Fabrikant’s eight main U.S. secured lenders have all, in separate and unrelated actions, sold their debts to five different hedge funds that specialize in investing in bankruptcies and distressed companies. The total amount involved is $161.9 million of debt, which was sold for approximately $85 to $90 million. This amount, from a banker’s perspective, was much better than they expected. Most banks had been resigned to the fact that they might lose between 70 to 80 cents to the dollar.

The transaction apparently took place before December 31, 2006, to enable the banks to make the necessary provisions and to put the recovered cash to more productive uses. (At least one source suggested that not all deals were final.) The prospect of a drawn out court case, multi-million dollar legal costs associated with the sales of Fabrikant’s assets, and, in the meantime, having the full amount of the doubtful debt and unpaid interest lingering on the balance sheets were not very appealing.

            From a banking perspective, the deal made sense. As each hedge fund negotiated in isolation, the actual purchase price is varied and ranged from 53 cents to 58 cents to the dollar. Some of the U.S. banks were holding both secure and unsecured debts. The hedge funds only bought debts that were collateralized by pledges substantially covering all of Fabrikant’s assets.

            Basically, the hedge funds – such as Morgan Stanley and Longacre Management Fund – are now in the driver seats. It is slightly premature to decide what it all means, since the scarcity of solid information and the plethora of rumors floating around warrant a degree of caution when analyzing the new situation.  

            Let us first take a look at the banks. ABN-AMRO’s secured debts were, according to the court filings, $45.5 million; they were sold for 55 cents to the dollar. (We think the actual figure was higher – but it doesn’t change the story.) This bank holds an additional unsecured debt of $13.9 million and, indirectly, some more. J.P.Morgan Chase sold its $35.8 million secured debt and Antwerp Diamond Bank sold its $5.45 million secured debt, but is still stuck with an $8.8 million unsecured claim. (All figures come from November 2006 court documents; they may be higher.)

Hedge funds bought a further $12.08 million from Bank of America and an identical amount from HSBC. Sovereign Bank sold $30.96 million of debts, Bank Leumi USA sold $11.59 million, and Israel Discount Bank sold $9.66 million. The big “loser” among the banks is the Union Bank of Israel, which holds a $7.87 million unsecured debt.

The expectations are that the unsecured debts and debts to the trade will not be recovered. (The total from the list of 25 largest unsecured creditors seems to be well over $60 million, but the balance sheet shows far larger amounts of accounts payables. Is that still relevant when the collateral is gone?)

            In the middle of last year, hedge funds offered approximately 50 cents to the dollar, which was outright rejected. Some time later, there were already talks about 30 cents – and some banks were inclined to agree, but nothing materialized. The fact that, in the end, the banks got as much as 55 cents to the dollar is amazing – unless, of course, the banks knew something about the liquidation values of inventory and accounts receivables (ARs).

New York financial sources have different explanations one being: today, hedge funds are literally “swimming” in money, and “good sexy bankruptcies” are hard to find. Fabrikant certainly falls in the latter category. The fact that there were numerous funds interested shows that banks could make their pick and were able to negotiate. As sad as it may sound: there aren’t too many Fabrikants. As these hedge funds generally are able to turn their investments around quickly making huge amounts of money, the question is whether they “know” something that others don’t.

            What makes Fabrikant (and the jewelry industry in general) attractive is the nature of the ARs. In most bankruptcy proceedings ARs that are past due more than 90 days are simply written off. Such ARs have no value – and even liquidators and receivers tend to dismiss long overdue accounts. In the diamond and jewelry business, we all know that 90 days is pretty good, and the recovery rate of the ARs is probably much higher than would be the case in other economic sectors. The worldwide diamond and jewelry community is small and as such, major players will not try to “get out” of honoring their commitments. (Will this behavior change when the payments will mainly benefit a hedge fund?)

