A toll tale

Allan Moss, the chief executive of Macquarie Bank, dislikes corporate labels. "If a label exists, it does so because there is an existing business model that it describes," he tells Institutional Investor. "We really don't want to be doing things that others are already doing. We want to do something different."

Macquarie indisputably does do something different. The Australian bank controls and operates a global portfolio of infrastructure assets, ranging from the Chicago Skyway to the Sydney Airport to the U.K.'s M6 tollway to South Korea's Incheon Grand Bridge. In all, the Sydney-based bank and its dozen infrastructure funds own A$48.5 billion ($36 billion) of roads, airports, power stations, broadcast towers, ferryboats, parking lots and more -- hundreds of facilities around the world.

Undoubtedly the most high-profile of all Macquarie's deal-making efforts, though, was its audacious £1.5 billion ($2.6 billion) bid for the London Stock Exchange, which it wound up abandoning on February 21. Macquarie viewed the exchange as simply a financial-infrastructure asset and balked at upping an offer that the LSE had dismissed as derisory. Gossip in the City of London about the upstart bank and its unusual business model, which relies on bidding aggressively for assets and collecting steep fees, helped to unsettle Macquarie's share price and those of its specialized infrastructure funds. That may have had as much to do with the bank's decision to withdraw the bid as the strenuous opposition of the LSE. In any event, the market was relieved at the bank's retreat; Macquarie's share price rose 5 percent in one day.

"It was a positive inference on the discipline with which they invest," says John Gethin-Jones, general manager of global equities for Sydney-based Queensland Investment Corp. "The opportunity arose, and to their credit they walked away from it."

CEO Moss is not troubled by the market's intermittent misgivings about Macquarie. "It's a feature of this business that there will be times when listed funds will be subdued in price even though the business is going really well," he contends.

No other bank does anything quite like Macquarie, though a number are trying to imitate it. The bank's modus operandi has been to use borrowed money, mostly bank debt, to buy long-term concession rights to public facilities, then stuff those into one of its infrastructure funds and either take the fund public or sell shares in it privately.

The stable 10 to 15 percent returns on Macquarie's funds have been a godsend to yield-starved investors. Over the past decade the bank's portfolios have on average done three times as well as the typical Australian stock. And at every step of the process, Macquarie harvests fees, including a hedge-fund-like 20 percent incentive premium on returns above a benchmark. UBS estimates that the funds will spin off management fees for the bank in the fiscal year ending March 31of A$360 million and transaction fees (for buying and selling assets and underwriting and managing share issues) of a further A$401 million.

Perhaps not since 1851, when Edward Hargraves discovered a grain of gold in a Bathurst waterhole in New South Wales and set off the Australian gold rush, has the Lucky Country witnessed so lucrative an endeavor. Macquarie expects to only "slightly" beat last year's record profits of A$823 million on revenues of A$4 billion in its current fiscal year; over the past five years, the bank's profits have quadrupled.

Its market capitalization, meanwhile, has surged from A$1.3 billion ten years ago to A$14.6 billion as of February 24. And Macquarie's stock price has soared 900 percent, to A$62.70, since the bank went public in July 1996.

At least until February 1, the stock price had soared during recent years. That was the nervous-making day when Macquarie --Macbank to Australians -- informed investors that its investment banking unit would collect no "significant" performance fees from its nine chief infrastructure funds for its fiscal year's final six months; seven of the funds had underperformed their benchmarks in a climate of rising interest rates in the fourth quarter, the bank said, and would have to make up the deficit before performance fees kick in.

The drop-off in fees was jarring to investors, but at least it had been hinted at earlier by Macquarie. More unsettling was the bank's disclosure that it would be pushing some crucial deals for its funds into the following fiscal year -- most notably, initial public offerings of explosives maker Dyno Nobel's Australia assets and of the Macquarie Korea Infrastructure Fund. For shareholders accustomed to being happily surprised by ever-better results -- the bank's stock rose 70 percent in the 15 months through November -- the news was a jolt. Macquarie's stock dropped 7 percent in that day's trading.

