Macquarie model blowtorched

April 4, 2008

Michael West, The Sydney Morning Herald 

New York-based corporate governance service RiskMetrics Group has delivered a stinging rebuke to Australia's infrastructure sector, and in particular the "Macquarie Model" which has been mimicked by Babcock & Brown, and has spawned a generation of toll-roads, airports, telecommunications and power generation stocks.

In the most detailed independent research of Macquarie Group and Babcock satellites to be published, Risk Metrics critiques the financially-engineered infrastructure model for its high debt levels, high fees, paying distributions out of capital rather than cashflow, overpaying for assets, related-party transactions, booking profits from revaluations, poor disclosure, myriad conflicts of interest, auditor conflicts and other poor corporate governance.

The RiskMetrics research is likely to send shockwaves through the sector and give both state and federal governments cause for concern as governments have mostly privatised public assets via these structures.

RiskMetrics is a leading adviser to institutional investors both in Australia and overseas. They have been a critic for some time of individual transactions, but this is first time they have strung all the pieces together, and raised doubts about the model's viability.

An example of RiskMetrics' previous scepticism was its advice to domestic institutions to vote against the Macquarie Bank remuneration report last year. The result was a 20% protest vote against the bank's pay structures.

Anyway, this report is a haymaker.

Although the report has not put a figure on it, fees in the billions above normal public-private partnership (PPP) rates of return have gone to the investment banks.

"The infrastructure model raises investment-related concerns that can be grouped as follows: a series of issues related to the sustainability of the model; a danger of overpaying for assets; fee structures that deliver high fees and provide an incentive to increase a fund's size; and accounting practices that have the capacity to provide an overly robust picture of a fund's profitability,'' says the report.

The model was "pioneered by Australia's Macquarie Group" and the research covers Macquarie Airports, Macquarie Capital Alliance Group, Macquarie Communications Infrastructure Group, Macquarie Media Group and the original and largest fund:

Macquarie Infrastructure Group and Babcock & Brown spinoffs Babcock & Brown Infrastructure, Babcock & Brown Capital, Babcock & Brown Environmental Investments (presently subject to a takeover offer by Babcock & Brown), Babcock & Brown Wind Partners and Babcock & Brown Power,  as well as Rivercity Motorway, Duet, Hastings Diversified, Challenger, ConnectEast SP AusNet and Spark Infrastructure.

The initial success of the model, at least in capital raising and fee generation terms, has allowed the growth in infrastructure funds to expand overseas into US and European markets.

RiskMetrics, meanwhile, had been chipping away earlier at the more ambitious deals being done by Macquarie-type acolytes, such as Allco Finance Group.

For example, it recommended strongly against the Allco proposal to buy Rubicon Asset Management last year, and institutions came close to voting the deal down.

Allco principal David Coe had led an Allco roadshow to spruik the merits of the deal and it finally scraped through.

In retrospect, Allco shareholders should have taken RiskMetrics' advice. The Rubicon transaction proved disastrous.

The three Rubicon trusts are now down more than 80% in just a few months and Allco teeters on the verge of insolvency.

In the case of Allco, the proxy adviser raised doubts about corporate governance and potential conflicts of interest on the Rubicon.

It should also be noted that the adviser was a critic of MFS, Centro and ABC Learning for some of the same reasons it has criticised Babcock and Macquarie in its latest, most in-depth, paper.

Those three, like Allco and Rubicon, are close to corporate extinction.

MFS, Allco and Centro all favoured the externally-managed model as does the Hedley pubs stable of companies which has just fallen into trouble. Many real estate trusts or REITs also have the trust structure.

Their underperformance has been significant since the downturn in credit markets as the aggressive financing practices, and booking profits from revaluations, hamper performance when credit spreads blow out and asset values come under pressure.

But back to the latest RiskMetrics report. Of prurient interest is their work on fees.

As an extreme example, it takes Babcock & Brown Wind Partners which "had operating cash flow of $14.2 million in the 2006 financial year, but paid distributions totalling $48 million in relation to that year. The distributions were equivalent to 54% of the total cash receipts from customers during the year,'' says the report.

"Even the most mature infrastructure fund of all, Macquarie Infrastructure Group, is no exception.

It had operating cash flow of $306.9 million in the 2006 financial year, but paid distributions totalling $512.9 million in relation to that year.

Furthermore, the distributions were equivalent to 116% of the total toll revenue received during the year.''

The ''stapled'' entities of the infrastructure model "have multiple boards, and are run by an external management company employed under a management agreement providing for substantial fees.

Many of the features of these vehicles appear to make it practically difficult, and possibly expensive, for investors to replace the external manager if dissatisfied with its performance.''

In sum, RiskMetrics finds the model probably has more in common with private equity than with publicly traded property funds.