            What made it really worthwhile for the hedge funds were the various collateral agreements that Fabrikant concluded before the Chapter 11 filings. In an affidavit on behalf of both M. Fabrikant & Sons (MFS) and Fabrikant-Leer International (FLI), company president Matthew Fortgang states that “the [eight secured] Lenders acquired and hold, as a group, a valid, enforceable and properly perfected first priority security interest in substantially all of the assets of MFS and FLI including, among other things, MFS’s accounts and specified related assets, inventory, specified intangibles and related assets, MFS’s claims, liens and rights against FLI with respect to loans made by MFS to FLI, all monetary obligations of FLI to MFS, certain chattel paper and instruments issued by FLI to MFS, and all securities issued by FLI and owned by MFS.”

            In the same affidavit, the amount of secured debt is listed as $161.9 million. In addition, there was an amount of $36 million to third-party creditors and $124.0 million to other parties. (The amounts of total unsecured debts aren’t relevant anymore – it is probably higher than the balance sheet figures quoted here.)

            Looking at the balance sheet of Fabrikant (July 2006), it listed $135.2 million as inventory. (Worth how much when liquidated? Twenty cents to the dollar?) Accounts receivables are split between $82.5 million and an additional $135.6 million of ARs at affiliated companies. Thus, the hedge funds now hold ARs possibly worth $218.1 million.

            ARs and inventory together comes to some $353.3 million. Assuming that there is no double accounting in these figures, the situation doesn’t “look” so bad. But looks can be misleading. In any event, it seems that the Fabrikant collapse was more the result of low profitability and an acute liquidity crunch rather than of an asset shortage. But maybe we should be more cautious about the asset values – after all, banks did force the company into Chapter 11, and we assume most or all of the banks knew what they were doing. (One of my sources wondered, “How much bad debts would banks have tolerated to be carried on the company’s books?”)

            As the hedge funds now sit on $161.9 million of over-collateralized claims, a back-of-the-envelope exercise shows that if they are able to get 45 cents to the dollar out of the available collateral (in reference to the collateral available on the balance sheet submitted in court), they will earn nearly  100  percent profit on their investment. On the downside, if they only recover 24 cents on each (inventory and AR) dollar, they’ll merely recover their investment without making anything.

And, if they do better than 45 cents, they’ll leave some money for all the other trade and banking creditors. But don’t hold your breath. Trade and unsecured creditors will probably end up in the cold, especially if the accounts receivables aren’t as readily collectable as we like to assume. (One New York industry player commented that “there is a significant distinction between assets in a jewelry operation as compared to a diamond specific operation. Clearly the recovery on jewelry is much less than on diamonds.” The hedge funds will have a chance to test that hypothesis.)

What Will the Funds Do?

            The first reaction of some New York insiders was that if the hedge funds were willing to pay more to the banks than the latter had truly expected, they must be pretty sure that they’ll be making money. Are they acting on behalf of an undisclosed third party? After all, it was known that some pretty heavy industry players had done their due diligence on Fabrikant and indicated an interest – prior to the November 2006 Chapter 11 filing – in purchasing the company or the business.

            The name ‘Rosy Blue’ was mentioned so frequently that it was justified calling Dilip Mehta, who was celebrating the spectacular wedding of his son Vishal to Aditi Doshi. When I asked him point blank about the rumor, we got an unequivocal denial – Rosy Blue has nothing to do with it. (Actually, it wouldn’t make business sense: most of Fabrikant’s clients are also Rosy Blue clients, so why buy into that business?) The other names mentioned were Fabrikant’s Indian partner Tara – which is handling most of the current business anyway – or any of the Fortgang Family Trusts. We don’t know.

            Intuitively, the Fortgang option sounds like a master stroke. Get rid of the secured creditors (banking debt) at half the price, then reinvest, and continue the business. That would almost be too good to be true. One New York lawyer dismissed these speculations on grounds that you need extremely sophisticated financial advisers to pull this off, and there are many legal “good faith” issues involved. Again, we don’t know.

            Incidentally, some of the (unconfirmed!!!!) speculation about Matthew Fortgang having something to do with the purchase of the banking debts was probably triggered by his intention to continue the business in one way or another. Together with Indian partner Tara Diamonds, Fortgang has taken offices on the 15^th floor of 529 Fifth Avenue, and soon they’ll open the doors for business.