Is the gold rush over for Macquarie? THERE are some worrying glimmers of pyrite in the bank's once-dependable lode. Interest rates are creeping upward, meaning not only that Macquarie must pay more for its financing but also that bonds offer investors a more competitive return. The bank may be tempted to buy assets faster than it can recycle them. "I'm concerned Macquarie could overpay for assets, as the base fees are a motivation to buy more assets," says Anton Tagliaferro, investment director of Investors Mutual, a Sydney-based money management firm.

In December the bank had to postpone the IPO of Macquarie International Real Estate Fund in Singapore, saying conditions weren't right. Meanwhile, becalmed markets have put a damper on its derivatives and stock trading operations. Only Macquarie's property division, which manages A$26 billion of real estate, and its pension fund operation, which manages A$47 billion in assets, are expected to report profit increases for the six months through March 31.

Perhaps more ominous, competition from other banks entranced with Macquarie's business model is growing. Goldman, Sachs & Co. is said to be raising $3 billion to stick into infrastructure deals. Australia's Babcock & Brown, Allco Finance Group and Challenger Financial Services Group, which have leasing and investment expertise, are working up similar models.

Macquarie CEO Moss, however, doesn't see any bank doing what his does in any comprehensive way. "If I were associated with management of a Wall Street firm, I wouldn't be seeking to emulate the model of Macquarie Bank," he says. "They are outstanding organizations with wonderful franchises that are very successfully serving traditional markets. The markets we operate in, although in some cases substantial in relation to the Australian market, are nevertheless niche markets by global standards."

Still, for a niche bank, Macquarie has attracted a lot of international attention -- not all of it flattering. Some mishaps have dented the bank's aura of invincibility. For instance, Macquarie suffered a security breach on an Australian Defense Department contract, prompting Canberra to snub it for a role in the further privatization of the country's largest telecommunications group, Telstra Corp., according to analysts. Macquarie is not one to sulk over setbacks. And although its infrastructure-investing formula may not be foolproof -- the bank has had manageable reverses in fiber optics and utility deals -- the model remains basically sound. Macquarie's host of imitators suggests as much. "It's very easy to paint a pessimistic picture," says J.P. Morgan & Co. banking analyst Brian Johnson. "But I'm very confident that the model is not broken."

There was a time when the company labels that CEO Moss so disdains were not an issue for Macquarie. The bank began life conventionally enough in 1969 as the Sydney-based Australian subsidiary of British merchant bank Hill Samuel & Co. Moss joined in 1977, after business school. For much of the 1980s and into the '90s, Macquarie -- the bank changed its name in 1985 after it took out a banking license -- was a plain-vanilla investment bank competing successfully against local subsidiaries of Wall Street and European giants.

But the bank's thrust changed in the early 1990s, first with its success in real estate investment trusts and then, dramatically, with its bright idea for financing construction of Sydney's M2 motorway. The government had called for a competitive tender, and Macquarie came up with the odd notion of paying for building the road through an IPO -- Hills Motorway. It was the first time anywhere that such a proposal had won a tender for an infrastructure project.

Moss says the deal was the trigger for the bank's first fund -- Macquarie Infrastructure Group -- launched in 1996. That toll-road fund would supply the schematic for a new form of investment banking that allowed Macquarie to reap fees for originating, underwriting, financing and advising on a deal and to pick up more fees for managing the asset through a fund.

Today, Macquarie -- part investment bank, part fund manager and part facilities superintendent -- is the biggest toll-road operator in the world as well as the biggest private investor in airports. CEO Moss, though, balks at the conglomerate label. How about federation of entities? "That's a good description," says the 55-year-old Harvard Business School honors graduate (class of '77). "In many respects it is a federation because we do work to provide a home for entrepreneurial activity, and there are some rules along with being part of the federation, particularly the observance of risk management."

