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The unhinging of a hedge fund

Portus, an upstart Toronto hedge fund firm, began raising concerns about its operating methods last year, PAUL WALDIE, KAREN HOWLETT and SINCLAIR STEWART report. And it may take several months before investors get answers

Mark Kent has dealt with a lot of hedge fund companies in his time but he's never seen anything quite like Portus Alternative Asset Management Inc.

Mr. Kent is president of Portfolio Strategies Corp., a Calgary-based mutual fund dealer with nearly $1-billion in assets. Early last year, his 340 agents were offering Portus funds just like thousands of agents across the country.

It made sense at the time. Portus was one of the fastest-growing hedge fund companies in Canada. It had an aggressive marketing pitch and offered some products that appealed to a broad range of Mr. Kent's retail clients. But within a few months of dealing with Portus, Mr. Kent became concerned. He could never understand the Byzantine structure of the funds and he had doubts Portus was doing the proper follow-up with Portfolio Strategy's clients.

Then, he says, when two commission cheques from Portus bounced last Easter, Mr. Kent pulled the plug and stopped dealing with the company. "There were a lot of little things that happened within a few months that just made me very uncomfortable," he said in an interview this week.

Mr. Kent was not the only one with concerns. Early this month, provincial securities regulators across Canada launched investigations into Portus and issued temporary orders preventing the fund company from accepting any more money from investors or setting up new accounts. The reasons for the probe were both varied and vague: questions over whether investors' money was properly guaranteed by a bank, concerns about the suitability of investments for customers, and "apparent irregularities" with sales practices and bookkeeping.

The drama deepened yesterday, when the Ontario Securities Commission issued another order prohibiting Portus from trading in any securities or redeeming any funds for its clients. The securities watchdog has also blocked Portus founder Boaz Manor from trading notes held by the company.

Michael Watson, director of enforcement at the OSC, said it appears that the principal invested by Portus clients, totalling approximately $730-million, is protected by a basket of notes issued by the Canadian subsidiary of the French banking giant, Société Générale. However, he said about 12 per cent of that amount, or nearly $90-million, has already been paid out in the form of commissions, fees, and referral payments to agents.

The OSC is still trying to figure out why Portus was trading Canadian securities from an account in the Grenadine Islands, and whether it invested its clients' money offshore in order to sidestep rules dictating which type of investors can buy hedge funds.

"I would anticipate the next step is to make contact with offshore regulators and see what they can provide us," Mr. Watson said.

Nervous customers -- the firm has 26,000 clients -- hoping to get some answers about their investments at an OSC hearing next week may be in for a long wait. Mr. Watson said the regulator plans to seek an extension of its order, possibly spanning several months, in order to complete its investigation.

When asked whether Mr. Manor and others at Portus are co-operating, Mr. Watson would only say that information is being gathered "very slowly." He added that it's doubtful the regulator will have much of an explanation for investors before six months time. "It's hard to imagine it would be too much before then."

Mr. Manor has declined comment but Portus has always maintained its funds are backed by a major bank. Yesterday, the firm said it was "pleased" with the OSC's statements regarding the principal protection and said it supports the halt on withdrawals. It added that it is co-operating with regulators.

The Portus saga has shaken the booming hedge fund industry, which has been growing at a rate of 40 per cent annually over the past several years. Total assets in Canadians hedge funds has jumped to about $16-billion from $2.5-billion in 1999.

While many industry players say Portus is a unique case, the crisis comes at a time when the industry is coming under increasing scrutiny from regulators, notably in the United States.

Portus illustrates the potential risks associated with investing in a product where so little is publicly disclosed. Even regulators such as Mr. Watson, who have been poring over the firm's books and records, are having a difficult time following the path of the fund's investments.

Portus was born two years ago as Paradigm Asset Management, the brain child of Mr. Manor and his partner, Michael Mendelson.

The two met in 1998 at a recruitment fair. Mr. Mendelson was running an investment firm at the time called Southview Capital Corp. and he was looking for some young talent. He was immediately impressed by Mr. Manor, who was barely out of university.

Mr. Manor had graduated from the University of Toronto in 1996 with a bachelor of applied science degree and appeared to be headed for a career with his father Daniel. The elder Mr. Manor immigrated to Toronto from Israel in 1988 after a 30-year career developing defence systems for the Israeli military. He put his engineering training to work and started a company called Electronic Integrated Systems Inc., or EIS, which makes cameras that monitor traffic flows.

Boaz Manor worked briefly with his father at EIS but jumped to the financial world and became a partner in Southview, which made a handful of investments in the mining sector. Around 1999, the pair turned their attention to the booming technology sector and started KBL Capital Corp., which specialized in drumming up financing for new ventures.

When the high-tech bubbled burst in 2000, the pair considered starting a labour sponsored investment fund but decided to move into hedge funds instead.

Mr. Manor spent some time in New York learning the business from hedge fund guru James Park, chairman and CEO of Paradigm Global Advisors LLC. The men also struck a consulting arrangement.

By early 2003, Messrs. Manor and Mendelson created Paradigm Asset Management. Mr. Mendelson was considered by many in the industry as the driving force behind Paradigm, but Mr. Manor was the public face. His picture dominated its website and Paradigm touted his expertise in "alternative investments" and his background as a mathematician who graduated "magna cum laude." Records show Mr. Manor graduated with honours but no special distinction.

