Diamond Circle Capital Plc (DCC), a closed-ended investment company incorporated in the Isle of Man, has successfully completed its initial public offering (IPO) on the London Stock Exchange. The company has raised $74.32 million for the creation of the world's first listed polished diamond fund. In about six months, a further equity-raising round is expected.

I have been in touch (and involved) with the promoters of this fund, and I have come to view it as a very significant and constructive development for the diamond industry. The fund will only invest in “important polished stones” ranging from a minimum $1 million to a maximum $20 million per stone. Each purchase will need a GIA certificate (issued in the same year as the year of acquisition).

The fund’s diamond experts will now commence its initial purchases. The diamond portfolio will consist of approximately 60 percent of white diamonds and 40 percent of rare colored diamonds; the average diamond sizes will be 20 carats for white diamonds and five carats for colored diamonds.

The fund is almost like having a new major polished dealer in large goods alongside the handful of existing major players. The strength of the large dealers is in their ability to hold onto $20 million stones, if necessary, for many years. Their professional and financial prowess can defend prices. Hitherto, such activity has never been financed by public money – equity raised for only one purpose: to deliver value to shareholders by making money buying and selling the largest goods.

A back-of-the-envelope calculation will show that less than 40,000 polished stones weighing more than three carats are produced annually, and that these easily represent well over 10 percent of the value of the total annual worldwide polished supply. The truly remarkable stones within this category count, at best, only a few hundred diamonds per year. This business represents a relatively small, highly specialized, quite risky and enormously capital-intensive niche in the diamond market. This niche stands and falls by the ability of the dealers, whenever necessary, to hold on to their diamonds for years – to secure and guarantee their optimum value.

About a year ago, a first placement of some $300 - $400 million by DCC was postponed, due to the financial turbulence that then swept the international markets. Just imagine what a portfolio of large rare stones acquired at that time would have been worth today. Share prices might have doubled or tripled, as almost any truly large stone purchased today can be sold at a profit tomorrow.

It is not without reason that the market for rare large stones is currently in the hands of less than a dozen companies. The launch of DCC will instigate more competition, create more demand and – most importantly – bring cheap non-interest-bearing money into the diamond trade.

The key difference between the investment funds of the 1980s and the DCC lies in the “distance” between investors and the fund’s activities in the market. If, hypothetically, a large group of shareholders suddenly may want to dispose of their shares at a time of slow demand, the share price may decline – but this will have absolutely no impact on the underlying assets. No diamonds need to be sold to accommodate the share sellers. There will never be a “distress” sale or any shareholder pressure to either buy or sell.

The DCC, which has been promoted by the Swiss UBS Investment Bank, has assembled a team of experienced diamond industry specialists to source opportunities, to decide on investment strategy and to provide independent valuation of the portfolio. Though long-term asset growth is the main objective, attractive sales opportunities will not be ignored. The fact that the securities are fully compliant with Shariah principles makes the fund also attractive to wealthy Arabian investors.

De Beers Supports the Concept

When the concept of the fund was presented to De Beers’ managing director Gareth Penny, he was, reportedly, very enthusiastic about the idea. Penny believes that such investment vehicles will bring much needed outside (i.e. new) money into the industry, which will lead to greater liquidity and, ultimately, a reduction of banking debt. This is a U-turn from De Beers’ traditional position.

In the past, De Beers categorically opposed the concept of diamonds for investment purposes and believed that diamonds sales should have a finality to them – which meant that they needed to go to diamond jewelry consumers who would not “return” the diamond to the market. In those days, De Beers was managing the industry’s buffer stock and tightly managed the supply side. Any accumulation of stock in investors’ hands not just jeopardized stability, the company reasoned, but it also impaired De Beers’ own ability to manage the market.

These arguments have lost relevancy in the current market-driven, competitive diamond market. Today, the market is thirsty for liquidity ever since the main rough suppliers dumped their buffer stocks onto the market.

We estimate the global banking indebtedness of the diamond industry at $18-$19 billion (not just counting the main centers, but also financing sources such as Dubai, Moscow, England, Singapore, Hong Kong, Johannesburg, etc.) The level of industry indebtedness (manufacturers and traders) is close to one year of polished sales at polished wholesale prices (pwp). With the return of inflation and increases in interest rates, financing costs are bound to go up.

The DCC brings money from outside investors – “free” money not encumbered by financing costs. Without any hesitation, one ought to welcome the influx of capital provided by the DCC and similar funds, which will undoubtedly follow in the future.

Though many of us suspect that there is currently considerable speculative buying in the larger goods, so far there were few institutional frameworks for investing in diamonds for the non-diamond professional investor. This was bound to change – and the sooner the better. Why? Commodity markets have been booming. Prices of most commodities (especially those of oil, nickel, tin, corn and wheat) have reached record highs despite credit market turbulence (subprime crises) and the slowing economic activity in many major advanced economies.

