Venture capital has been at the center of Israel’s emerging high-tech industry, raising billions of dollars from overseas and shepherding start-up companies to Wall Street offerings, and cross-border mergers and acquisitions with big names in the global tech sector. Meanwhile, private equity was considered part of the Old Israel, lacking glamour and growth, and confined to businesses focused on the domestic market.

Israel’s venture capital industry evolved first, in the early 1990s when the government established its Yozma fund to hedge VC’s risk in the country’s burgeoning high-tech sector. Israel’s first PE fund was established in 1996 and, even today, the industry remains heavily weighted toward domestic-market, old-tech companies. An estimated 40% of all deals involve such companies, compared with a worldwide average of just 15%.

But capital market reforms in the first part of the last decade have created an initial pool of investment funds for Israeli PE firms to tap. The government weaned pension funds off of the non-tradable treasury bonds that formed the core of their portfolios, put an end to government-financed pensions, and forced banks to sell their institutional investment arms. Suddenly, there was capital that needed to be invested and fund managers developing the talents to do it. Some of that money went into alternative investments, like PE.

The PE industry today remains small and undeveloped. IVC Research Center, which tracks both the PE and VC industries in the country, counted 28 active Israeli PE management firms with a combined $8 billion under management. Only one Israeli private equity fund raised capital ($200 million) during 2013. According to financial daily TheMarker, no more than 2% of all Israeli pension and long-term savings assets are invested in PE, compared with 15% and 20% in the U.S. Israeli institutions have little experience with PE and lack the industry benchmarks that would facilitate investment. By comparison, IVC reported that 13 Israeli VC funds raised $526 million last year

But the numbers don’t tell the entire story. Israel’s technology sector remains as strong, but the local VC industry seems to be in a state of terminal decline, underperforming the global industry on returns, struggling to raise money and ceding the role of financing start-ups to foreign firms, angel investors and corporate funders. Observers note that Israeli VC funds are still weighed down by the impact of the global technology bubble that burst some 15 years ago.

“Because of the businesses [PE] invests in, we don’t have the privilege of being passive investors. We want them to grow aggressively, so we have to be involved.” –Gilead Halevy

A Successful Run

Meanwhile, the handful of PE funds operating in Israel has enjoyed a successful run. FIMI Opportunity Funds is ranked one of the top funds worldwide in terms of long-term return for investors by Preqin, the alternative assets industry’s leading source of data and intelligence. With $2 billion in assets, FIMI is the biggest local PE investor and the oldest.

When Apax Partners — a British buyout fund with a significant presence in Israel — exited Bezeq, Israel’s biggest telecommunications company, in 2009 it earned four times its investment. Fortissimo Capital, a local fund with some $500 million under management, turned a $12 million investment in home carbonation company SodaStream into $100 million when it took the firm public in 2010. In May of this year, Apax made global headlines in a pact to sell its 56% stake in Tnuva, Israel’s biggest dairy company, to China’s Bright Food. Between the sale proceeds and dividends it took out of Tnuva in the six years the company was invested in it, Apax and its partner are estimated to have earned five times their $500 million investment.

Tene Investment Funds, a $500 million fund, earned back all of investor’s money with just two exits last year in the drip irrigation company Netafim and in Caesarstone, the maker of engineered quartz kitchen countertops. On Caesarstone alone, Tene earned back five times its original investment, and still has 13 companies in its portfolio.

Warren Buffett can take much of the credit for alerting the world to Israel’s pool of well-managed, technologically-advanced, medium-sized companies through his acquisition of an 80% stake in the machine tool maker Iscar in 2006 at a $5 billion company valuation. Buffett arrived in Israel to seal the deal just weeks after the country had fought a month-long missile war with the Islamic militant group Hezbollah that shut down much of Israeli business. But Buffett went ahead with his acquisition anyway. Seven years later, he bought the remaining 20% of the firm at a valuation in excess of $10 billion.

“Many investors had looked at Israel as a technology hub,” says Gil Raveh, an attorney with Raveh, Haber & Co. in Tel Aviv. “Suddenly they found out that Israeli industry has to deal with big obstacles — a strong currency, high transportation and labor costs, difficult transportation, and intense competition with global companies. But they also saw that Israeli companies succeeded because they were efficient and technology oriented.”

Israeli PE managers differ from their American counterparts who tend toward highly-leveraged acquisitions predicated on low rates of interest, notes Amit Frenkel, general partner at the $700 million Vintage Investment Partners. “Israelis are much less focused on financial engineering and much more on increasing operational efficiency and growth.”

Gilead Halevy, one of three partners in the $100 million Kedma Capital PE fund, describes how the fund worked to create value out of a company that grows mushrooms. When Kedma bought a 50% stake in Marina in 2009, the company had about 90 million shekels ($25.9 million at current exchange rates) in revenues and an EBITDA (earnings before interest, taxes, depreciation and amortization) of nine million shekels. Kedma turned the company into Israel’s largest distributor of chilled vegetables, boosting revenues to 250 million shekels.

