assuming the buildings’ mortgages ($35.6 million).xxiii In December 2013, just after SERE Holdings sold the last building to MVP REIT, the shares issued for the six buildings constituted 76% of all the equity capital raised by MVP REIT.xxiv

Interestingly, by March 2014, SERE Holdings had divested itself of 1.6 million shares of the non-traded MVP REIT (50% of MVP REIT’s shares outstanding)xv without selling any of the shares back to MVP REIT and without selling more than 5% to any single investor. This is interesting because, in less than nine months, SERE Holdings sold more than 1.5 times the number of MVP shares that MVP REIT had issued to other investors since the beginning of its capital raise 18 months earlier (September 2012).

The Second Sale

Within one year of buying the six buildings from SERE Holdings, MVP sold all six buildings to VRM I and VRM II. In return, MVP received cash and interests in parking structures and storage facilities from VRM I and VRM II.xxvi As shown in Table 2, MVP sold the buildings to VRM I and VRM II at MVP’s purchase price ($55.1 million). As part of the transaction, MVP paid $1.3 million in expenses to VRM I and VRM II.xxvii

One odd aspect of the second sale is that it ever happened. VRM I and VRM II are mortgage REITs, meaning they invest primarily in mortgages rather than actual real estate. After purchasing the properties, 80% of VRM II’s assets were tied up in real estate.

Table 2. Summary of the Transactions in Round 2



The Third Sale

Table 3 summarizes the third sale of the buildings. Between January 2016 and May 2016, VRM I and VRM II sold the same six properties to companies owned and managed by Stable Development, LLC. As part of the transactions, VRM I and VRM II paid $0.8 million in disposition fees to Vestin Mortgage.xxviii

Stable Development was owned by Lance Bradford, who was also the managing member of SERE Holdings.xxix In other words, after the third sale, the properties belonged to the same person who sold them in the first round. However, despite rising values for office properties in Las Vegas (see Table 4),xxx VRM I and VRM II sold the properties back to an entity controlled by Mr. Bradford for $9.2 million less than the 2014 transaction prices.

Table 3. Summary of the Transactions in Round 3



Table 4. Capitalization Rates for Class A Office Property in Las Vegas, Nevada. Lower capitalization rates mean investors are willing to pay more for a building.

 
Repeatedly selling the six buildings makes little economic sense, and looks more like a shell game than transactions with economic substance. Together, the three rounds of buying and selling the properties transferred

  • $3.0 million from MVP REIT to VRM I and VRM II through fees,
  • $0.8 million from VRM I and VRM II to Michael Shustek through disposition fees, and
  • $9.2 million from VRM I and VRM II to Lance Bradford through reduced sales prices.

Given rising commercial real estate values in the Las Vegas office market, it appears that either MVP REIT acquired the shares at an inflated price, or VRM I and VRM II sold the shares at a sub-market price – or both.

A Possible Fourth Sale

The sales of the six buildings to Stable Development in 2016 included provisions allowing VRM I and II to repurchase each building within one year, at a 12% mark-up.xxxi Just before the repurchase options began expiring in January 2017, VRM I, VRM II, and Stable Development revised the repurchase agreements.xxxii The new purchase agreement allows VRM I and VRM II to acquire 100% of Stable Development—whose only assets are the six buildings—from two entities for $16.8 million plus the outstanding debt on the six buildings.xxxiii If Stable Development did not pay down any of the mortgages, the revised repurchase agreement allows VRM I and VRM II to acquire the six buildings for $38.6 million (a 16% mark-down from the previous sale price).xxxiv

Shortly after VRM I and VRM II sold the six buildings for a $9.2 million loss—but before the repurchase agreement was renegotiated, VRM II proposed a 1:1,000 reverse stock split.xxxv VRM II required that partial shares (i.e., investors with fewer than 1,000 pre-split shares) be bought out by the company. It is curiously serendipitous that VRM II took what turned out to be a temporary loss equal to 60% of its equity market capitalization at a time when Mr. Shustek and other large shareholders of VRM II would benefit from lower share prices.xxxvi In the six months before the reverse split was announced, Mr. Shustek increased his holdings from 19.9% to 21.5% of VRM II. The reverse split, by eliminating smaller shareholders, would further increase his holdings to 25.5%.xxxvii Together, the $9.2 million loss and the renegotiated repurchase agreement transferred more than $1 million in wealth from small VRM II shareholders to Mr. Shustek and other large VRM II shareholders.

Conclusion

VRM I, VRM II, MVP REIT I, and MVP REIT II illustrate the perils of non-traded REITs in which control persons can direct transactions for their benefit with little or no regard for the harm they cause retail investors.

The extreme disregard shown by control persons for investors in these registered investments also highlights the potential risks associated with proposals to allow easier sale of unregistered investments to retail investors.

