Rapaport Magazine

Hedging on Color

Can a newly launched colored diamond hedge fund deliver huge returns?

By Teri Buhl
The colored diamond trade is about to become a lot more transparent. At least that’s what former Bulgari executives Mahyar Makhzani and Philip Baldwin think their new Sciens Colored Diamond Fund will do when they attempt to show the industry how the intersection of Wall Street high finance and the diamond trade can ring in profits. 

The new fund is a joint venture between Makhzani and Baldwin, acting as the fund’s managing directors, and Sciens Capital Management, which has more than $6 billion under management. Sciens Capital is one of Wall Street’s leading alternative investment firms — firms that invest in assets other than stocks and bonds. The joint venture fund is designed to invest only in intense deep and vivid colored diamonds and hopes to attract $150 million in investments within the next six to seven months.

Entry into this unique hedge fund isn’t for the Main Street investor, however. High net worth individuals (HNWI) will need at least $2 million to participate in the fund and institutional firms will be required to put up a minimum investment of $5 million.

Promises and Worries

Iranian-born Makhzani, who is 52 and currently based in Geneva, told Rapaport Diamond Report (RDR) in a recent interview that investors will not be allowed to ask for their investment back for the first three years of operation. At the end of that period, however, Makhzani said, they can expect to reap returns of at least 25 percent to 30 percent on an annual basis.

What is particularly interesting to the diamond industry is the fact that the fund will disclose to its investors the prices paid for the diamonds and the associated costs in their purchase. “We realize the dealers won’t like how Sciens, through its due diligence and compliance commitments to investors, will show transparency in the price of the colored diamonds,” Makhzani said. He admitted that the hedge fund team knows they are giving away their entry cost into the diamond investment, but they also want to dispel the myths surrounding colored diamonds’ subjective pricing.

Bruno Scarselli of Scarselli Diamonds in New York says, “It’s foolish to give away your cost. Their exit strategy might work today because of the demand from China and the auction houses’ boom-boom prices. But I don’t know how a global exit will work in a few years unless they are selling an illusion.” But Makhzani tells RDR, “With more nonindustry investors coming into the market, they need better education on what is often an illusionary and opaque market. They need to see that the real markup by the big diamond houses for these rare and special diamonds is only 30 percent to 40 percent, unlike the 200 percent to 300 percent they think it is. With supply of these diamonds shrinking, price transparency will only create more investor confidence, which, in turn, will help drive demand and lead to higher prices.”

While the industry’s colored diamond dealers might be concerned about how the release of price information might open a window into their businesses, one experienced industry insider doesn’t think transparency is an issue. After hearing about the fund’s investment strategy, Henri Barguirdjian, chief executive officer (CEO) of Graff USA, told RDR, “I wish them the best of luck but I don’t see how this will work. Giving away their entry cost and offering transparency isn’t their problem.”

Instead, Barguirdjian is concerned about the time frame the fund has established. While he doesn’t dismiss the hungry demand and expected growth in prices for colored diamonds, which the fund is focused on buying, he doesn’t see how they’ll be able to get their hands on enough of the limited supply of colored diamonds to return a consistent profit of 25 percent to 30 percent year over year.

Makhzani explains that he and Baldwin are not going after the world-record big-ticket diamonds but will focus on stones of at least 1 carat in high-demand colors, like yellow, pink and blue. Brown, gray or black diamonds are not on his radar and he says it is likely he will be able to hold the fund’s entire asset portfolio in the palm of his hand.

Work in Progress

The fund’s new managing directors are in no way novices in buying and selling colored diamonds. They actually launched another fund, Codiam Fund, in September 2008, just before the U.S. economic collapse, with a few million dollars from investors who had used them to locate stones in the past. Baldwin told RDR that within its first 18 months, the fund delivered to its investors a 12 percent return on their money. He considers that a pretty good return since it came during a time when hedge funds were scrambling not to shut down as the financial crisis hit Wall Street.

Baldwin thinks by having more buying power with this new joint venture fund — which expects to launch with $25 million —he’ll be able to more than double returns. The duo wouldn’t divulge the names of their new investors, but they did confirm they are talking to pension funds and large banks as institutional investors, as well as previous clients who invested with them in Codiam.

Jose Sanchez, senior managing director of Sciens Capital Management, is thrilled about the new fund, noting that “This is where Sciens excels, at identifying unique alternative asset investment strategies and then finding the best people to execute them for our investors.”

But Baldwin and Makhzani admit that coming up with a net asset value (NAV) for each diamond, one that the fund’s investors can trust and understand, has been a work in progress. Baldwin told RDR they will use two independent appraisers from different regions in the world to appraise each diamond, but Makhzani was reluctant to name the appraisers or their countries. To the appraised value, the managing directors add their own estimate, and the final price is audited and approved by their insurer, Lloyds of London. They say so far they’ve never sold a diamond for less than its NAV and recognize it’s likely their own investors could also be buyers of the diamonds.

Francois Curiel, Christie’s international director of jewelry, questions why the hedge fund managers won’t disclose the appraisers and said there is not enough world production of colored diamonds to meet the demand he’s seeing, especially after his auction house sold what was at the time the most expensive pink diamond per carat sold at auction on December 1, 2009. The vivid pink cushion-shaped 5-carat, VS1 potentially flawless sold for $10,776,660 — that’s $2,155,332 per carat — and was purchased by a Chinese collector.

Several New York diamond dealers, who preferred to remain anonymous, admitted they are seeing many more buyers from outside the industry coming in to park their money in colored diamonds this year as an investment, instead of putting money in the dollar or treasury bonds. The same dealers admitted their phones were ringing with calls from customers looking for pink diamonds the day after a 24-carat pink diamond fetched an enormous price at Sotheby’s Geneva in November — with a presale estimate of $27 million, it sold for $46.2 million.

Curiel says for the colored diamond hedge fund to be successful, it will be all about “the buy of the diamond” since the fund won’t be using memo, which would add to the selling price through inflated commissions, or leverage to buy the diamonds. Baldwin acknowledges that having ready cash could help negotiate lower prices for their diamond portfolio.

Other dealers wonder how the fund will liquidate its assets and whether that could put pressure on the prices of the diamond if they have to sell in only three years. But Makhzani tells RDR he’s advising investors to expect a year and a half liquidation schedule. Surprisingly, he also says the only income Baldwin and he will take is their 2 percent management fee and that the fund managers won’t collect their 20 percent performance fee until all the diamonds in the portfolio are sold.

“A dealer at the Geneva auction in November told me he thought I was a nut when we started this two years ago,” says Makhzani. “Now he says we were lucky to have made that ‘mistake’ by getting into this then.”

Shrugging off the thought of his fund as a lucky mistake, Makhzani says he’s been planning such a fund for five years and that he has 30 years of relationships in this business that he’s counting on to help identify the exact diamonds they want to buy before they get to auction. He also notes that the fund’s investment strategy isn’t just about coming up with a hedge against inflation during a troubling U.S. recession, but it’s about the managing directors’ passion for colored diamonds, and for helping others enjoy them, that really drives his investment plan.

Article from the Rapaport Magazine - December 2010. To subscribe click here.

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