The Spectacular Rise and Fall of Direct Lending Investments (DLI)
SEC says wildly popular fund inflated returns for years and investors could lose 25% (or more) of their money. Also: how the "roach test" saved me from investing in DLI, and how it might help you avoid a similarly catastrophic mistake.
(Disclaimer: I'm not an accountant, registered financial advisor or attorney. Always consult your own financial and/or legal advisors before making any tax, financial or legal decisions. Code of ethics: We do not receive any money from any sponsor or platform for anything including guides, tutorials, postings, reviews, referring investors, affiliate leads or advertising. Nor do we negotiate special terms for ourselves above what we negotiate for the benefit of private club members.)
2020-03-11 Update: Bloomberg, reports that investors are expected to lose at least 60%+ now, and Brendan Ross is no longer part of the firm.
CORRECTION: April 4th 2019 9:18 AM: The reference to 75% in the investor class action lawsuit referred to the percent of Guardian VOIP invested in the 2 bankrupt telecom companies, and not the percent DLI invested in GVOIP and subject to loss. This has been corrected.
Saying that Direct Lending Investments (DLI) was "popular" with investors is like saying a car that's lit on fire is "a little bit warm".
Back in 2012, the fund was one of the first to invest in the trendy new asset class of unsecured personal (and later small business) loans. And it was able to avoid the disappointing returns and increasing defaults that afflicted many competitors like LendingClub and Funding Circle. Instead, it kicked out month after month of reliable returns like a finely-tuned financial machine. DLI had impressive-looking data showing that it would probably survive even a severe recession without any losses. And they let investors cash out at virtually any time with an incredibly generous 35 days notice.
"Jump on in, the Water's Fine!"
The combination of these 3 things was irresistible to many investors. From 2014-2016 alone, the fund exploded in size by 10 times. The young, good-looking CEO, Brendan Ross, was seen by many as a "wunderkind" and featured in the Wall Street Journal and numerous prestigious financial conferences as a speaker. For many years, Lending Academy's Peter Renton pointed out that DLI was his portfolio's "best-performing asset" (in the otherwise deteriorating class). This appeared to only feed the frenzy.
"Steady Eddy"
Year after year, the fund continued to crank out consistent returns and developed a rabidly loyal investor base. By 2019, Direct Lending Investments assets crested over a mammoth three quarters of a billion dollars ($758 million). In an interview with the Los Angeles Times, Ross talked about his many business successes as well as his Porsche, Tesla and a personal table tennis coach who visited his LA residence three times a week. Life was good and everyone was happy.
However, unfortunately for investors, some very unpleasant surprises were lurking just around the corner.
The First Signs of Trouble
The first crack didn't appear until February 2019. In a letter to shareholders, Brendan Ross shared some troubling news. One of the fund investments, VOIP Guardian, had loaned out the fund's money and not received back the promised payments. Ross claimed:
"We now suspect that the cessation of payments is the likely result of misconduct (although we have not yet determined by whom) and that a substantial portion of the $160 million may not be recoverable." [Bolding added.]
Ross said that this was about 25% of the fund's investment, and Direct Lending Investments was suspending withdrawals until the situation was worked out.
Investors React
Many shareholders were stunned to learn that a very un-prudent-sounding 25% of their money had been invested in a single company. Years of gains might be wiped out and they might potentially face a huge loss. Many were upset and wanted to pursue legal action. Others pointed out that the fund had produced years of reliable returns and urged the naysayers to give Ross a chance.
Peter Renton of Lending Academy (who at that point had been involuntarily cashed out as of 2017) felt he had unique insight into Ross's motivations. Renton said: "I have known Brendan for many years and while he has shown poor judgment here I am quite certain he still has the best interests of his investors at heart. At this stage I am not sure what any investor would gain from a lawsuit because that will only complicate matters for his firm and distract them from trying to get as much principal as possible back."
[Bolding added.]
