Markstone Fraud Puts Legitimacy of Israel Funds Into Question

Why did Israeli institutions put public money into Markstone? Were officers there bribed?

When back in 2004 Elliott Broidy, Ron Lubash and Amir Kess announced that they'd raised $800 million for Markstone, a private equity fund they'd founded exclusively to invest in Israel, jaws dropped. Theirs wasn't the first private equity fund in Israel, but Markstone had funding several times larger than anybody else. The amount was almost too big to believe.

The first question on everybody's lips was, naturally, who put up the money. The answer? "American pension funds." Market animals sat down with a thud, picked up their jaws and did some math. They quickly concluded that with management fees of 2% of assets a year, Kess, Lubash and "the American" had it made. For life. They'd be withdrawing $16 million a year, for at least seven years, irrespective of how well the fund did.

It looked too good to be true. Now we find it was.

After a long investigation in the United States, throughout which the Markstonites firmly denied any wrongdoing, last week Broidy, the main partner in Markstone, admitted at a Manhattan court that he'd scored the first $250 million, from the New York workers' pension fund, in sin.

That is, not by merit. Broidy simply bribed four string-pullers at the Office of the New York State Comptroller, in order to obtain the quarter-billion dollars from the New York State Common Retirement Fund. Following Broidy's success in "persuading" the New York pension fund to invest, others came on board, too.

But what is born in sin will end in ignominy. Markstone's managers never took - let alone passed - the tests of the markets, which is when a businessman has to convince investors that he can do the job, that he can outperform other investments in order to justify his asset management fees.

Easy money: Born in sin

When they met with managers of institutional investors, Lubash and Kess didn't have to convince anybody of anything. All they had to say was, "The pros of New York checked us and decided to give us a quarter-billion dollars. Want in? Sign here."

Broidy, Lubash and Kess turned networking into an art form. The fund boasts a "council of strategic advisers," including luminaries such as Eli Hurvitz of Teva fame, Jacob Perry and Lehman Bros.' Harvey Krueger. All were recruited to bring in money and to allay concerns.

When the money involved is so big and so easy, and when the investors are bound to complicit silence with the fund's managing partners anyway, the temptation to make rash investments is immense. Markstone pounced on the marketplace and bought up companies for top dollar, again leaving the business sector open-mouthed. The directories company Golden Pages. The books chain Steimatzky. Provident and mutual funds were bundled together under a new investment firm called Prisma.

All were bought for prices that market animals suspected were too high. Meanwhile, Markstone recruited local talent, again paying through the nose.

Asked, "How will you make money?" Lubash would say, "Wait and see."

We saw. Markstone's returns disappointed. It did generate returns, but there were two problems with its presentations.

Firstly, Markstone aggressively used every trick in the book to gussy up its figures. Second, it should be compared with other funds founded in 2004.

Markstone reported returns of 11% a year, but the sector produced returns greater than 20%. Businessman Haim Saban, who beat Markstone in the race to buy Bezeq, achieved returns of more than 30%.

The truth is that Broidy's confession is just a station on Markstone's path to the garbage can of history, and it opens a Pandora's box of questions.

A bribe is a bribe is a bribe

Why did Israeli institutions put public money into Markstone? Were officers there bribed? What will happen to Markstone now? And most important, is Markstone an isolated case or did other funds indulge in similar corruption? How carefully do Israel's institutional investors do their homework before giving the public's money to somebody else to manage?

The institutional investors should demand that Markstone's unit holders convene, and demand explanations from Lubash and Kess about what happened. Then the shareholders need to decide whether to replace the entire management.

Lubash and Kess are likely to say they had no idea about how the money was raised. But that will beg questions about how competent they are, if they had no clue what was happening under their very noses.

Usually investment contracts in funds like Markstone have a clause that, under extraordinary circumstances, allows the fund to freeze its activities. Might Lubash and Kess simply decide to wind down Markstone and distribute its assets? Will investors sue over the criminal acts now uncovered?

The one thing we know for sure is that the practice among institutional investors (who charge management fees), of giving the public's money to yet another set of people to manage, who charge a second layer of management fees, is losing its credibility and its legitimacy too.