For whom the tolls swell

A global bank that epitomised the era of easy credit confounds its critics—so far

April 17, 2008

The Economist

WHEN the credit crunch hit last year, few outfits looked more vulnerable than Macquarie Group, an Australian bank that for the past 15 years has been accelerating up the fast lane of finance, led by its enterprising boss, Alan Moss.

The former three-man Sydney outpost of a British merchant bank named Hill Samuel, Macquarie now has over 13,000 direct employees and, indirectly, 65,000 people spread across 25 countries in firms owned by its managed funds. These firms run toll roads from Chicago to Seoul, airports in Sydney and Copenhagen, a water utility in London, wind farms in France; the list goes on. It also does more conventional buy-outs, though of unconventional assets—almond farms in Australia, tyre-inflation machines in Canada and beer-keg leasing in America.

There is nothing necessarily wrong with such investments—indeed, most are long-term, cash-generating assets that big pension funds such as those prominent in Australia ought to hold to match their liabilities. But one of the flashing lights that short-sellers saw as they circled Macquarie last year was that the returns from these schemes looked nothing like the safe but dull earnings normally associated with owning low-growth enterprises. Since going public in 1996, annual profit growth has averaged 28%. Since 1991 Macquarie's annual return on equity had fallen below 20% on only three occasions (see chart 1).

Part of the secret of that success was financial innovation—once thought of as a mark of brilliance, but a stigma since last year owing to the leverage it had concealed across the financial system. Macquarie's mix of businesses behaves a bit like overlapping shadows; it is hard to know where one begins and another ends. It is at once a private-equity firm, a retail fund manager, a quirky lending business specialising in law, accountancy and commodities, a high-end wealth manager and one of Asia's leading investment banks.

Many are unperturbed by these complexities. It has loyal shareholders, thanks to annual returns of 25% since going public; its signature funds have returned 17% a year. Governments like it; it is a welcome bidder in privatisations around the world. And employees like it; not only is it known in Australia as “the millionaire's factory”, some people call it the “entrepreneur's factory” for letting its employees run with good ideas—backed by the money it raises.

Its critics have called Macquarie a giant house of cards, which is likely to topple in the gales blowing through the credit markets. They are troubled by the overlapping interests of the funds and the group, the use of borrowing to pay dividends, the way its entities are valued, and the high fees Macquarie earns from its funds. On top of this, Mr Moss is retiring in May, to be replaced by Nicholas Moore, head of investment banking, whom some credit with being the firm's main driving force in recent years—but who may not have his boss's sure touch. Macquarie's shares fell 9% on news of Mr Moss's departure. Since the crisis began, they are off 42%. Its large Australian-listed infrastructure funds, for example, are down by a third.

Three big Australian financial firms, Centro Properties, Allco Finance and Octaviar, have blown up recently, yet Macquarie itself is not only still standing, it pre-announced that earnings for the fiscal year ending March 31st would set a record—for the 16th year in a row. Few expect the record to continue, but even as many other global banks are retrenching, Macquarie is not. It continues to do deals. Last month, through its Korea Opportunity Fund, it became the joint owner of a South Korean cable-television company; it made its 12th global port investment; and its leisure fund bought ten health clubs in Australia. Meanwhile, all the analysts who cover Macquarie now have a buy recommendation on it. Credit-default swaps, measuring the likelihood of default within a year, have been far more sanguine about Macquarie than they have about Wall Street firms (see chart 2).

Hard shoulders, soft centres

For some, this optimism is based on an aspect of the Macquarie model that is hard to pin down: its people. Much of Mr Moss's 30-year experience has been on the trading floor, which has taught him to be adventurous—within limits. The trick, he says, is to encourage employees to come up with fresh ideas, back them if they are good, and award big bonuses if they are successful, and, importantly, contain losses. Some analysts believe this approach, similar to that of Goldman Sachs, is Macquarie's strong suit. “This ability to innovate and explore new opportunities, rather than grow by large, risky acquisitions, makes Macquarie remarkable,” says Greg Hoffman of the Intelligent Investor, an Australian newsletter, who is a backer (and owner) of the shares. “Welcome to the ‘soft side’ of analysis.”

There is a hard side, too, however, and it involves delving into Macquarie's $A228 billion ($211 billion) of assets, most of which are housed within 60 specialised funds that provide about a fifth of the group's profits. Twenty of those funds are publicly listed in any of half a dozen different countries. The rest are sold directly to institutions. It is here that short sellers such as James Chanos, an American investor, have focused. RiskMetrics, a risk-management firm, produced a report on April 3rd that revived enduring concerns about the funds' complexity, leverage, ability to cover dividends, and governance.

Macquarie's fund-management approach differs from that of many other global asset managers. It not only handles the funds, but operates the assets they own as well. It buys and sells them, allocates ownership rights to them, structures their finances and has substantial control over the access investors have to any return of their capital. So the funds are like mini-conglomerates run within a giant one. Macquarie can hold onto them for as long, or for as little time, as it likes.