Unfortunately, later events would cause many to question Renton's personal endorsement. And for investors, this was only the beginning of what would become a train wreck of bad news.
"So Who's Guarding the Guardian?"
When VOIP Guardian filed for bankruptcy, more information became public. And it raised some very uncomfortable questions about DLI.
According to DeBanked, Guardian wasn't lending to small businesses, which many investors thought was DLI's fund model. Instead, it all went to global telecommunications companies in overseas locations. Over $1 billion of VOIP Guardian's money was lent to a Hong Kong-based company called Telacme and millions more to a United Arab Emirates company called Najd. Both companies claimed to be global telecom companies, yet stopped paying at the same time at the end of 2018 and shut down their websites apparently overnight.
Even more disturbing, to some, was a lawsuit against Direct Lending Investments, uncovered by DeBanked. The lawsuit complained:
"DLI falsely represented to investors that it typically made loans that ranged between $5,000 and $100,000 when in fact DLI had been financing multi-million dollar telecom deals as far back as 2014. The plaintiffs went so far as to claim that at one point up to 50% of DLI’s portfolio was invested in telecom receivables. .... DLI would not only go on to raise more money but also lose more than $190 million of investor money in telecom deals that weren’t overtly advertised." [Bolding added.]
This news wasn't a complete surprise to me, as my 2015 deep-dive into DLI found it wasn't following its own claimed business model. (I'll talk more about this below). But, for most investors, this was a new and even bigger shock.
Even now, the avalanche of bad news for investors was only just beginning. Things were about to get much worse.
Aren't Rats Always First to Abandon Ship?
Around the middle of March, Ross sent out another letter announcing he was resigning as CEO. According to Bloomberg, Ross claimed the reason was an SEC investigation into whether DLI "may have overvalued its investment in a small-business lending platform called QuarterSpot Inc."
Ross's attorney vigorously maintained his client's innocence. He claimed the QuarterSpot deal was just a $2 million, "immaterial" investment and that "[d]espite the salacious allegations regarding the QuarterSpot investment, payments were made on the loans. We believe a quantitative analysis will show that owning the QuarterSpot loans was profitable for investors." [Bolding added.]
Ross presented his resignation as a decision to take the high road and protect investors. He said: “I am committed to doing what is best for the investors and to preserve the value of the fund.” [Bolding added.]
Unfortunately, later events would cause many investors to question every part of that claim.
The 500 Pound SEC Gorilla Weighs In
In late March, the SEC made a stunning public announcement. It had been silent while much of the DLI news had been breaking in the media, but was finally ready to go public. And, it was charging Brendan Ross and Direct Lending Investments not with a minor issue, but with a laundry list of extremely serious offenses, including:
"Inflating annual returns by about 2% to 3% for years"
"Overstating the valuation of its QuarterSpot position by approximately $53 million"
"Collecting roughly $11 million in excess management and performance fees from the Funds that it would not have otherwise collected"
...and more (See LA times and SEC release).
How Not to Commit an Alleged Fraud
But there was still more. The SEC also revealed that it had some explosive evidence. They had taken possession of Ross's personal emails -- and said they had years of emails -- in which he instructed QuarterSpot on exactly where and how to falsify loan information.
The SEC charged that Ross "encouraged QuarterSpot to manipulate the loan level information that it reported to DLI, including both directing it to delay recognizing new equipment and falsifying borrower payment information to make it appear that payments have been made by borrowers." [Bolding added.]
How I Learned to Stop Worrying and Love the (alleged) Fraud
Reading the emails in the detailed charges is fascinating. In one early email in 2014, Ross appeared to be very stressed out by the defaults he was hiding. He said they were "substantial" and “scary”. Ross said: "I need to understand how we get out of the woods that we’re in right now, where you are using up equity to make up for the underwriting, which is scary as hell for both of us". [Bolding added.]
