Are You Too Big to Fail ?

 Nochi Dankner’s Fall From Grace and the Israeli Economy

Clive Minchom / By Clive Minchom /

So when do you “pull the plug” on a failed enterprise or a bad loan?

The answer should not be decided by whether or not it is “too big to fail” but rather when “it is worth more dead than alive”.  In the end though in practice the answer also has a lot to do with the corporate culture in the business, social and political environments where the question is asked, and is something which can be as surprisingly personal as it is  systemic.

 

The Nochi Dankner case

Nochi Dankner is the Chairman and controlling shareholder of IDB Holdings Ltd. (IDBH). IDBH, also called the IDB Group, is one of the pillars of the Israel industrial scene and it is a public company listed on the Tel Aviv Stock Exchange. He presently controls it with partners through Ganden Holdings Ltd. (Ganden), a private company.

 

IDB Group has extensive industrial interests and controls some of the leading companies in Israel, such as the Shufersal supermarket chain, high-tech companies Elron and Given Imaging, mobile phone company Cellcom and the Clal insurance company as well as significant real estate investments.  Due to over-expansion in recent years and, in particular, an ill-advised plunge into the shares of banking giant Credit Suisse the company has become heavily indebted and is having trouble keeping up with the demands of its banks – particularly Bank Leumi – and of its bond-holders.  The IDBH share price has plunged accordingly from a high in 2009 of around NIS 120 per share to a recent price of just NIS 10 per share.

 

Creditors have been closing in for some time and both banks and bondholders had been seeking new equity injection into the company as a condition for a “soft” restructuring which would leave Dankner still in charge of the business.  After casting around with the help of investment bankers Nochi Dankner appeared to have found a new partner in Argentinian billionaire Edouardo Elsztain to come into Ganden with a $100 million equity investment which would then be injected into IDBH itself.

 

Results Part one

As a result there appeared to be a deal on the table for the bond-holders and the banks.  However part of that deal seemed to entail a forgiveness of NIS150 million – or one third – of the IDBH debt to Bank Leumi and the other banks in its banking syndicate which was actually announced last week.  At the last moment this has caused a political uproar and has been cancelled.  The notion of forgiving a local “oligarch” has had huge populist reverberations when many other, poorer, clients are routinely treated much worse by the banks here in Israel.  As a result however this may now lead to a much stronger demand by bond-holders for Dankner to step aside completely –  which perhaps should have been on the table from the beginning.  His future therefore now appears to depend on whether Edouardo Elsztain, his potential new partner, will now stay in the deal having failed to get the banking haircut Elsztain was presumably also looking for.

 

So the game is still in play and everybody’s positions are now pretty much understood, but we do not yet quite know the final outcome.  So the question then is how did we get to this point: why has the Israeli business scene been so kind to its business elites – for this is not the first time this kind of soft restructuring amongst “friends” has taken place here.  What is the context therefore in which this is taking place.

 

To answer the question one must step back and look at the background to two quite different types of business traditions when it comes to dealing with businesses that get into difficulty: the continental European one and the Anglo-Saxon tradition. We shall see that in practice Israel today exhibits some elements of both traditions.

 

European & Anglo Saxon Business Traditions

First, the continental European business tradition tolerates large amounts of financial leverage, with the banking system of Germany, for example, historically being both lender to, and significant shareholder of, large segments of the German economy.  The industrial compact that existed between German banks and senior industrialists led to significant debt-fuelled expansions that restored Germany as an economic power after World War Two, to the benefit of all concerned, including the State and the population as a whole.

 

Such a system presumes high levels of competence and sense of mutual purpose, even as the dynamics of economic growth remain highly affected by both cyclical business ups and downs and by recurring mistakes on the part of individual entrepreneurs and managers.  In this kind of environment “pulling the plug”, calling in the loans and declarations of bankruptcy are comparatively rare.  In bad times the “Club” of mutually-connected participants that constitutes the business elite pulls together until it can get things back on track.  In Japan the system is similar and if anything even more systemically intertwined between the government, banking and industrial sectors of their economy.  In both cultures financial leverage can be high as the threshold for “pulling the plug” is also very high and there are large cultural disincentives to doing so.  On the other hand those who incur the leverage by and large have also had a strong cultural imperative not to squander their privileges.

 

The Anglo-Saxon business culture on the other hand is completely different; financial leverage is generally speaking tolerated much less and poor results are punished more frequently.  The joint stock corporation and contract law were British codifications in the nineteenth century of earlier practices going back to medieval times, which together then helped to drive the industrial and commercial success of the British Empire.  The British then also systemically transplanted this to the business cultures of their then colonies – including in some respects to Israel.  This “hard” culture is exemplified the most today in the United States where bankruptcies of both industrial organizations and financial firms such as banks are almost the norm, it seems, rather than the exception.  Since bankruptcy can in principle be a “rapid response” policeman of the financial system, loans could be handed out sometimes with largesse in good times without completely breaking the system in bad.

 

With the recent financial crisis that began in 2007 being systemically so much larger than prior experience everything changed, and a number of banks and corporations were indeed bailed out in the US as simply being too big to fail – GM, Chrysler and several major banks being the best examples.  Also a number of larger-than-life entrepreneurs have historically skated very close to the edge in the US a number of times – ask Donald Trump. Historically this has happened most frequently in real estate which is usually highly leveraged at the best of times, and where values can change rapidly – in both directions.