On its home turf Macquarie still bears many of the hallmarks of a traditional investment bank. In fact, it ranks as Australia's largest investment bank; the No. 1 brokerage; one of the top two M&A advisers; and one of the top three pension fund managers. It also has an extensive treasury and commodities trading business. Yet it is those infrastructure funds that make Macquarie as indigenous to Australia as the kangaroo.

To understand Macquarie's approach to finance, consider the origin of the bank's logo -- a stylized version of a coin known as the "Holey Dollar." In 1813, Lachlan Macquarie, the governor of the then­British penal colony of New South Wales, was confronted with an acute currency shortage. So he purchased Spanish silver dollars worth five British shillings apiece and ordered their centers to be punched out, thereby creating two coins. The Holey Dollar was still valued at five shillings, while the "Dump" -- the hole-in-the-doughnut slug -- was worth one shilling and three pence. In a stroke, Macquarie had doubled the coins in circulation and increased their worth by 25 percent.

That simple but ingenious act of financial engineering is still much admired at the bank named after the governor. Innovation is a trademark of Macquarie.

"We'd much prefer to sit back on Wall Street and do IPOs and get 6 percent fees," Nicholas Moore, Macquarie's head of investment banking, says slyly. "Sadly, God has deemed that that is not our business, so we've got to do the hard stuff."

The originator of, and now the driving force behind, Mac's infrastructure initiatives, Moore, 47, has been with the bank since 1987 and is as brash as Moss is reserved. He notes that the business models of most investment banks encompass a spectrum that goes from ideas to brokerage activities to mergers to equity capital markets, all accompanied by a rising scale of fees.

"That is the traditional investment bank view of the world," he says. "What makes us different is that we add the capital on the right-hand side."

The bank's own gold rush began in 2001 when Macquarie made the strategic decision to raise A$500 million through a rights issue so it could accumulate businesses to use as seed assets for its funds. "It was an important part of our strategy to expand the specialist funds business," explains Moss. "And we felt it would be helpful to be able to buy seed assets before the establishment of new funds, rather than having to establish funds and then look for key assets."

How the Macquarie model works can be illustrated by a typical deal. In December 2004 one of the bank's listed funds, Macquarie Communications Infrastructure Group, led a consortium that bought British cable company NTL Group's broadcast-transmission business in the U.K. for $2.47 billion. Macquarie picked up £16 million in advisory fees and shared in A$47 million of underwriting fees when the communications fund raised A$920 million through a rights issue to pay for its share of the equity component. Mac Comm took a 54 percent stake.

The bank also collected A$25 million in management fees that year for running the fund. And when Mac Comm, helped by earnings from the NTL business, outdid its benchmark, the Australian Stock Exchange's all-industrials index, Macquarie pocketed 20 percent of the overage, or A$85 million in performance fees.

As an example of how the bank's fee machine works, Moore likes to cite the activities of Macquarie Capital Alliance Group, a so-called cashbox, or public investment, company that Macquarie arranged to list on the Australian stock market in April 2005, after it had raised A$1 billion. The creation of Macquarie Capital has crucially relieved pressure on the bank's own balance sheet.

Teaming up with Macquarie Bank, which retains a 10 percent stake in it, Macquarie Capital has purchased European directories business YBR Group, BBC Broadcast (rebranded Red Bee Media) and nursing home operations in Australia and New Zealand. Macquarie Bank will pick up an annual base management fee of 1.5 percent from Macquarie Capital and a performance fee of 20 percent of all gains above that of the S&P/ASX200 accumulation index.

All this activity, however, has prompted critics to speak of a deal-making frenzy. Macquarie, they say, has been too aggressive, paying top dollar and grabbing whatever appears on its radar screen. Moss and Moore contend that this accusation is simply misguided, and they cite in their defense a deal that the bank's detractors hold up as glaring proof of Macquarie's excesses: the Chicago Skyway.

