Bottom Shekel / Markstone's Fee Scheme

The lesson to be learned from the corruption scandal at Markstone is about the ploys. Elliott Broidy's corruption is one; fees and their real cost is another.

Markstone raised the eye-popping sum of $800 million not by virtue of the quality of its managers Ron Lubash and Amir Kess, nor thanks to their unique managerial abilities. Nor was it because of reforms launched by Prime Minister Ariel Sharon and his finance minister Benjamin Netanyahu, or the perception that Israel is a good place to invest the pension funds of New York's firefighters and teachers.

That vast amount of money, pledged in 2003, was received by virtue of a pathetic bribe. A pitiful amount, a few hundreds of thousands of dollars. And a few criminally culpable public servants. We don't need money like that here.

The private equity industry is known for the quality and sophistication that it brought to the markets. No more managers sitting around with their feet propped up. No more sleepy family-run companies that ignore their investors. Private equity funds bought badly-run businesses and turned them around.

The process also posed a threat to other companies, forcing managers to change.

Of course, some funds have did generate gains for their investors. The problem is that the race for gains has at times left companies injured and bleeding by the roadside - companies of the ilk that everyone had wanted to buy before, and no one wants to touch now with a ten-foot pole. Companies like Golden Pages and Tefron: both went broke mainly because of their huge debts to banks and because all their cash had been siphoned out.

How were they reduced to that state? It is easy for investment funds to apply a leveraging trick to help new owners reduce their own risk. But the gambit may place the company in a chokehold, without sufficient liquid reserves to weather bad times.

Here's how it works: The fund buys a company with a positive revenue flow, reasonable profits and stable balance sheet.

It proceeds to squeeze as much money out of the company as possible, through dividends, management fees or even by using the assets of the company being acquired to finance the acquisition.

If possible, and if the market allows, the leverage can be spiced up with the sale of shares and real estate, or through the flotation of a subsidiary.

After repaying most of the investment, it doesn't matter much what happens to the company. Well, actually it does matter - that's the difference between an excellent yield and a reasonable one, but the important thing is that the fund can no longer lose money. The worst that can happen is that the company closes down and its employees are sent home. It worked very well for Apax and Bezeq, and a number of other strong companies.

For Golden Pages and Tefron the burden was too much.

In all their responses, Markstone's managers emphasize that beyond the 2% that they charged in management fees (which they say is accepted practice in the industry, and they have heavy expenses), they won't receive another shekel until their investors get all their money back, plus 8% interest.

It's all true. The thing is, that 2% is a lot of money.

Moreover, it's not 2% but much more. Each year Markstone charges its investors 2% of assets, that is, 2% of the entire amount that they have undertaken to invest - $800 million.

In other words, the fund charges $16 million a year. Over a period of ten years $160 million of New York and Tel Aviv pensioners' money will make its way into the pockets of Broidy, Lubash and Kess.

So while they're charging 2% of $800 million a year, Lubash and Kess do not manage $800 million all year long, and certainly not over the entire ten years.

Like any private equity fund, Markstone issues a cash call to investors as needed: when they invest in a company.

In 2004, the first year of its operation, Markstone bought two companies (Golden Pages and P.R.S.) for a total of about $73 million. Even though the two companies were purchased in the fourth quarter of that year, Markstone charged its investors management fees of $16 million, or 2% of $800 million.

During the second year of its operation Markstone bought two more companies - seeds company Zeraim Gedera ($489 million) and Steimatzky ($32 million). By then the fund managed a total of four companies worth $150 million, and its managers had already taken in $32 million.

To date, Markstone has invested about $560 million in 10 companies, and charged fees of $80 million (it made no new investments in 2009). Two of the businesses have already been sold for about $200 million, which was repaid to investors. In short, Markstone manages an average of far less than $800 million. In fact there has not and will not be a single year in which Markstone manages $800 million, and nonetheless, it charges $16 million every year. Even before success fees.

The situation of provident and pension fund members who invested in Markstone is even worse, because they pay management fees twice: once to Markstone and then to the provident fund itself.