In the Money / IDB's Two Big Mistakes

IDB Holding Corp, which is struggling to stay afloat in a red sea of debt, made a pair of errors that may prove fatal.

When we search for what's behind the troubles of IDB Holding Corporation, one of Israel's biggest companies, the same two causes keep coming up.

The first was the critical error made by IDB group controlling shareholder Nochi Dankner when he had subsidiary Koor Industries buy shares in Credit Suisse. In doing so Dankner turned Koor into a hedge fund, for all practical purposes, at a time when he had no experience in managing such funds.

The second was the massive amount of debt that IDB Holding Corp. and IDB Development Corp. assumed, which was far beyond what they could afford to service.

While the first mistake stemmed from hubris, the second is much more disturbing because it appears to stem from a structural flaw in Israel's capital market.

The two holding companies at the top of the IDB group, IDB Holding Corp. and IDB Development Corp., borrowed billions upon billions of shekels, some from banks but most of it from investors. They did so not because they needed the money, but simply because they could.

Both companies exercised the ironclad maxim of the Israeli capital market - "Raise money because you can, not because you have to" - to the limit. They borrowed billions of shekels merely because someone offered them cheap and easy money. Neither the borrower (IDB ) nor the lender (the capital market ) ever mentioned the issue of repayment.

In the final analysis the most troubling thing about IDB's situation is not the mistakes of its executives. Rather it is the mistakes of the institutional investors that lined up for the chance to pass out billions of shekels in unsecured loans without examining IDB's ability to make good on them.

The institutionals' use of public money to make bad loans was investigated by the treasury-appointed Hodak Committee, which issued binding rules for investment by institutionals in corporate bonds in order to prevent similar bad investments in the future.

The fundamental problem

Important though the regulatory act was, it did not solve the fundamental problem with the capital market: On what basis do the institutionals choose their investments? To what degree are they serving themselves, and to what degree the public interest?

It should come as no surprise, then, that a senior investment manager in the capital market told us, "An institutional investor's goal is to make as much of a profit as possible for the management company. The good of retirement savers is definitely secondary."

For years people have suspected that the main priority of institutional investors is themselves: maximizing management fees, looking after the interests of their underwriters, brokerage firms or the company's own investment portfolio, the nostro account, seeing to their insurance interests (in the case of insurers ) and making sure their shareholders profit. Only after all this is squared away, if at all, do they consider the people whose pensions they are managing.

As a result, they charge the highest fees possible while making lousy investment choices.

"There's nothing to be done," our capital-market source told us candidly, adding that the aim of the institutional investment manager is "to create yields that will allow his portfolio to sell well, to create profit for the stockholders."

That means money managers look for investment vehicles that are profitable in the short run, producing high annual returns, without considering their long-term implications for the pension fund.

"Plus, you need to remember the pressure coming from the controlling shareholder, deals they want to go through because they owe someone," added the market animal. "They don't need to push explicitly, it's enough for them to innocently ask you, 'What do you think about so-and-so's offering? Don't you think it should be in our portfolio?' Every investment manager understands that hint."

And the controlling shareholders' business interests are more complicated than they look. Big institutionals such as insurance companies, which also have underwriting subsidiaries, mutual funds, brokerages, nostro accounts and obviously insurance portfolios, will always face conflicts of interest.

For instance, if a mutual fund is stuck in an awkward investment position then the pension fund under the same roof may be pressured not to make things worse by taking a contrary position. These factors are particularly potent when it comes to the company's own account, the nostro.

"A nostro account is the worst conflict of interests, since all the profits go straight into the company's pocket," said the source. "For every investment I make through the pension fund the company receives at most 2% in management fees. But in the case of the nostro account, the full 100% belongs to the company. So when you have to decide whether a good investment should be made through the pension fund or through the nostro account the choice is obvious," the source said.

"In practice, the decision is made in advance: The insurance company puts its best investment managers in charge of the nostro, not the pension fund," he said. "It works the other way around, too: Let's say I need a special person to manage my short-selling account, which could become a very important portfolio for the pension funds. Such a professional could cost NIS 400,000 a year while ensuring profits of NIS 2 million. But there would be no question about employing him for the nostro account. For the pension fund, the NIS 2 million in profits would translate into only NIS 40,000 in revenue, so there's a good chance I'd pass him up.

IDB is at the mercy of the court

The future of Nochi Dankner's IDB Holding Corp. may be decided in court within the next few days. Tomorrow, IDB Holding is scheduled to pay its Series B bondholders NIS 35 million, but many of its other bondholders say such a payment would be preferential treatment between creditors - and are planning to challenge the payment in court. Of course, if IDB decides not to pay, the Series B bondholders are also threatening to take the company to court. CEO Haim Gavrieli continued to insist yesterday the company is solvent despite the "going concern" warning Michael Rochvarger contributed to this report.