In January 2005, Macquarie Infrastructure Group and a partner, Spanish tollway operator Cintra Concesiones de Infraestructuras de Transporte, handed Chicago a check for $1.83 billion for the toll road. The price that the bank was willing to pay in a sealed-bid auction left not just rival bidders but also city officials dumbstruck. The latter had been hoping for $1.2 billion at the very most for a road that produced only about $43 million a year in toll revenue. A consortium that included two Toronto-based companies, Borealis Infrastructure Management and Canadian Highways Infrastructure Corp., offered just $701 million; Spanish toll-road operator Abertis Infraestructuras bid even less -- $505 million.

The Chicago City Council's finance committee chairman, Edward Burke, described the Macquarie deal as the greatest single financial coup in the city's history and the biggest windfall for an American city since "Manhattan was sold to the Dutch for 60 guilders."

Why such a steep price? "We won because we had the highest price; it's not very subtle," says Moore. "But how do you get to a higher price? You can be just foolish and pay more than everybody else. What we do is do more work than anyone else. We don't just put two investment bankers on a deal, we put 40. We'll address all the risk aspects and come up with a view on all of them -- on whether they are acceptable -- and price them."

In any case, notes the investment banker, the equity component of the Chicago Skyway deal was small. "We've raised more debt for this than the other people bid for it, which is quite extraordinary," he says. "We wouldn't say that they didn't know what they were doing, but the evidence is that they weren't serious. When we approach a deal, we approach it on the basis of being deadly serious." Macquarie Infrastructure Group paid $397 million in equity for its 45 percent stake but got back $168 million last August when it refinanced the debt portion.

Macquarie cut salaries, upped tolls and introduced electronic tolling, reducing traffic backups and encouraging more users. Average daily toll revenue is up 65 percent. The fund says the Skyway's earnings before interest, taxes, depreciation and amortization was ahead 40 percent in the six months ended December from the like period in 2004.

Macquarie executives are adamant that if they sometimes pay far more than other bidders, it is because they understand infrastructure better. "Industry knowledge is of absolutely fundamental importance and the key to our success," says Moss. Moore adds that Macquarie assigns nearly 400 people to managing infrastructure assets. "That's a huge number," he says. "If you ask Kohlberg Kravis Roberts & Co., they have about 57. If you ask [other buyout firms], they've got 20 to 30. We're happy to hire the best and the most."

Moore and Moss cite Sydney Airport as an instance of applied acumen paying off. Macquarie and its co-investors forked over A$5.6 billion for the facility in 2002, and skeptics quickly derided the purchase as vastly overpriced, especially because SARS, terrorism and a global recession were rattling the aviation industry. Shares in Macquarie Airports, the fund created and taken public in April 2002 to handle Sydney and other airport deals, initially slumped by more than 60 percent. From March to September of 2002, the bank's own share price slid by more than half, as investors fretted that Macquarie had paid too much and couldn't sustain its fee-driven business model.

Yet even at the worst of the aviation slump, Macquarie was able to extract double-digit profit growth from Sydney Airport by cutting costs and lifting revenues from ancillary businesses, such as shops, on-site property development and parking lots. Flying into Sydney is now like visiting a mall with airplanes. Over the past three years, the airport's pretax earnings have increased by more than half, to A$493 million in fiscal 2004­'05. Macquarie Airports' 54 percent stake in Sydney is worth twice what the fund paid for it.

The airport may have been the biggest infrastructure investment in Australia, points out Macquarie Airports CEO Kerrie Mather, but it was poorly understood by investors. "It was a new asset class," she says. "There was no analyst coverage for the stock, and we had to do a significant amount of communication to explain its merits."

Mather says Macquarie Airports' portfolio -- which now also includes the Rome, Brussels and Copenhagen airports -- has returned pretax profit growth of 15 percent per year since its April 2002 IPO, compared with 5 percent on average for other leading European airport groups. Her team of 50 specialists encompasses experts in airport marketing, traffic forecasting, property and regulation and planning. "We're very active managers," she says. "That's why we like to have majority control."

