Nicholas Moore: Potholes not pitfalls on Macquarie’s road

Euromoney, September 2009

IF MACQUARIE GROUP is at a crossroads, it probably already owns it. The financial services group, best known outside Australia for its infrastructure investments from Sydney Airport to the M6 motorway in the UK, has had a difficult year and has seen one part of its model – the satellite fund – run into trouble. It has faced belligerent hedge funds intent on bringing down the stock, and indeed the bank; it has taken billions of dollars of impairment charges on its listed funds; and it has faced a certain local Schadenfreude in a country that shows little warmth for tall poppies. But as imitators have gone bankrupt it has stayed profitable throughout and is already tweaking, evolving and reinventing, just as it has ever since it started out in 1969.

“In the time I’ve been covering the stock it’s gone from market-making equity options to gold bullion trading, to R&D tax financing to cross-border structured financing to listed infrastructure,” says Brian Johnson, one of Australia’s most highly rated banking analysts, who recently moved from JPMorgan to CLSA. “The model just continues to evolve.”

It has been common in the past 18 months to talk about the Macquarie model, and to ask if that model is broken. Typically, when people use this term, they are referring to an approach that Macquarie pioneered: buy infrastructure assets, put them into funds, gear them and then list them, with the parent drawing base and performance fees for the management of the funds.

This has unquestionably been big business for Macquarie – it has 14 listed real estate or infrastructure funds or fund managers listed in Sydney, Singapore, Tokyo, New York and Seoul, with A$11 billion ($9.1 billion) equity under management between them even after market declines, but the bank has lately been at pains to point out that in terms of the overall business it’s not that big a deal. In the year to March 31, specialized funds accounted for just 13% of Macquarie’s A$7.6 billion in operating income – ranking just fourth as a source of revenue behind such areas as lending and leasing, commodities and FX, and cash equities. That is partly a consequence of declining values and performance but this business’s contribution has never been higher than 20%. 

“That includes all the income from specialist funds, M&A fees, advisory fees, underwriting fees – everything to do with those funds,” says Nicholas Moore, chief executive. So is Macquarie misunderstood? “Well it’s certainly an important point to make,” Moore says. “Because our [funds] business is so strong people will naturally recognize that. They might not recognize the other 87% of the group.” And even that overstates the contribution, he says. “Of that 13% we estimate the listed portion is less than 5%. The group is more than 95% non-listed funds.”

It’s natural, though, that this has captured the most attention, and Macquarie was much more vocal about this point of differentiation when the model was working well. People get attached to infrastructure because they can see it, be it the motorway they drive on to get to work or the airport they fly out of. Once you start exposing retail share investors to these assets, that visibility increases dramatically – particularly when things are not going well. And, lately, they haven’t been.

Things were fine in an era of cheap debt and a ready acceptance of leverage, and investors in many satellite funds have done very well out of them over the years. However, the approach fell drastically out of favour as sentiment towards indebtedness changed. Some listed funds, such as Singapore-listed Macquarie International Infrastructure Fund, are trading at around one-third of their listing price. At a group level, the full-year result to March 2009 included A$2.54 billion of provisions, one-off costs and equity losses, some of it from one-time hits such as the group’s exit from Italian mortgages and for modest ABS or CLO exposures, but mainly for the funds, real estate and resources equity investments, and co-investments in infrastructure such as Japan Airports and Spirit Finance.

In the event, these impairments weren’t even enough to put the bank into the red: its A$871 million profit for the 2009 financial year was down 52% on 2008 but still mocks the multi-billion dollar losses of many banks in Europe and the US. But the era of those listed funds is over, at least for now.

The final straw from the retail investor perspective was Brisconnections, set up by a Macquarie-led consortium to design, build, operate and finance an A$4.9 billion airport toll road in Brisbane. BrisConnections was floated in July 2008 using an installment model: investors were to pay A$1 up front, with two more A$1 payments to come in subsequent installments, to make a A$1.2 billion flotation, which Macquarie also underwrote (with Deutsche). By November it had reached the lowest possible price on the Australian Securities Exchange, one tenth of an Australian cent, with investors still on the hook for two installments each 1,000 times higher than the trading value of the stock. (See Euromoney June 2009, page xx for more on this; most investors have since taken up a Macquarie offer to give up their shares for nothing in exchange for being excused payment of the next two installments.) Moore points out the road will still be built on schedule, but clearly the brand damage to Macquarie and listed infrastructure was severe. Broadly, many feel that Macquarie’s involvement in listed funds as both a manager and as the recipient of fees from that fund based in part on scale and transactions is a conflict of interest. Moore responds: “It’s pretty clear the governance structures are designed to ensure that’s not the case.”