 

Back to Nochi Dankner

 

Which brings us back to Israel and Nochi Dankner. The Israel economy is young, comparatively un-developed – the country only recently acceded to the OECD – and is one highly exposed to events in the outside world.  Business is tough to develop here, the market is small, costs are high even with low labour costs and the State imposes high demands on both businesses and individuals.  It has to in order to carry the security burden of high defense expenditures and of its substantial presently non-productive elements of society.  Also, since historically external lenders were not very forthcoming to the new state, other than Jewish donors frequently importuned from all sides, a reliance on strong balance sheets and little debt was initially a characteristic feature of the early economic development of the country since independence in 1948.  This was so therefore both out of necessity and because of Israel’s earlier colonial exposure to British business practices and philosophy.

 

The other characteristic of developing the economy of a small country typically includes local production cartels, import cartels, excessive demands by key labour participants in strategic industries such as power generation and the ports, and these then result in the inevitable concentration of wealth in key areas as private businesses do succeed and lead to a pattern of economic growth.  In this respect Israel has been no different to, say, Canada, where similar patterns of initial development took place after World War Two, with Canada leading the way by a number of years in its progress.

 

In such an environment banks and selected entrepreneurs tend to relate to each other symbiotically, with the argument for tolerating this being it is essentially just micro-economics at work and that otherwise a true private sector economy cannot grow and succeed.  So when the State of Israel many years later separately, and correctly, for budgetary reasons privatized certain key industrial sectors that had been previously reserved to the State, it was obvious that in the first instance a few key elite groups might benefit – as how else can you do it at all? And, at the time values did not seem out of line using then current models and the state of overall business conditions and the economy at the time.

 

Elite group

Nochi Dankner fits perfectly into that kind of elite grouping, and if the German model had been followed entirely according to the script the State, the people, the banks and the industrial sectors he has worked with would all be better off for the experience.  However life doesn’t always work out according to plan and, as in Canada, after the first forty years or so, things begin to go wrong and borrowed money was sometimes thrown carelessly at problems or at false opportunities, either due to accident or incompetence it is immaterial to say.  Then the links between many such groups suffer from the negative aspects of such incestuous relationships more than the positive ones.  In addition in Nochi Dankner’s case the IDB Groups two major cash cows, Shufersal and Cellcom ceased to have the same commanding hold on their industrial segments as they once did and dividends to the parent to fund bond payments started to lag. Since the Israeli banking system had gradually increased its exposure to its local entrepreneurs without the same safeguards as it had in the past trouble was eventually inevitable in one way or another as corporate financial leverage in these entities increased it seems with no real self-discipline.

 

When octopus-like business groupings have access to large amounts of financial leverage without inspection or restraint, given human nature it is no surprise that eventually such leverage may be used excessively, and sometimes abused, simply because the money was there and available from a compliant system of relationships.  For Nochi Dankner the push into investing in Swiss banking group Credit Suisse, which yielded some initial gains that were applauded at the time, then became a disaster with the onset of the international financial crisis and this has dogged him additionally since.

 

Again using the Canadian experience, which followed this kind of curve itself a few years ahead of Israel, many of the kinds of links between original entrepreneurs and banks that the IDBH case illustrates have now been broken, and the institutional side of the capital markets have become deep enough to fill in the gaps in ways that are both transparent and to the long term benefit of the country. In contrast the standard complaint of some of the entrepreneurs in Canada who went bust a few years ago was to the effect that “… well the banks gave us the money so we had to do the deals”!

Israel: Small country thin capital

In economic terms Israel remains a small and young country, with only quite thin capital markets, hence a transition away to such a system of more transparent relationships, with sometimes forceful restructurings more often, where the original tycoons and entrepreneurs can even be dispossessed of their holdings when they serially screw up may still take some time.

 

At this point in time IDB Holdings, Nochi Dankner’s vehicle for his industrial activities, may be better off with him remaining in charge if he is still essential to the successful future of the firm, or without him if he is on balance an impediment.  It is now therefore timely to ask the question and to deal with it rationally on both sides of the argument.   An economic system is working when nobody is too big to fail, where mistakes are caught, on average, early and before they become disasters and where the financial system is not allowed to simply be lazy and comfortable lending only to its friends.

 

However, just a knee jerk populist response of outrage to a proposed banking settlement is not the answer either here without proper analysis, though there is almost certainly a strong argument that Bank Leumi should take equity for what it may have to give up by debt forgiveness – and maybe there should be management changes too, including at the very top.

 

Looking at it solely from the outside though it is very hard to say. Nochi Dankner at this point must be a very patient man as he continues his attempts to restructure his finances and his group, and to bring in new equity shareholders to shore up his empire.  He is likely now at this point deep in conversations with Edouardo Elsztain to see if he still has his man.  For him, as for the bond-holders, we go back to the original answer to the opening question, only turned on its head: “is it worth more alive than it is dead?”

 

More long term change is coming to the Israeli economy as it continues to grow, to mature and to add depth and, hopefully, increase its management expertise and transparency in its systemic approach to business and finance – where business owners, managers, bankers, regulators, legal and financial professional resources collectively can constitute a well-functioning economic system that is attractive to global investors.

 

 

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