Moss is satisfied with, but not surprised by, Sydney Airport's success. "Despite the challenges and skepticism," he says, the airport "performed pretty much as we expected, and it is recognized by analysts everywhere as an outstanding investment. Some people reacted to the high price, but their knowledge of the asset was superficial."

Can the same perhaps be said of investors' grasp of Macquarie? "While there was an infatuation with growth stocks and then technology, the market didn't pay too much attention to boring old toll roads," says Moore of the bank's hard slog raising funds in the early days. When investors weren't indifferent, they tended to be incredulous. "We had this wave where we would go to the markets and people would say: 'This time they really have gone too far; it doesn't make sense,'" the investment banker recalls. "We're kind of used to this."

Success, of course, is the best sales pitch. The triumphs of Macquarie-backed toll roads and other projects, despite their detours and potholes, have helped the bank master the art of selling arcane infrastructure-financing concepts to a leery market. Do not, however, discount good timing and sheer luck. In Australia, critically, the bank has been able to cash in on a government-mandated retirement scheme set up in 1992 that requires employers to invest 9 percent of their employees' salaries in pensions, making for a national nest egg of nearly $600 billion that grows by $70 billion to $80 billion a year.

"There is no way in the world in a market where capital was short, where the market was based on bonds and indexing, that we could ever have built this business," acknowledges Moore. "It's based on investors who are sophisticated, open-minded and who have the time to put into new investment categories."

So the foundation was laid, but Macquarie built its financial equivalent of a remunerative toll road through performance. The bank says its infrastructure and property funds have had an average cumulative return of 151 percent over the past five years.

Those sorts of gains have won over many a hesitant investor. Peter Morgan, co-founder and investment director of Sydney-based asset manager 452 Capital, is a onetime critic of the bank's approach who now concedes that it has produced good returns. He became a Macquarie shareholder. Nevertheless, he has lately grown concerned about the stock's valuation and has begun to sell his shares.

"It's not to say we were right or wrong" about the stock, Morgan emphasizes. "But we made the decision to sell based on fundamentals and Macquarie's increasing risk profile. Just by definition, the more they pursue overseas assets, the more they lift their risks."

Rob Patterson, who manages A$3 billion in Australian equities at Adelaide-based Argo Investments, says he has 10 percent of his portfolio in Macquarie and its satellite funds. "We have been a shareholder from the start," Patterson says. "We can't afford to sell any because the tax man will have a field day." (Australia's capital gains tax is 33 percent.) In any event, the portfolio manager is not that worried about Macquarie. "Frankly," he says, "the share price movement has been an overreaction. Having said that, the outlook for performance fees from the Australian managed vehicles is looking bleak. But Macquarie doesn't rely on performance fees; they are just the cream on top."

UBS's profit forecast for the bank would seem to confirm this observation. The Swiss bank predicts that in the fiscal year that starts April 1, Macquarie will earn zero performance fees but that its management fees will rise by 23 percent, to A$444 million, and its transaction fees by 50 percent, to A$646 million. So total fees will climb to A$1.09 billion from UBS's estimate of A$934 million for the fiscal year just concluding.

J.P. Morgan analyst Johnson regards Macquarie not so much as a conventional investment bank but rather as an infrastructure investor/growth company. On that basis, he argues, it warrants a share valuation of A$130 -- nearly double the current price; as an investment bank, he says, it's worth only A$65.

"Quite apart from the performance and management fees," Johnson explains, "the specialist-fund model creates a circle of internally generated deal flow in the advisory, equity and debt functions and an earnings sustainability that is not likely evident for other global investment banks."

What concerns some investors is the sheer scale of the business Macquarie is building. For one thing, they worry that the bank will be pushed into bidding ever-higher prices as it strives to maintain its growth rate. Moss and Moore, however, counter that their successful bids represent only a fraction of all infrastructure activity. Moore reckons that Macquarie lands only one in three of the deals it examines. Adds Moss, "What people don't see is all the transactions we withdraw from, and they rarely see all the transactions we lose because we have been outbid." The London Stock Exchange is surely exhibit No. 1, but Macquarie also dropped out of the bidding in December for the Budapest Airport.

