Babcock & Brown faces up to leaner times

Euromoney magazine, July 2008

This time last year, Phil Green had plenty to smile about. The chief executive of Babcock & Brown, Australia’s newest and fastest-growing investment bank, was preparing to announce a 53% increase in interim group net profit year on year, with 44% growth in earnings per share. B&B’s landmark bid for the Alinta energy group, in partnership with Singapore Power, was on its way to completion; the share price was flying high at almost $35.

What a difference a year makes. On June 13 this year, the share price hit a low of $4.70 – a more than 80% drop since last July. Investors have fled over concerns about the bank’s debt load, and when their flight breached a threshold in market capitalisation, a covenant was triggered allowing a consortium of lending banks to review a $2.8 billion debt facility (which, in turn, set off further share price falls). Since then, the bank has suspended distributions in some of its listed infrastructure funds, spurring further alarm. These days Green is spending much of his time trying to reassure the market that the whole thing isn’t going to keel over.

Quite a shift for the bank that was welcomed to the Australian Securities Exchange with such fanfare in 2004. B&B seemed a curious arrival then: far from a start-up, it had been founded in San Francisco in 1977. But the banks’ management had spotted in Australia a local investor base hungry for a competitor to local incumbent Macquarie Bank, and carefully followed the Macquarie model: buy lots of assets, put them in funds, list those funds, and get a steady flow of fees from them to the parent.

It has certainly been busy: the bank says its pipeline of assets in greenfield development include 16,000MW of wind assets, 1400MW of solar, 3360MW of gas-fired power assets, and a host of PPP projects from Europe to North American and Australia. But along the way, it seems to have borrowed a bit too much for the market’s liking. At a group level its total gearing was 53% in December, the last publicly stated figure.

The troublesome A$2.8 billion loan (B&B calls it an “evergreen facility”) had been extended to 2011 only in April, but the problem was a caveat that if the company’s market cap dropped below A$2.5 billion, the banks could review their loan and potentially call it in earlier. The precise meaning of this caveat has been open to some dispute, with B&B itself seeking to clarify it in an announcement to the ASX on June 16. “The market capitalisation clause in its corporate debt facility does not constitute a default or breach of covenant,” it said. It “provides for the facility banks to have the right to call for a review of their position under the facility rather than any specified action.” Peter Hofbauer, global head of infrastructure at Babcock & Brown, tells Euromoney: “the banks haven’t as yet indicated whether they will or won’t take a review” but that “the discussions we’ve had have been very constructive.” Many in Sydney believe that hedge funds, aware of the threshold, helped to breach it by aggressive short selling.

Whether or not the banks’ do opt for review, B&B has set about putting some of its assets up for sale – Green calls this “asset recycling” – in order to de-leverage the balance sheet. First on the block is a portfolio of European wind energy assets, which the bank says are likely to be sold in the third quarter of this year. These assets, believed to be worth about A$2.5 billion, are owned by B&B and one of its listed satellites, Babcock & Brown Wind Partners. Deutsche and JP Morgan are advising on a sale.

Asked whether such a sale would fix the debt problem, Hofbauer is quick to retort: “I don’t think we have a problem. Our underlying business is no different. The only thing is our share price has moved. We continue to have an extremely good franchise. There’s no problem to solve.”

As if to illustrate the point, Babcock & Brown has been continuing its acquisition strategy as if nothing has happened. Remarkably, straight after the share price crash, it closed a deal to buy Angel Trains, the British train leasing business, from Royal Bank of Scotland for $3.6 billion. Babcock & Brown was also the arranger to the transaction and its long term financing – which comes to another $2.8 billion (although it is a separate entity, Babcock & Brown European Infrastructure Fund, leading the consortium, which also includes Deutsche Bank and AMP Capital Investors).

Be that as it may, the group does expect gearing to come down. Hofbauer says the bank uses its own balance sheet for three purposes: to co-invest in funds, for development of assets, and to aggregate assets for the introduction of third party capital. The business is shifting more towards the first two and is putting less cash in the third, so “our leverage will progressively reduce over time,” he says. He adds that gearing ought to be seen in a different light for infrastructure. “Our infrastructure funds are involved in activities that generally have high barriers to entry. They have very stable cash flows, are largely immune to economic cycles, and are involved in the provision of essential services. That needs to be taken into account when you look at the capital structure of those businesses.”

Most expect Babcock & Brown to survive this blip, although possibly not as an independent entity – a A$600 million fund-raising by Macquarie in June, coming when it already had A$3.6 billion in surplus capital in the parent stock alone, has been rumoured to be for a tilt at its rival bank. Nevertheless, the model is under increasing scrutiny in a tight credit market with falling asset values. Macquarie, which pioneered the approach, has by and large come out of it unscathed so far (notwithstanding a near halving of its share price in the last year) but its satellite funds have been under stress. It will privatise one of its listed vehicles, Macquarie Capital Alliance Group; this may prove to be a common approach and B&B has appointed advisors to look at the group’s own Australian-listed funds.

Still, Hofbauer does not think the model is the problem. “The financial world is based on managers managing third party capital,” he says. “I don’t believe there’s any material difference between our business, and the cornerstone of third party capital in the financial markets globally.”