Sunday, June 14, 2009

Tannenbaum and the alleged Ponzi Scheme Extrapolating the numbers

Update 16 June It appears as there may be even more to this. The various authorities in SA are working together and intend investigating the investors for using the scheme as a way to get money out of the country and/or avoid tax. They have said that those investors that come forward with info will be seen in a different light to those that don't. My view is that these allegations, if true, go a long way to explain why the wealthy experienced businessmen invested without asking too many questions. For decades, those that have money in SA have looked for and found ways of sending it offshore. Usually they would pay a premium of eg 10% to someone who accomplished this for them. Since it was illegal, there was desire for a paper trail and many deals were done on a handshake with someone from within the inner circle or recommended by someone from the inner circle. With this opportunity, it could be that some investors may have invested on this basis and used it as a mechanism to get money offshore. Alternatively, they may have seen it as an opportunity to wake up hidden offshore illegal "lazy money" from earning a measly few percent in an offshore bank to rapidly growing the offshore funds tax free. By definition that money was not cash they needed in SA anyway so when this smooth talking salesman sold them the opportunity and dropped all the other big names, they jumped at the chance.

Tannenbaum and the alleged Ponzi Scheme Extrapolating the numbers

Much has already been written on the allegations that the South African entrepreneur Barry Tannenbaum (who is now living in Sydney)was running a classic style Ponzi scheme. The purpose of this post is to discuss my take on it, a few of the implications of this scheme as well as some guesses as to the psychology behind both the alleged scheme perpertrators and those that were convinced into parting with their cash.

I do not wish to rehash the allegations here as these are covered extensively elsewhere in the media eg on the site If you are reading this, you are doing so because you already have read most of the allegations and articles and are looking for new undisclosed info. I do not have any such new info as I was not and am not directly involved. I am not commenting on the guilt or innoncence of those involved as that will be a matter for the courts. I am giving my view on what I thought when I first heard of this venture. I was told about this scheme around 3 months ago by an acquaintance whose aunt had allegedly just invested. At the time my initial reaction was one of fascination. In light of the Madoff scandal, I was extremely skeptical. I have seen many Ponzi schemes come and go over the years as I work closely with the investment community. This one seemed to have all the hallmarks of a classic scheme except that the promised returns were higher than any I had ever seen.

I was told that what was being promised was a return of 20%. I immediately thought Wow - 20% PA, in this recessionary environment! That is an impressive return - if true. I was dumbfounded when my acquaintance corrected me by saying that this was over an 8 to 12 week period not PA. I thought about that (literally for a few seconds) and felt that can not possibly be correct and he has made a mistake. He responded that his relative had invested and rolled over the investment a couple of times already. Now it was becoming ridiculous. I could at a stretch almost buy the argument that as a one off short term loan this was on offer to solve an immediate cash flow issue. If however, the business was so good and that orders had been secured with listed companies (backed by contracts detailing large amounts owing), my view was that a reputable business should be able to get terms from a bank (using the contracts as security) that are a small fraction of what was on offer.

I thought to myself if I was to invest in this business like a typical long term investor would invest in say a listed company over a 5 to 10 year time scale, what return would this yield? I got out a compound interest calculator and started playing with some numbers. I took the view of someone investing $10 000 and rolling it 4 times a year and leaving it there for 10 years. This yielded a balance of $14,697,715. Wow! I was told that the minimum investment was $100 000 and that numerous high profile wealthy people had allegedly invested large sums, some in excess of $10m. Now I knew that either I was the subject of a candid camera joke, or, I believed, many people were about to lose a lot of money. Plugging $10M into the same calculator yielded a return of over 14 Billion. But wait there's more. I was told that those that committed higher amounts reportedly got even higher interest either through being able to roll it over more times PA eg every 2 months for a total of 120% PA or higher nominal interest rates. Back to the calculator and the "smart" investors that put in $10 million would each be worth half a trillion dollars in 10 years! There is no-one in the world that had that kind of money. Bill Gates and Warren Buffet have around 50 Billion after a lifetime of being the world's most successful entrepreneur and investor respectively. OK so I hear you say, well this is only if these returns continue over 10 years and clearly they won't. Fine. My initial calculations were to get a sense of the promised returns and whether they were at all plausible. Let's take a 5 year horizon. Our $10 000 over 5 years grows to $383 376. Putting $26 000 in would make me a millionaire in 5 years. What an easy way to become a millionaire. Still too long. OK how about those big investors that invest $10 000 000 for 2 years. They walk away with nearly $90 000 000.

I have been in business for over 25 years and invested in many companies and been involved with clients and their many businesses for many years and have never seen a business that could generate a $90 000 000 excess profit in 2 years to cover finance costs like that. (And that was only for 1 investor - what about the rest). This was not even a "major" business. It was a small player supposedly supplying the large listed companies by buying chemicals from other foreign suppliers. Whilst markets are not always that efficient, it beggars belief to think that a small business could buy and sell goods at the required volume with mark ups so high as to sustain those financing costs not to mention all the other costs of purchasing, securely transporting, importing, wharehousing, taxes etc. If there was such a mark up, the smart guys at the listed pharma componies would simply buy direct, even if the supplier charged a higher rate than it charged this middle man.