A year later in 2015, Ross seemed to have figured out the answer. In a remarkable email in the SEC charge docs, he says, "More loans are going late each month than I can afford and still have normal returns. So that the can we are kicking down the road is growing in size". [Bolding added.]
What Ross appears to be clearly describing is taking new investor money to cover fund losses. If so, this is of course the classic definition of a Ponzi scheme and the same method that Bernie Madoff used to defraud investors of $64.8 billion. And I'm not a financial wunderkind, but I suspect that kicking this can down the road has very rarely ever worked.
"Cutting Off Your Nose to Spite Your Face"
On April 2, 2019, a class action lawsuit was filed by 2 DLI investors against Brendan Ross, Bryce Mason (the CIO) and several others "alleging breach of contract, breaches of fiduciary duty, aiding and abetting breaches of fiduciary duty, and fraudulent inducement." [Bolding added.]
This may have been seen by some Direct Lending Investment investors as positive news. Many of them were understandably mad and wanted to see some pressure put on Ross and others. However, almost always the defense of the lawsuit is paid for by the investors through indemnification clauses. So in a way, they are only hurting themselves and probably greatly reducing whatever final return they may hope to receive in the end (if any).
In my opinion, investors look unlikely to be limited to just a 25% loss.
"How Could Anyone Have Ever Known?"
Back in 2015, I spent many hours digging deeply into Direct Lending Investments. Like everyone else, I was drawn in by the promise of the asset class, the claimed recession resistance and the easy withdrawals. But by the end, I was very disturbed by what appeared to be serious ethical problems.
"The Roach Test"
I don't claim to be able to catch every fraudster. However, I was very grateful that I was able to avoid investing in this specific catastrophe with a simple test. I call it the "roach test."
When I discover an ethics issue that a company won't resolve to my satisfaction, I consider that to be like finding a roach. If I see one in plain sight, there are probably hundreds more hidden where I can't see them. So if I see one, the company has a "roach problem" and they fail due diligence. And I move on to another opportunity.
Some people find my roach test too conservative and too restrictive. I've been told that all fund companies are essentially salesmen, so I shouldn't be taking things like ethics too seriously, because they are "just doing their job."
I personally feel there are many investment firms that do market themselves very ethically, and don't feel this is impossible to do. I do acknowledge that being so strict on this may cause me to miss out on some investments that ultimately do great for others. (And for many years I even thought DLI was one of those investments). However, even if I miss out on several fantastic deals, I'll probably end up ahead if I can avoid just one catastrophic loss. So I'm fine with those odds. And I'm happy the roach test helped save me from the losses that are certain to occur now at DLI.
Here are the "roaches" that I found. Perhaps my process may help you avoid the next Direct Lending Investment-esque debacle.
Prime Borrowers That Aren't so Prime
At the time, Direct Lending Investments marketed themselves as making loans to prime (680-739 FICO) and super prime (740+) borrowers. However, after diving deep into their loan data, I found the average FICO score was only 680. So, looking at their borrowers, the reality was that half were below prime and some of them severely below.
That alone wasn't great for me because I'm a conservative investor and I didn't want to be loaning to high risk borrowers. But I assumed the DLI marketing was just dated, and to help them out, I told the investor relations person about it.
Instead of getting a quick apology and a promise to fix it, he sent me a combative response that refused to admit that they were marketing themselves inaccurately. At first I thought it was a misunderstanding. But soon I realized DLI wasn't going to budge on this.
In the distant past, I would have tried to push this issue up the ladder to see if it was an issue with the salesperson alone, or systemic. But many times I've found the attitudes flow down from the top. And with so many investments to choose from, I no longer bother. So for me, the refusal to recognize the issue and fix it was a blatant "roach problem" and the reddest of red flags.
"The Hits Keep Coming and Coming"
And this wasn't the only problem I found. They had a pitch deck slide that many people loved which claimed DLI would probably survive even a severe recession with no losses. But so much of it didn't make sense to me.