Asked if that model is gone for good, Moore speaks of “the frustration we feel and our investors feel” that the good assets in the funds are not reflected by the listed markets. He adds: “Needless to say, whether it’s Macquarie or anybody else, there’s no capital going into listed funds to buy infrastructure assets today because they’re just not valued by the listed market. Will that turn around? Sure… but where we sit today, plainly there is frustration.”

And so a shift is under way: Macquarie is stepping away from listed funds (see box) and moving more and more into unlisted. The net effect is that Macquarie is going to remain every bit as active in infrastructure as it always has been, and indeed already the equity under management in the unlisted funds (including real estate), at A$41 billion, is almost four times the amount in listed vehicles.

And it’s growing fast. In August Macquarie signed a deal to put $50 million into a $530 million infrastructure fund with Vnesheconombank, Russia’s state development bank, to capitalize on Russian government promotion of private sector activity. This followed the April launch of a $1.04 billion Indian infrastructure fund with State Bank of India, in which Macquarie committed $150 million. Next up will be a joint venture with China Everbright to raise $1.5 billion for investment in North Asia infrastructure projects.

Clearly Macquarie still has to make these vehicles work but doing it this way has a lot to recommend it. Stock market investors, particularly retail ones, tend to be skittish, and also want a dividend yield, which in the good times was generated by re-gearing the assets in the funds but is impracticable now. “In the unlisted model, you’ve still got governments selling assets, but you’ve got wholesale pension funds that want to buy long-duration assets to match their liabilities,” says Johnson. “They don’t need the illusion of a distribution of the capital value. They are more worried about the long-term value of the asset. To me the unlisted model looks a lot more sustainable.”

Chief financial officer Greg Ward says: “I like unlisted funds. Retail is hard, you’re dealing with exchanges and mass investor communications – it’s quite a process. In unlisted you can sit around a table with the investment committee… you put it all together and it’s done.” Moore depicts the decision between listed and unlisted models as “a market driven issue – it’s not a call we’re making, we’re just reflecting what’s happening in the broader marketplace”.

A big question with this shift is what happens to the fee structures, which have long been a keystone of the bank’s investment banking division. There have been years in which as much as half of Macquarie’s overall M&A transaction count has featured a party with a Macquarie link. Ward says the fees are “about the same” in the listed and unlisted models, although clearly the bank will lose its underwriting fees on the flotations that will no longer occur. Johnson feels that this area is “where the jury is still out” but thinks the fees will end up being similar, just pushed further back in the fund’s process. Macquarie should hope so, as the investment banking arm is the one part of the business that was still declining in the first quarter of the 2010 financial year compared with the fourth of 2009.

But, if Macquarie is not just funds and infrastructure, what is it? Crucial to understanding Macquarie is a comprehension of its style of business. Allan Moss, Moore’s predecessor as chief executive, used to talk of the “loose-tight” approach to risk management; within certain parameters, if someone comes up with a good idea, they are pretty much given the keys to go and make it work. Moore too talks about “this entrepreneurial nature, making sure the initiative and the enterprise is really owned at the grass roots. These are the people who are going to see the opportunities and are going out into the marketplace, so we are going to create an environment that is supportive of them.”

The consequence of this is a business that can appear bitty, with siloed businesses apparently running in isolation from one another. “My two biggest competitors in the industry when I was there were other parts of Macquarie,” recalls a former employee. But it is extraordinarily wide-ranging in both a business and a geographical sense. Some 40% of its 2009 operating income came from businesses that did not exist five years ago, and a look at developments in the securities business, one of five key divisions within the bank’s structure, over that period illustrates how it happens. There was the Asian cash equities business, the old Baring franchise bought from ING Asia in 2004; the launch of a cash equities business in India; a joint venture with First South Securities in South Africa; the acquisition of Orion Securities in Canada in 2007; greenfield businesses in Europe and the US, the establishment of a European structured equity finance team, and a synthetic products business. Other divisions, including treasury and commodities, corporate and asset finance, banking and financial services, and funds, look the same: incremental shifts into tightly defined new areas, almost franchises.

If we accept that Macquarie is through the worst, where next? Following its A$1.2 billion share capital raising in May, it has A$4.3 billion above minimum regulatory requirements. Although that has clearly been highly useful as a buffer and a source of security for investors, it will soon become a drain on return on equity (which, incidentally, has an unusual side effect at Macquarie since the calculation of its bonus pool is directly linked to ROE). “The drag of capital will become a big issue over the next 12 months,” says Deutsche bank analyst James Freeman, “and they are going to want to use it sooner rather than later.”