According to Halevy, the most important change was overhauling Marina’s way of doing business, improving its economies of scale by adding customers, increasing the efficiency of the supply chain and upgrading the production process, which now yields as much as 30 kilo of mushrooms a square meter. Marina’s founder, who still owns half the business, was a mushroom maven, but he allowed prices to fall to the lowest common denominator by making sure he sold off his perishable product quickly. “His mission every day was to sell all the mushrooms in his warehouse,” Halevy recalls. The Kedma team advised him to destroy whatever he couldn’t sell at the right price. “The first time he threw away mushrooms he had tears in his eyes. But look what we’ve done,” Halevy adds. Marina has doubled its EBITDA margins to 20%.

“I see more international players coming to invest in PE because the sector has been able to generate world-class returns.” –Amit Frenkel

“Because of the businesses we invest in, we don’t have the privilege of being passive investors. We want them to grow aggressively, so we have to be involved, very deeply,” Halevy says.

Although Israeli PE managers win plaudits for their savvy management skills, they have also benefitted from a shortage of PE capital and a plethora of fundamentally good companies with good growth potential. “When you look at the entry price based on EBITDA and compare it to the U.S., it’s dramatically lower. You can get into companies where the risk is much lower,” Frenkel notes. Vintage keeps a vast database of Israeli companies and PE fund performance in Israel, Europe and the U.S. Because the data are proprietary, Frenkel declines to provide figures, but he describes the Israel industry’s performance as “outstanding.”

“I see more international players coming to invest in PE because the sector has been able to generate world-class returns,” Frenkel adds. “You don’t have scores of PE funds, but those that are operating here are doing so with world-class returns.”

Overcoming ‘A Bad Reputation’

To some extent, the success of private equity in Israel has been overshadowed by the widely reported failures of one of the industry’s biggest players, Markstone Capital Group. Formed in 2004, the fund suffered repeated blows. Elliot Broidy, one of the founding partners, pleaded guilty in 2009 to paying out some $1 million in bribes to New York State pension officials to win $250 million in pension capital. Markstone’s capital was huge by Israeli standards and the three partners were all new to PE. According to industry observers, the fund acquired assets too quickly and perhaps even recklessly, with a notable example being its ambitious strategy to buy and merge a group of investment managers to create an Israeli financial services giant in 2007. The plan failed and the Prisma investment house that Markstone had created was merged two years later into its bigger rival, Psagot.

PE industry executives say Markstone broke another rule followed by Israeli PE funds — to refrain from highly-leveraged buyouts. The firm borrowed half the two billion shekels capital it used to create Prisma. Markstone also pledged holdings across its portfolio, risking other assets when one went sour. Today, Markstone may lose the 24% stake it acquired in Psagot through the merger.

“Private equity has a bad reputation in Israel right now with people saying Markstone was gambling with other people’s money,” says one industry figure, who asked not to be identified. “They lost so much money — it’s a massive blow to the industry.”

Putting Markstone aside, the outlook for Israeli PE is excellent, industry figures say. Although it is a small country — 8.2 million people and a gross domestic product of about $270 billion — the number of acquisition opportunities is big and the competition is small. Halevy says he has a database of 1,000 acquisition prospects.

One big source for deals will be the Business Concentration Law, which was approved by Israel’s parliament last December. The law is expected to prompt a wave of divestments by Israel’s big holding companies over the next six years as it goes into effect because, among other things, it mandates that big holding companies structured as pyramids reduce the number of tiers to just two and bars crossholding of major financial and non-financial companies.

“It’s a 65-year-old economy, and there are many third-generation businesses, which is traditionally a breaking point.” –Amit Frenkel

The next factor is the relative youth of the Israeli business sector. “It’s a 65-year-old economy and there are many third-generation businesses, which is traditionally a breaking point,” Frenkel notes. “There is a good possibility in a family business that the second generation will continue running it. But at the third generation, you reach the breaking point when owners want to sell.”

Many of these companies are traded on the Tel Aviv Stock Exchange, but effectively operate as if they are family controlled. But regulations requiring more transparency and enhancing minority-shareholder rights are making this increasingly difficult, which is expected to move many families to sell.

Companies owned by kibbutzim — a unique Israeli phenomenon — are also being put up for sale. Israel’s technology sector is another potential source of acquisitions as the industry ages. The growing prospects are attracting more foreign players. In recent months, The Wall Street Journal has reported that Apax is readying to set up a $300 million dedicated Israel fund. The Blackstone Group, the WSJ reported, is considering opening an Israel office, and two Chinese PE funds have been formed in recent months. But while the acquisition landscape is attractive, people in the PE industry don’t see much foreign competition emerging because most of the deals are too small to interest the giants of U.S. and European PE.

Indeed, if the Israeli PE community has a concern it is over a recently introduced cap on the fees that institutional investors are permitted to pay the funds they invest in. While the cap covers all third-party fund managers, it effectively discriminates against PE, whose fees are higher than other categories of fund manager given its need to actively manage its portfolio companies. If PE fund managers have to be paid 2%, institutions will prefer to invest in other funds, industry observers say.

Will that have an impact on the market? “I think so,” Raveh notes. “But it’s too early to see what the impact will be. Clearly some institutions will reduce their allocation to private equity even though PE is already under allocated.”