Analysis / IDB's Two Mistakes

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

When we try to analyze the reason for troubles of IDB Holding Corp., one of Israel's most massive companies, we see two the same two causes over and over.

The first is the critical error made by Nochi Dankner, who holds the controlling stake in IDB, when he had Koor Industries buy shares in Credit Suisse. Dankner thereby turned Koor into a hedge fund, for all practical purposes, at a time when he had no experience in managing such funds.

The second is the massive amount of debt that IDB Holdings and IDB Investment took upon themselves - much more than they could afford to service.

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

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

Both companies used the ironclad maxim of the Israeli capital market – “Raise money because you can, not because you need to” – to its limit. They piled up debt of billions of shekels merely because someone was there to offer them available, cheap and easy money. The question of how and when they would repay the debt was never mentioned either by IDB, which raised the money - or by the capital market, which lent the money.

Ultimately, the most troubling thing about IDB's situation isn't mistakes by its managers. It's mistakes made by the institutional investors, which stood in line to lavish billions of shekels in unsecured loans, without any serious investigation into IDB’s ability to repay.

The institutionals' use of public money to make bad loans was already examined by one government committee, the Hodak Committee. Hodak laid down binding rules for investment by institutionals in corporate bonds, to prevent similar bad investments in the future.

Important though the regulatory act may be, it does not solve the fundamental problem in the capital market: On what basis do the institutional investors pick investments? To what degree are they serving themselves, and to what degree the public interest?

It should come as no surprise, then, that a veteran 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 the pension savers is definitely secondary.”

For years, people have suspected that institutional investors are occupied primarily with their own good -- maximizing management fees, seeing to the interests of their underwriters, brokerage firms or nostro account, seeing to their insurance interests (in the case of insurers) and making sure their shareholders profit. Only after all this, if at all, do they start thinking about the people whose pensions they invest, if they consider them at all.

The result of this proliferation of extraneous interests is evident in the way the institutional investors function: they charge the highest possible management fees while making lousy investment choices.

“There’s nothing to be done,” the senior capital-market personality candidly told us. “The investment manager at an institutional aims to create yields that will allow his portfolio to sell well, to create profit for the stockholders.”

This means the money manager is seeking investments that are profitable in the short run, producing high annual returns, while not looking at the 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 since they owe someone something," 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 like 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 worth by taking a contrary position. These forces are particularly true when it's a matter of the company's nostro account.

"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 via the pension fund, the company will receive 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.

"In practice, the decision has been 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 -- lets 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."