This ties in to a nagging fear that, in demonstrating its stability, Macquarie might have neutered some of the outside-the-box entrepreneurship that made its name. “When I look at Nicholas going from Macquarie Capital [the investment banking and specialist funds arm, which Moore built] to CEO, he goes from being the entrepreneur to being the risk rationer and that must be hard for him,” says a person who has worked with him. And Moore’s unavoidable change of focus, a function of promotion and market environment, is perhaps emblematic of a necessary group-wide shift in attitude from brassiness to caution. The use of that surplus cash will say a lot about the group’s confidence and boldness as the financial crisis eases. (Five days after the interview as Euromoney went to press, Macquarie announced a US$428 million acquisition of Delaware Investments, a US money manager, in the largest foreign acquisition the group has yet announced. Perhaps rumours of lost gumption were premature.)

When will it be deployed? “That’s the sort of dilemma or debate we have internally,” says Ward, who thinks that the 2011 financial year – which starts for Macquarie in April 2010 – is the time when “there will be a bit more attention to the traditional metrics of return on equity” and therefore banks will be expected to put excess capital to work.

Macquarie historically has never gone anywhere near its regulatory capital minimums – at March 31, before the share capital raising, its tier 1 figure was 11.4% compared with a 7% minimum – so not all of that excess capital is deployable, although Ward says “if the minimum held was a billion over or a billion and a half I think that would be more than ample.” On that methodology about A$3 billion is available to be put to work.

Asked where it might go and when, Moore’s detailed response covers every area of the business and pretty much the world, from US debt capital markets to Australian and global fund management, corporate and asset finance lending, leasing, and domestic retail banking, but what’s lacking from it is any sense of a visionary or transforming acquisition or a major deployment of funds. “We’ve always had a relatively small and expensive balance sheet and we’ve always been very cautious in the use of it,” says Moore, stressing the bank’s role as a provider of services more than a lender of capital. “We don’t see the role of the organization to be taking the last basis point of use out of the balance sheet.”

If one were to identify the acquisition that comes closest to transformative in the past five years, it would probably be the ING Asia brokerage business, which brought more than 400 people into the fold – yet that deal’s cost was so low that it has never been disclosed, meaning it didn’t even meet the Australian Securities Exchange’s definition of a material transaction. This can seem at odds with the bank’s recent history of landmark bids for, for example, the London Stock Exchange and Qantas, but those (neither of them successful) were mooted investments in which Macquarie would actually not have put much of its own capital on the line. Macquarie does get linked with specific businesses – such as Fox-Pitt Kelton and ING’s Asian wealth management arm – but it is never likely to turn up buying an entire continent of Lehman staff like Nomura, for example. Moore says that the deployment of capital is typically for organic growth rather than big deals.

At times this can be a difficult business to get a sense of direction from. “What’s the model going to be?” asks Freeman. “It seems a collection of businesses trying to make money but with no overarching strategy. I’d characterize it as being in limbo: surplus liquidity awaiting a defined strategy.”

Still, there is a common theme to the modest acquisitions of the past 12 months: energy. In May it bought Tristone Capital Global, an energy advisory and capital markets business based in Canada, for C$116 million ($106 million); this followed, in February, the purchase of Constellation Energy’s downstream natural gas trading operations in Houston, and the earlier development of a gas trading business called Macquarie Cook Energy. Between them, the three have quietly made Macquarie one of the leading players in North America’s wholesale natural gas market.

Johnson in particular thinks this is the next big step for Macquarie. “I can see the next wave of the business model beyond the unlisted funds, which is oil and gas,” he says. “That’s certainly the space Macquarie is moving into. The evolution continues.”

BOX: GETTING OUT

Macquarie’s departures from its listed funds are happening in a variety of ways. One key deal came when Macquarie sold its Macquarie Communications Infrastructure Group – which contains the communications assets Broadcast Australia, Arqiva and Airwave – to the Canada Pension Plan Investment Board for A$3 a share shortly after fund itself was trading at 83 cents. Moore sees this as vindication of his view that the underlying assets in the funds are far better than the listed markets think they are. Other trusts have been selling assets to raise cash or retire debt, notably the Macquarie Countrywide Reit and Macquarie Infrastructure Group (which sold a 25% stake in the Westlink M7 motorway in February), while Macquarie’s 26% stake in the Singapore-listed Macquarie Prime Reit was sold outright to YTL. A co-investment vehicle called Macquarie Capital Alliance Group was taken private in August 2008, and others may follow.

Increasingly, though, Macquarie is keeping its stakes in the funds but backing out of their management completely. This has been put to shareholders in two trusts – Macquarie Leisure, which owns theme parks; and Macquarie Airports, which with a A$4.1 billion ($3.4 billion) market capitalization is one of the biggest funds (and the most visible, since it owns most of Sydney Airport). Macquarie Infrastructure Group, the other heavyweight listed fund, is also believed to be considering going it alone without the parent  – and may also be split into two vehicles.