The fund company got its first big break in August, 2003, when it struck a referral arrangement with Manulife Securities, a unit of Manulife Financial Corp. The Manulife connection made it easier for Portus to get accepted by other dealers.

J-P Bisnaire, a lawyer for Manulife, said yesterday the insurer has asked Portus and regulators for more information about the current situation. However, he stressed that the company only has a referral arrangement with Portus.

By early 2004, the fledgling hedge fund was facing problems. Mr. Kent, the Calgary mutual fund dealer, dropped Portus. Several months later, Mr. Manor flew out to urge him to stick with the company's funds. "He was very personable," Mr. Kent recalled. "He just said that they were relatively new to this and they had made some mistakes, but they have cleaned a lot of things up and asked us to consider giving them another chance."

The company's relationship with Mr. Park of Paradigm Global also began to sour and he told Portus it could no longer use his company's name. In May, Paradigm bought a Montreal company called Portus Investment Inc. and adopted that company's name.

Mr. Mendelson and Mr. Manor wanted to move swiftly to establish the firm's credibility in the hedge fund world. Enter Renata Neufeld, author of A Practical Guide to Hedge Funds. They quickly struck a deal to buy the rights to her book and hired a ghost writer to rewrite and publish it under Mr. Manor's name.

To get back on track, Portus started an aggressive marketing effort in the financial adviser community with a goal of reaching $1-billion in assets by the end of 2004.

Portus initially came to the attention of regulators when one of the company's employees inadvertently mailed a commission cheque to the wrong address, according to a former executive at the firm. The cheque was supposed to go to a private company owned by Bruce Schriver, a Halifax mutual fund salesman, he said. Instead, it went to his employer, Select Money Strategies Inc. That prompted the Nova Scotia Securities Commission to start looking at Portus.

But its regulatory woes were just beginning. Last July, staff from the Mutual Fund Dealers Association began asking questions about the referral arrangements many of its members had with Portus, confirmed Larry Waite, president of the association. The MFDA learned about the arrangement during routine compliance reviews of several dealers, he said.

Its questions made Portus officials nervous that the firm could lose a lucrative sales channel, the former Portus executive said.

Around the same time, staff at the Nova Scotia regulator began questioning exactly what the firm was marketing. Last July, a meeting with Portus management did little to resolve the regulator's concerns about the firm's sales practices, a commission source said. It opened a file and began to dig further. Last November, staff from the compliance division spent three days at Portus's Toronto office, inspecting its files and records.

Three compliance officers from the New Brunswick Securities Commission arrived at Portus on Jan. 19 and spent the next three days in its offices, said executive director Rick Hancox. Shortly after they left, staff from the Ontario Securities Commission's compliance and enforcement came knocking.

"One of the things that needs to be addressed from a philosophical point of view is if all this money was not raised in accordance with applicable securities laws, what do you do with [the] money?" the OSC's Mr. Watson said yesterday. "It's just a difficult question to answer at this point."

How it normally works

Many hedge fund companies offer products now that include so called "principal protected notes." The reason for their growing popularity is simple: They provide relative safety, and at the same time allow unsophisticated retail investors to participate in an industry that was once the exclusive playground of the wealthy.

Typically, an investor is sold a note that is guaranteed by a bank for a specific period. The investor also participates in an underlying hedge fund. Under that structure, the investor is guaranteed the principal at maturity on the note and receives any excess return from the hedge fund portfolio.

The note is clearly marked by the bank or institution providing the guarantee. The hedge funds themselves are typically sold by a sales agent who is responsible for making sure the investment is suitable for the investor, a process known as the "know your client" rule.

Sinclair Stewart and Paul Waldie

How it works at Portus

Regulators are still trying to figure out exactly how Portus invested its clients' money, but one thing is clear: The structure is highly complicated, and it appears highly unusual.

For one thing, clients open a managed account directly with Portus, which transfers the money offshore before eventually moving it back to one of its own accounts, according to regulators. The investors are buying units of a fund, called the BancNote Trust, which then invests in a basket of Canadian securities. At the same time, Portus buys five-year and seven-year notes, essentially bonds, from Société Générale. When these notes mature, the French bank agrees to repay Portus the original principal, plus any returns from an underlying group of hedge funds Portus has invested in.

Adding to the complexity is that Portus appears to strike derivative agreements with two offshore parties. The BancNote Trust, which originally used investor money to buy Canadian securities, agrees to swap the returns on this basket of stocks for the returns on the SocGen notes.

With more middlemen come more fees. People familiar with the Portus probe estimate the fund would have to earn more than a 15-per-cent annualized return -- an astronomical amount, even for the most gifted stock picker -- to cover the various levels of fees in the structure and enable investors to begin seeing a positive return.

Unlike other hedge funds, Portus gets its customers by paying lucrative referral fees to outside brokers. As a result, it was ultimately responsible for the mandatory "know your client" checks to make sure investors take on the appropriate level of risk.

Sinclair Stewart and Paul Waldie

© 2007 The Globe and Mail. All rights reserved.

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