The advantages of this structure for Macquarie are plain. Until last year, when it became a holding company, it was a bank, and it was not allowed to put roads and airports on its balance sheet, because they are not liquid enough. By holding these assets within funds, Macquarie insulates itself from the risk of a market panic.

By using separate funds, Macquarie can also spread its borrowing more broadly, rather than shouldering it at the holding-company level. Individual funds can overcome political hurdles (its business in South Korea is helped by having a special Seoul-listed fund, for instance), and investors can hold assets they want (eg, airports) and avoid others (eg, a bank).

Macquarie believes they are also a fairly stable source of capital for the operating companies. Typically, the unlisted funds are ten-year closed-end investments. Investors can sell, but through the tortuous process of a private sale, rather than through redemptions that would affect Macquarie's liquidity.

Nevertheless, the relationship between Macquarie and its funds is fraught with potential conflicts. As RiskMetrics points out, it could lead to overpayment for assets, fee structures that encourage big investments with lots of debt, and accounting policies that can exaggerate performance. On each count, Macquarie is vulnerable.

Since fees are tied to the size of assets, it makes sense to raise lots of money, pile debt on top of it, and make big acquisitions. The gearing on average is 58% across the funds and acquisitions have been done at far higher leverage. When assets are bought and sold, it often (but not always) receives investment-banking commissions. Management of the underlying assets—the airports and toll roads, for example—generates yet more fees for Macquarie. Payments can be huge. In the most egregious case, RiskMetrics estimates that the Macquarie Media Group, a fund, paid fees equivalent to 10.5% of its assets under management in 2006.

Running on empty?

Dividend payouts are another bone of contention. In most places, by law they must be drawn from profits. But many of Macquarie's funds are incorporated in Bermuda, where it is legal to distribute greater sums than profits alone. Last year the Macquarie Infrastructure Group fund covered only 68% of its payout to shareholders from the cash it received from underlying operations; the Macquarie Airports fund covered 75%. This strategy can persist only with a rising value of the assets, and the cashflows derived from them.

Macquarie says this has happened. But in yet another cause for concern, the entity valuing the assets is Macquarie itself. Some of the methods it has used for triggering a revaluation—such as reducing the rate used to discount cashflows because of a perceived reduction in risk, as it has on Britain's M6 motorway—might seem arbitrary. What if the valuation model is wrong?

A common check on management is shareholder action. But Macquarie has taken care of this pesky detail with a special class of shares that, in effect, ensures it has full control over its funds.

Macquarie is used to accusations that it overpays for assets. In its defence, it has been the underbidder on deals when others have clearly overpaid, sold assets at a profit and made clever acquisitions. A good example is Sydney Airport. In 2002 Macquarie spent $A5.6 billion (of which $A3.7 billion was borrowed) to buy the airport, a deal that produced a roar of disapproval. It came shortly after the World Trade Centre disaster, which battered air travel. Mr Moss was rumoured to be in the ejector seat.

Now Sydney Airport is seen as a coup and Mr Moss is going out on a high, rather than at high pressure. Dividends alone have repaid the equity investors, and earnings before interest, tax and depreciation have soared from $A316m to almost $A600m. The gains have largely stemmed from Macquarie's effectiveness as an operator, bringing in budget airlines, reconfiguring for the Airbus A380 (more traffic) and moving stores to behind the security barriers where (post-9/11) people can shop for longer because of early check-ins. (It has its critics; passengers, for example, hate the expensive luggage trolleys, provided by another Macquarie company.)

That said, credit conditions are now tougher and it has had at least one narrow escape. In May Macquarie led a consortium that failed in an $8.7 billion bid for Qantas, Australia's national airline. Had it won, it would have had to cope with rising fuel costs and falling load factors, not to mention huge debt. But even if conditions worsened, it could cut distributions from the funds (remember, shareholders are locked in). That is not on the horizon. Last year it restructured much of its debt, extending maturities at relatively low rates.

It is also possible that its infrastructure investment will not be dramatically affected by the credit crisis. Macquarie benefits from exposure to Australia and the rest of Asia, which continue to grow. And competitors are trying vigorously to get into the business, which shows that Macquarie is not the only bullish firm. Among the most enthusiastic are pension funds and sovereign-wealth funds, which have low-return expectations and should be formidable competitors. However, Macquarie believes it is a proven operator that has built up a good reputation among governments. It also hopes that tighter budgets may prompt governments to continue to flog assets.

Long-term concerns over Macquarie's model are bound to persist for as long as the world is worried about financing, accounting, disclosure and complex financial structures. Mr Moss's departure raises fears about the future—the price of five-year credit-default swaps has risen much higher than the one-year ones. Yet its investors have little choice but to trust the millionaires on the factory floor—they are tied in anyway. If Macquarie fails, many people will say that it should never have existed. But if it survives, it may say a lot about the value of locking up investors for the long term.