Commodity prices have risen for many reasons – and rising demand is only one of a number of factors driving the steep value appreciation. The diamond industry has largely missed the boom in commodity prices. This can partly be attributed to the absence of access to the trade by outside investors (speculators) who, in other commodities, contributed to price rises.

Diamonds as “Alternative Assets” Class

There is little need here to stress that the decline in the effective value of the dollar has decreased the returns on dollar-denominated financial assets in foreign currencies. This has catapulted investments in commodities into a more attractive class of "alternative assets" to investors. Take oil for example. In the current upward spiral of energy prices, large financial institutions, hedge funds, pension funds, and other investors have been pouring billions of dollars into the energy commodities markets to try to take advantage of price changes or hedge against them. Most of this additional investment has not come from producers or consumers of these commodities but from speculators seeking to take advantage of these price changes.

Let’s be precise in our terminology. In the present context, a speculator is someone who “does not produce or use the commodity, but risks his or her own capital trading futures in that commodity in hopes of making a profit on price changes.”

The large purchases of crude oil futures contracts by speculators (i.e. investors) have, in effect, created an additional demand for oil, driving up the price of oil for future delivery. “The price of crude oil today is not made according to any traditional relation of supply to demand. It’s controlled by an elaborate financial market system as well as by the four major oil companies (the ‘four sisters’). As much as 60% of today’s crude oil price is pure speculation driven by large trader banks and hedge funds. It has to do with control of oil and its price,” says F. William Engdahl, a leading analyst and author of many best-selling books on oil and geopolitics.

What is true for oil is just as true for diamonds – though the sizes of the markets are, of course, hugely dissimilar. Because of the nature of the product, investments in diamonds have a far longer time horizon. Eventually, the diamond industry will also have futures – which will create additional demand.

As far as the market is concerned, the demand for a barrel of oil that results from the purchase of a futures contract by a speculator is just as real as the demand for a barrel that results from the purchase of a futures contract by a refiner or other user of petroleum. This will be the same in the diamond industry – and the demand originating from consumers will be just as real as the demand from investors, especially investors who are willing to hold onto the stones for many years.

Is there a downside? Of course there is. Declining share prices of a diamond investment company may have psychological ramifications; this will be noticed by analysts, journalists and investors. As this is a closed-ended investment company, basically operating as a mutual fund with a limited number of shares outstanding, the performance of DCC may, over time, be seen as an index for truly large diamond prices. If the fund, or funds like this, is badly managed, there is a definite downside due to the transparency and visibility of the fund’s activities.

From a “reputational” perspective, the fund will create positive spillover effects. It will demonstrate that the diamond business can be managed in a truly transparent environment, where outside investors can have confidence in the operations. Today, the diamond industry is almost exclusively privately owned, except for some listed companies in India, which remain controlled by the shareholdings of these firms’ promoters. DCC may enhance public confidence and raise the comfort levels of investors. Provided, of course, that it is successful.

Exacting Reporting Requirements

We have grown used to seeing new diamond companies start with a listing on London’s AIM market for smaller growing companies. DCC is traded on the London Stock Exchange’s (LSE) main market. The LSE is one of the world’s oldest stock exchanges and it traces its history back more than 300 years. It is unquestionably the city’s most important financial institution. Being on the Main Market is prestigious and instills confidence. The fund couldn’t be at a better place.

The obligatory reporting requirements for listed companies will mandate detailed descriptions and valuations of the company’s diamond trade and inventories. Though the growth of the fund will probably be gradual, it has the potential of becoming a major force in the diamond business – and a source of important market information on large polished price trends.

The fund is not allowed to invest in rough diamonds. The company’s principal consultant is Diapason Commodities Management S.A., based in Lausanne, Switzerland, which is one of the largest commodity investment advisers in the world and oversees approximately $7.4 billion of funds and investment vehicles in various commodities programs.

A major role is being played by UBS Wealth Management, which is providing a comprehensive range of products and services individually tailored for wealthy clients around the world. Just imagine the impact on DCC of a UBS recommendation to include some diamonds in all of the portfolios under its management. The importance of enjoying the backing of commodity traders with the experience and financial strength of both Diapason and UBS should enhance the industry’s comfort level with the new diamond investment fund. Diamond Circle Capital will be closely watched and, if successful, the formula will undoubtedly be emulated by others.

Given the present shortages of supplies in the larger goods, it’s quite exciting to have an additional player that will only exacerbate the shortages. This may hold the best promise on diamond prices we have heard in a long time.

Have a nice weekend.