I was very suspicious of the slide from the start, because data I'd seen from other sources showed that unsecured loans have lost money in virtually every recession. And when I dove in, I saw that the data used to justify the numbers didn't actually match their borrowers. It was based on prime and super prime borrowers and (as I had discovered already) half of their borrowers were no such thing. And the data was based on terms of loans and other things which didn't apply to the borrows of the fund. In my opinion the entire slide was almost nonsensical.
Yet again, investor relations at DLI added to the smoke and to the implication of fire, rather than clearing the air. What could've been dismissed as a marketing mistake now suggested something more serious for me. Instead of just acknowledging the inaccurate info and saying it would be fixed, the DLI representative again became very combative.
After going back and forth on it, he eventually claimed the problematic inaccuracies didn't matter anyway. He alleged they had an agreement with every marketplace where they agreed to take back loans if they defaulted.
So his argument was basically that none of the slides' inaccurate data mattered, and neither did misleading promises to investors about the nature of the loans (that the loans were made to prime and super prime borrowers). In the end, the only thing that mattered was that investor money would, he assured me, be fully protected.
This at least sounded plausible, but still left me unsatisfied. An investor couldn't rely entirely on that system of marketplace agreements, because in a pinch a marketplace might not honor their obligation. (And in fact, this turned out to be a large part of DLI's undoing). Again I got a combative response.
The bigger issue to me was not what he said, but what he didn't say. He didn't acknowledge that the data was inaccurate. And he didn't say that they were going to change it. Again this to me was another show-stopping "roach problem." I was very disappointed after spending weeks of intense due diligence. But I was done with Direct Lending Investments
Other Signs
Looking back, there was also a huge classic sign of a potential Ponzi scheme that I hadn't noticed at all at the time. Per the SEC, one of the "red flags" of Ponzi schemes is they often claim unusually regular returns.
"Overly consistent returns. Investment values tend to go up and down over time, especially those offering potentially high returns. Be suspect of an investment that continues to generate regular, positive returns regardless of overall market conditions." [Bolding added.]
Here are the claimed returns from 2014-2015 for DLI. They are showing a a freakishly consistent 0.9-1% return, which I find really hard to swallow now, thinking about how loans should have variable profit and default rates. This should have been at least a yellow flag to me:
Nobody Wants to Hear That the Emperor Has No Clothes
Back in 2015, I shared DLI's "roach problems" with other investors who were also looking at it at the same time. And I was very surprised at the reaction. A few people took what I said seriously and appeared to stay away. But the overwhelming majority invested anyway. Many told me I was being too picky and shouldn't expect salespeople to be 100% honest. Another told me that what I found couldn't have been too big of a problem, since Fidelity had approved DLI to be on their Alternative Investment Platform. (In my experience, Fidelity AIP does not do what I consider to be an adequate level of investor due diligence). Others just completely ignored what I was saying. In my opinion, some or all of them had fallen in love with the claimed returns, the claimed recession resistance and the withdrawal policy. And they didn't want me ruining any of that for them. For many years they appeared to be right, and DLI looked like a "good one" that I let "get away." But if SEC allegations are accurate, then DLI's castle-in-the-sky presentation really was too good to be true, and the castle was just an elaborately decorated roach motel all along.
In Conclusion
My roach test is not perfect. I acknowledge that relying on it may cause me to miss out on some good deals. And I also acknowledge that it isn't fool-proof and if I invest long enough I will eventually be unfortunate enough to invest in what turns out to be a fraud.
However, I do personally believe that this test is a good way to identify and avoid firms that have a higher than normal chance of causing catastrophic losses to my portfolio. And that's why I continue to use it.
I found another great way to uncover fraud is to participate in a good investor club. No one person can catch everything on their own and it helps to have other experienced eyes on the look-out. (Click here for more information on the site's Private Investor Club).
And by the way: if you're interested in how I look at real estate deals in general, see "The Conservative Investors Guide to Picking Real Estate Investments."