            It is my guess that none of what has happened has impacted the family’s personal reputation, and the trade will be more than happy and ready to continue to do business with Matthew. (As we’ll describe below, a number of unrelated events converged leading to the liquidity crunch.) The traditional banks may not enthusiastically line up to extend new lines of credit – but there are other banks – and then there are hedge funds.

            What seems certain, however, is that when hedge funds get into the diamond and jewelry business, they are likely to stay – and the Fabrikant debt purchases may be “testing the waters” for un-hoped for future contingencies.

            Observes one lawyer: “The estimated $1 trillion hedge fund industry is increasingly encroaching on the traditional turf of banks across the nation, with alarming and far-reaching results. This trend is particularly evident in Chapter 11 bankruptcies. Gone are the days when the secured lenders' table at the creditors' meeting was filled only with lawyers from the major banks. Now these lawyers, if they are there at all, must make room for the lawyers for the hedge funds, whose clients often hold substantial debt, equity, or second lien positions for the debtor's assets. This often puts these institutions at odds with one another and makes it difficult for the banks to remain players in the game.”

            This is something that all of us need to reflect on. The diamond business is driven by bank finance. Any borrowing company always had the comfort that if, at some point, he/she would encounter business trouble, he/she would be facing a trusted banker and together search for solutions. This, incidentally, was also, what Matthew Fortgang had done throughout the process. Until one or more banks became impatient.

            The new reality may well be that if a company gets into trouble, the borrower may find himself having to deal with a hedge fund. The diamond industry is extremely vulnerable, not just because of the high banking debt, but also because business failures tend to have a domino effect.

Domino Effects in the Industry

            What, at the end of the day, brought about Fabrikant’s problems to begin with? Could it happen to any of us? Can one really avoid a domino effect? As Matthew Fortgang explains it, the company’s troubles were due to the convergence of several events that occurred over the course of the past two years and that severely impacted the businesses. These include the bankruptcies of two of Fabrikant’s larger retail customers, Friedmans' and Crescent Jewelers. Their bankruptcies then led to substantial write-offs, reduced sales and cash flow, and the financial restructuring of a third significant customer, Whitehall Jewellers, which triggered the long-term deferral of a substantial portion of the then-current receivables.

Another factor was the implementation by one of Fabrikant’s most significant customers of poorly performing initiatives to source diamonds and jewelry directly overseas, thereby eliminating purchases from Fabrikant. (This, incidentally, is a general trend – more and more U.S. jewelers and retailers are sourcing directly in the cutting centers.) Fabrikant also faced a reduction in purchases by Wal-Mart as their retail sales came from their over-inventoried positions from prior years. Then, there were management misjudgments, such as an unfavorable interest-rate swap that led to significant cash losses.

            Fabrikant also faced lower margins, partly because of the increase in gold prices, partly because of rising pressures from low-cost jewelry manufacturers and, finally, due to diminished free cash flow as a result of the competitive environment. Largely as a result of the fore mentioned factors, MFS and FLI reported combined operating net losses of $12.6 million for the twelve months ending January 3, 2006, as compared to combined net earnings of $1.6 million and U$1.7 million for the twelve months ending January 31, 2005 and January 31, 2004, respectively. Given such operating performance, the banks imposed liquidity constraints requiring Fabrikant to seek alternative forms of financing.

            This failed and the rest is history. 

Distress Hedge Funds will Reduce Liquidity in Industry

            The financial markets have seen an explosion of unregulated hedge funds during the past several years. It is estimated that there are between 8,000 and 9,000 hedge funds worldwide, with assets of more than US$1 trillion, and scores of aggressive managers seeking a better-than-market return. These factors rule them out as long-term investors in the diamond and jewelry industry where, even in the best of circumstances, there are unlikely to be many better-than-market returns.

            No, hedge funds look for short-term gains. We must appreciate that hedge funds operate in a different environment than banks. Hedge funds have an advantage, as, unlike banks, they are not subject to regulatory restrictions and approvals that constrain their flexibility in a workout or bankruptcy. Moreover, banks tend to fear liability and are usually reluctant to get involved in the management of a debtor company. Hedge fund managers have not demonstrated being worried about such concerns.