The airport deal is controversial as Macquarie is surrendering its management rights at a cost: stock worth A$345 million at the time of the deal. The mechanics of calculating that figure – what’s the right to management worth? – are unclear and some shareholders plan to vote against the proposal, with Perpetual Investments believed to be among the big managers grumbling about the circumstances of Macquarie’s exit. Some think there should be no payment at all “It remains difficult for us to shake the feeling MAP has overpaid to sever the relationship,” wrote JPMorgan analyst Kirsty Mackay-Fisher in a note entitled: “MAP lays one last golden egg before flying the coop.”

While it’s not strictly fair to say Macquarie is cutting trusts adrift – if the deal goes through its stake in Macquarie Airports will actually increase – there is clearly a reputational issue if Macquarie trusts, granted independence from the mother ship, then get into trouble. That, surely, would make the listed model difficult to return to should Macquarie ever feel the need. CFO Greg Ward says he has never felt any of the satellite funds have had problems with gearing.

BOX

How close did Macquarie get to the edge?

As Lehman went under and Merrill Lynch lost its independence last year, attention turned to investment banks across the world. What of the pretender from the Southern Hemisphere?

At first glance there were plenty of reasons to wonder about Macquarie. There were widespread questions about leverage in the funds model, the strain impairments in those funds might cause on the parent, and the fact that two Australian groups that imitated that model, Babcock & Brown and Allco, both went bankrupt. The market clearly had its doubts – the stock fell from more than A$80 to A$15.50 in a little over a year from early 2008 to March 2009. But perhaps more ominously, credit default swaps blew out alarmingly: to 1,800 basis points on its subordinated debt in October, compared with a 200bp to 400bp range over the previous six months.

Logically there shouldn’t have been any cause for alarm, because of Macquarie’s capital position. Greg Ward, chief financial officer, says that Macquarie had been selling off lower-yielding assets such as margin lending and Italian mortgages through early 2008, realizing about A$15 billion ($12.5 billion), “basically to have in place the funding should we not be able to issue for an extended period of time”. Ward says that by the time of Lehman’s collapse Macquarie held a cash balance A$7.4 billion greater than all its short-term wholesale debt, enabling it to repay its commercial paper in full, while maturing longer term debt typically stands at A$3 billion to A$4 billion a year, so was well covered. “We’re not funding short and lending long like a traditional bank, we’ve been match funding,” says Ward. “That’s one of the reasons we didn’t have a problem – plus of course we didn’t have the principal positions [of Lehman] because we’re client driven, not a punting shop.” Additionally, it had built up the retail deposits in the bank, an area little remarked upon but by March worth A$18.8 billion, or 25% of the funding base.

Although some in the market say that Australia’s government guarantee on bank debt issuance was put in place because of mounting concerns about Macquarie and Suncorp, Ward is adamant “we’ve never needed the guarantee. The whole industry needed the guarantee but Macquarie back in March 2008 was unlike any other bank because of this match-funded balance sheet. If we had done no more borrowing in the last year, no more debt issuance, we’d still have more cash now than we had a year ago.”

But can fear bring down solid institutions? If counterparties had believed what those CDS spreads were implying they would have stopped doing business with Macquarie altogether. “We didn’t do any issuance at anything like what the CDS was suggesting,” Ward says. “Our major counterparties could see this was not real. The default risk when you’ve got more cash than borrowings is not real. But no one wanted to believe that at that point of time. It was: Lehman’s has gone, Bear’s has gone, in this market Babcock and Allco have gone, why aren’t you next?”

CDS, Ward says, are “obviously not a regulated market”. He recalls: “there would be three brokers or something that would seem to quote the whole market – they would talk about volumes per day of $2 million to $5 million and the thing would move 50 basis points on nothing.”

Some groups were working hard to hit Macquarie’s share price and CDS spreads with false rumours, a practice that prompted a stern and unusual statement from the Australian Securities & Investments Commission (which banned short-selling for eight months up to May). Around this time analysts and fund managers began to distance themselves from what was happening. Charlie Aitken, from Southern Cross Equities, previously a vocal critic of the Macquarie model, wrote to his clients in September: “I do not want to be even a peripheral part of a sinister campaign of Chinese whispers and manipulation to bring down a great Australian institution. It’s just not right.” Stephen Mayne, a renowned gadfly and shareholder activist usually tough on Macquarie, ran the letter in his widely read Mayne Report blog. A curious change of tone was taking place: Macquarie, often portrayed in the vigorous domestic press as a cold-hearted millionaires factory willing to go to any lengths for the last buck, was emerging from a “serves-them-right” attitude in press and population as concern grew about market manipulation.

For his part, did Moore ever perceive a threat to Macquarie’s sustainability as an independent entity? “No,” he says. “There was certainly a threat to our profitability… but there has never been a challenge to the underlying strength of the balance sheet.” He adds: “Worst case, if the world had actually stopped, we would have just run down the assets as they matured and run down the liabilities as they matured. Plainly, profitability would have been painful, but certainly it wouldn’t have impacted on the survivability or the existence of the organization.”