Nor do Moss and Moore see much evidence of heightened competition for assets. Although more private equity players have entered Macquarie's domain, they are often in different industries and have different motives. "We have a buy and a hold strategy in almost all of our funds," says Moss. Even when Macquarie bankers do cross paths with private equity players, it's rarely the same group twice.

The banker also points out that the supply of business opportunities looks promising; UBS puts the global infrastructure market at more than $17 trillion. The Chicago Skyway transaction has helped put privatization of toll roads and turnpikes firmly onto the public policy agenda in the U.S., notes Macquarie Airports' Mather. (Macquarie Infrastructure Group and Cintra said in January that they will pay $3.85 billion for the 157-mile Indiana Toll Road, which connects to the Chicago Skyway.) Mather points out that there's a long queue of airport deals lined up to take off in Europe.

Asia, with its massive infrastructure needs, also beckons. For instance, in the late 1990s South Korea ordered up a bunch of toll roads and invited foreigners to help finance them. Macquarie teamed up with the country's Shinhan Bank to create a first-of-its-kind road fund that is slated to be listed on the Korean Stock Exchange imminently. Analysts expect it to raise approximately $500 million.

Meanwhile, Macquarie is constantly looking for businesses that will fit its model. Its August 2005 purchase of BBC Broadcast "didn't come from me or from someone sitting in the bath shouting 'Eureka,'" says Moore. "It came from a guy on the ground, rattling around the industry, looking at cable one day, towers the next and saying, 'Hang on, there's a function here no one has looked at.'" Moss agrees that the bank is developing a wider concept of "privileged assets" -- those that enjoy limited competition and have a steady cash flow. "Our list of industries is somewhat longer than it used to be, but it is still quite a focused business," he says.

The prospect of continued rapid growth doesn't faze the CEO, who joined Macquarie's predecessor, Hill Samuel's Australian operation, in 1977 when it had 50 employees; the bank now has 7,500.

"We're used to managing growth," Moss says. "Our advantage is, we have a niche strategy, and we're used to rolling the model out. In some respects it is actually easier than it used to be, because we have so many resources and such a well-established process."

Indeed, Moss has the freedom to sit around and cogitate about risk. The CEO reports that he spends the majority of his day doing precisely that: assessing the perils, for instance, of introducing this or that product, running various scenarios to test their potential harm to the bank's balance sheet. Each day he receives a report on how Macquarie would fare if the markets were to abruptly drop 40 percent.

"We have a philosophy -- freedom within boundaries -- which means that we seek to control a relatively small number of parameters, and they are mostly about risk: credit risk, market risk, brand and reputation risk and operational risk," explains Moss. "We seek to give as much operational freedom as we can, and we try to provide an environment that is conducive and supportive of entrepreneurial activity. It's not an environment where a lot of black-and-white direction is given, but we work hard to control risk." He says a recent futures-trading infraction for which the bank was fined A$200,000 was "very disappointing" but that it does not stem from "something about our cultural controls."

Neither Moss nor Moore likes to be a meddlesome manager. "When I get involved it's not a question of knocking deals back, because mostly people knock back their own deals where that's appropriate," Moss says. "I get involved in a dialogue that is not a black-and-white, yes-or-no decision. It is often a question of considering under what condition we would be able to do a deal."

"Allan, to his credit, has given people their rein within boundaries and asked them to create profit for the organization and to be accountable," says 452 Capital's Morgan. "Some CEOs don't do that. Some want to take all the glory."

Moss prefers to reflect it downward. Asked to paint a picture of Macquarie's future, he demurs. "Where we go next will be a function of the collective efforts of the Macquarie team," he says. "I hope it develops in an unpredictable way, because one of the secrets of success is doing things that are different and therefore difficult to predict." And which don't come with those pesky labels.