I concluded that in my view, there was only one way these kind of returns could appear to be real and that was if they were indeed an illusion. I felt it was simply too good to be true. I didn't need to do any further analysis. In my view it was simply impossible to sustain this.

If however I were given the opportunity to invest (which I wasn't), and I did want to investigate it further and was considering puttin in significant cash, the first thing I would have done is asked for proof of the contracts. If these were not supplied, I would decline to invest. If they were supplied, I would contact the relevant companies to verify their authenticity. If the companies declined to talk to me as they likely would, I would ask the scheme managers to give permission to the company to talk directly to me under an NDA. If they refused, I would walk away. If they gave permission I would be in contact with them and only accept the docs as authentic if I received a signed confirmation directly from the a representative of the company that is in a position to verify the docs. Of course it would never have got that far if the scheme was not legitimate because the scheme managers would never let me talk to the company if the docs were fraudulent.

At the time, I felt that my acquaintance didn't have the correct story or if he did, there was something questionable about the scheme and I gave it no further thought other than to keep an eye on the news to see if this business ever made the news.

WHen the story broke last week, I was shocked. Not that the scheme allegedly is fraudulent, but of the calibre of the investors. I can understand the average man in the street being convinced to put money into these kind of ventures, but for some of SA's top business people to have done so left me kind of numb. I have no doubt that these are smart people. Unlike the Madoff scheme whereby returns were high but still only around 10% PA and many investors in his scheme did so through the pooled "respectable" feeder funds etc with proper prospectuses etc, this scheme had allegedly offered what is claimed to be between 80 and 200% returns and the money was given directly to the scheme with what seems very little paperwork. If anyone was truly offered 200% then $100 000 invested over 10 years compounded 4 times PA yields 1 Trillion plus. $10m becomes $256m in 2 years. Come on!

In particular there has been a report that investors were required to sign an NDA with the company which in itself is not surprising, however it allegedly contained a clause that stated that if the investor breaches the contract, the company doesn't pay any interest (fair enough) but also retains 50% of the capital! If true, the person ultimately doing the company the favour of loaning it money (granted for fantastic returns) stands to lose 50% of their capital if a confidentiality clause is proven to be breached!. This to me is a remarkable clause. I have never seen a clause like this in an NDA. Normally the NDA would set out remedies that would require the party that breached the NDA, to pay damages as determined by a court. Whilst a clause like this may not have held up in court it is amazing that these high profile business people signed this document if indeed they did. Proving a leak is often very difficult but if somehow the company (even if it is untrue)convinces a court that an investor leaked the info, the investor has already agreed to forfeit half his capital.

The question then is why did these people hand over their money? Greed is often cited in these kind of cases when they don't work out and rich people are involved. This may well be the case however I don't believe it is always that simple. If they had made lots of money they would have been cited as "astute" investors. Articles would be written on their achievements and these deals would be written in glowing terms. THose that didn't invest would lament the wasted opportunity and be upset with themselves for not believing and taking the risk. Everyone wants easy ways to increase their finances. Is it greed to put some of your retirement money in shares because returns in the bank are too low? Is it greed to borrow money to purchase a better house than you can pay cash for? Greed or the want to better yourself and your families fortunes or really in some sense in the eye of the beholder. Those that are held up as successful, typically worked very hard, were smart and took risks THAT PAID OFF. They usually weren't considered as greedy when they made their money as they are considered now when they try and increase it. Maybe therein lies the distinction? Because they have so much already we think they are greedy for trying to get more. Maybe they are but in their quest for more they often create jobs, give more to charities, pay more taxes help friends with businesses etc so it is not necessarily so bad if they aspire to make more. Also as has been shown money can be lost in a heartbeat in the markets, in a business or indeed in a ponzi scheme. Trying to maximise wealth I don't believe makes you a bad or greedy person. It depends what you do with it re charities etc.

Many people take the view "so what" they can afford it and it serves them right for being so greedy. There were those who could not afford it that will lose everything and those that do lose it are the entrepreneurs that could otherwise have invested in legitimate enterprises that employ people and generate wealth. Having less, they will now be more cautious and invest less both because they have less and secondly because they want to preserve the rest of their wealth. This is bad for everyone.

I suspect that the power of the recommendation and the calibre of the "other investors" as well as the apparently personable nature of the perpertrators and the fact that many were in the same community lulled investors into letting down their guard.

As to the alleged perpertrators, if this is a fraud, it may well not have started out that way but possibly a small real business had some cash flow problems that started with a loan from a friend that couldn't be paid back. As such more could have been borrowed rather than admit the failure and soon there was no turning back.

It will be interesting to see how this plays out as Tannenbaum and the others allegedly involved all continue to maintain that they are innocent and continue to live in expensive homes driving expensive cars etc. If so, where is the missing money? Tannenbaum's house cost around $1.6m about 2.5 years ago so whilst expensive, is a drop in the ocean compared to the allegations of $2 billion missing. I expect the $2B quoted number includes compounded interest that never really existed so the real capital lost would be significantly less. Of course those that believed they had that balance and live a lifestyle based on it will very much feel the loss almost as strongly as the capital they put in.

If they are guilty, they should be stripped of all assets and face criminal consequences. The sad part that those investors that have been destroyed as well as the innocent children of the perpertrators will find it very difficult to recover from this.