            Hedge funds certainly do have something to offer – especially for a Chapter 11 bankrupt company, which could capitalize on the knowledge, flexibility, and patience that a distress hedge fund manager may well possess and that the lenders to a company often do not have.

            A bank is certainly not in the business of trying to figure out how a reorganization process, which can last several years, will be resolved for the lenders or other stakeholders. Likewise, holders of trade claims are in the business of producing diamonds or jewelry and have no particular expertise in assessing the likelihood of getting paid once a company has filed for Chapter 11.

            Will the hedge funds that bought the Fabrikant debt try to “manage” or try a financial “hit and run”? Will the hedge funds seek an opportunity to buy at steep discounts debts from unsecured creditors (banks and trade)? Undoubtedly, some of the players to whom money is owed may not want to wait or can’t wait for the Chapter 11 reorganization to be completed. This may takes years and years. Will they try to get “something now” instead of “probably nothing later”? Will we see the emergence of a market in “Fabrikant claims” in which anyone with a claim who does not want to participate or cannot afford to participate in the bankruptcy proceeding can cash out with ease?

            Buying more debt may well increase the hedge funds profits. Does it? Or look at it the other way: a refusal to touch unsecured debt is a message in itself.

Ramifications for the Diamond Business

            On a conceptual level, when a diamantaire is in default, the lenders and other creditors will get together and assess the total assets. Assuming hypothetically that all creditors enjoy the same priority status, they all may get a share of the assets. But the total assets remain in the business, either with the trade creditors or the banks. If the gap between liabilities and assets is, for example, $30 million, the total loss to all involved players will not exceed that amount.

            However, assume now that a distress hedge fund is involved, as in the case of Fabrikant. They paid $85 to $90 million and are holding over $160 million worth of rights to the assets. If they make nearly a 100 percent profit – $80 million in this case – all this money will leave the industry. The total loss of the other non-secured and trade creditors will be increased by that amount.

            One might argue: what is the difference whether it goes to these outside investors or to the industry banks? There is a big difference. First of all, the chance that banks would have been collecting substantially more is virtually nil, otherwise they wouldn’t have sold the debt to begin with. Secondly, banks and trade creditors would have only one objective: to get money back – they are not looking to make huge windfall profits on these debts. That is the main difference. Who pays for these windfall profits? First of all Fabrikant itself – and it also diminishes the chances of a successful recovery. 

            But above all: it is all the other claims holders (the unsecured creditors) that will get less. This gets us back to the domino effect – and let me say no more. Somehow, the entry of distress hedges into the diamond business and the sale by diamond banks of their debts to these funds don’t seem to me to be a positive development. In Chapter 11 restructuring scenario – the sale of the debt to hedge funds may seriously jeopardize the ability of the company to reorganize and continue in business.

            Playing the “devil’s advocate”, there is, however, also an entirely different way to look at it: Having hedge funds’ capital invested in the diamond business may reduce the industry’s reliance on bank financing and may even lead to the development of additional securitization options. The key factor is that outside sources of capital will gain experience and confidence in the diamond business. The entry of hedge funds signals that capital market players other than the trade and diamond bankers feel comfortable with the value of the collateral assets, diamonds, and trade receivables.

            It may well be that the comfort level of hedge fund managers are derived from the very fact that banks have such a long-term and favorable experience with our industry.

That reasoning is quite logical. The diamond trade is heavily leveraged. It can be leveraged because banks feel comfortable enough to extend credit in this business, given the relative confidence banks have in valuing the assets.

One might consider it a welcome sign that outside capital is willing to acquire diamond collateral and seems at ease trading it. It translates into drawing new money into the business. It is the high debt-to-equity ratio in the business that enables traders to live with relatively thin margins. Having commercial banks in play signals a degree of predictability or safety in the recoverability of investments, attracting other financial players. Maybe the sale of the banking debt to hedge funds needs to be viewed as a “breakthrough.”

However, intuitively, I cannot find this a cheerful development with promising prospects, but maybe there is something that escapes me.

            Have a nice weekend.