_________________________________________

i“An Empirical Analysis of Non-Traded REITs,” Journal of Wealth Management, Summer 2016, vol. 19(1).
ii Form 10-K for 2015, VRM II REIT, filed with the SEC on 3/30/2016. Page 13.
iiiForm 10-K for 2014, VRM II REIT, filed with the SEC on 3/31/2015. Page 20.
ivMr. Shustek’s ownership percentages are from an MVP REIT prospectus dated 4/16/2015.
vMr. Bradford’s ownership of Stable Development is from VRM II’s 2015 10-K, filed on 3/30/2016 (p. 12). SERE Holdings’ ownership of the six LLCs is from MVP REIT’s 2013 10-K (pp. 86-87).
viForm 8-K, MVP REIT I, filed with the SEC on 1/7/2016.
viiForm 10-K for 2013, MVP REIT, filed with the SEC on 3/31/2014. Page 86.
viii Form 10-Q for 3Q 2014, VRM I REIT, filed with the SEC on 11/13/2014. Page 6.
ixForm 10-Q for 3Q 2014, VRM I REIT, filed with the SEC on 11/13/2014. Page 6; Form 10-Q for 3Q 2014, VRM II REIT, filed with the SEC on 11/13/2014. Page 8; Form 8-K, MVP REIT I, filed with the SEC on 3/11/2013.
xGerman, Jeff, “Official targeted in FBI probe linked to firm he supervised,” Las Vegas Review-Journal, February 24, 2016.
xiVRM I and VRM II also loaned $3.7 million to MVP Capital Partners II (the sponsor for MVP REIT II) in 2015 and 2016. Those loans were also completely impaired in the same quarter they were made.
xii Form 10Q for 2Q 2014, MVP REIT, filed with the SEC on 8/13/2014. Page 17.
xiiiForm 10-Q for 3Q 2004, Vestin Fund I, filed with the SEC on 8/9/2004 (p. 23).
xivForm 10-Q for 3Q 2014, VRM I REIT, filed with the SEC on 11/13/2014. Page 6; Form 10-Q for 2Q 2005, Vestin Fund I, filed with the SEC on 2/8/2006. Page 21.
xvTodd Prince wrote about VRM II’s plans to deregister in two news articles for the Las Vegas Review-Journal: “Real estate investor Shustek proposing to delist company” on January 13, 2017, and “Vestin property fund plans to delist by end of month” on March 9, 2017.
xviForm 10-K for 2015, VRM II REIT, filed with the SEC on 3/30/2016;
xviiForm 10-K for 2002, Vestin Fund II , filed with the SEC on 9/27/2002. Page 20.
xviiiForm 10-Q for 3Q 2014, VRM II REIT, filed with the SEC on 11/13/2014, (p. 45); Form 10-K for 2005, Vestin Fund II, filed with the SEC on 9/13/2005, (p. 45).
xixEight entities owned and or controlled by Mr. Bradford and Mr. Shustek lease space in Building A, located at 8880 West Sunset Road, Las Vegas, NV 89148.










xxVRM II owned 72% of each of the six buildings, suggesting VRM II lost approximately $6.6 million (72% * $9.2) from the purchase and sale of the six buildings.
xxiForm 10-K for 2013, MVP REIT, filed with the SEC on 3/31/2014. Pages 42-44.
xxiiForm 10-K for 2013, MVP REIT, filed with the SEC on 3/31/2014. Pages 42-44.
xxiiiForm 10-K for 2013, MVP REIT, filed with the SEC on 3/31/2014. Pages 42-44.
xxivForm 10-K for 2013, MVP REIT, filed with the SEC on 3/31/2014. Page 2.
xxvForm 10-K for 2013, MVP REIT, filed with the SEC on 3/31/2014. Page 102.
xxviiForm 10-K for 2013, MVP REIT, filed with the SEC on 3/31/2014. Page 62.
xxviiForm 10-K for 2014, MVP REIT, filed with the SEC on 3/31/2015. Page 88.
xxiiiForm 10-Q for 3Q 2016, VRM II REIT, filed with the SEC on 11/10/2016. Pages 18-20.
xxxForm 10-K for 2015, VRM II REIT, filed with the SEC on 3/30/2016 (p. 12); Form 10-K for 2013, MVP REIT, filed with the SEC on 3/31/2014 (p. 86).
xxxiIRR Viewpoint annual report published in January 2013, January 2014, January 2015, and a mid-year update published in August 2016. We focus on the going-in cap rates of Class A office properties in Las Vegas.
xxxiiForm 10-Q for 3Q 2016, VRM II REIT, filed with the SEC on 11/10/2016. Pages 18-19.
xxxiiiApparently, between the time VRM II sold the buildings to Stable Development and January 2017, Lance Bradford sold or transferred his ownership interest in Stable Development to Par 3 Nevada, LLC and DT GRAT CS, LLC. Par 3 Nevada is managed by Lance Bradford. DT GRAT CS is managed by Dennis Troesh.
xxxivBalances for each building’s debt outstanding are from VRM II REIT’s Form 8-K filed with the SEC on 2/3/16 and VRM II REIT’s Form 10-Q for 3Q 2016 filed on 11/10/2016 (p. 18).
xxxv The first mention of the 1:1,000 reverse split in VRM II’s SEC filings was on September 15, 2016.
xxxvi On December 31, 2014, VRM II had market cap of $10.417 million (2.578 million shares outstanding and a share price of $4.04) and a book value of $28.916 million. A $6.6 million loss in 2015 is 63% of the $10.417 million market cap.
xxxviiForm 10-K for 2015, VRM II REIT, filed with the SEC on 3/30/2016; Proxy Statement, VRM II REIT, filed with the SEC on 1/17/17.

Thursday, March 30, 2017

$4.4 million Cummings v UBS of Puerto Rico Award

In March 2017, a FINRA arbitration panel in San Juan, PR ordered UBS Financial Services and UBS Financial Services of Puerto Rico to pay $3,919,359 in compensatory damages, $61,499 in costs and $442,318 in attorneys’ fees. In addition, the panel voided debts claimed by the Respondents. You can read the award here. Dr. O'Neal testified on liability and damages over UBS Puerto Rico's sale of UBS Puerto Rico municipal closed end bond funds.