In recent years, Australia has been captivated by the rivalry between Babcock & Brown and Macquarie Group, two investment banks that competed fiercely to make big leveraged investments in infrastructure projects around the globe and mint millions for their partners and shareholders. But the stunning resignations last month of Babcock’s CEO, Phil Green, and executive chairman, Jim Babcock, as well as the decision to drastically scale back the group, have raised serious doubts among investors about the sustainability of both companies’ specialist fund business model.
The Macquarie-Babcock rivalry reached a climax last year when the two companies vied for control of Perth-based energy infrastructure group Alinta. Babcock claimed victory with a complex and highly leveraged bid that valued Alinta at A$13.9 billion ($11.2 billion). CEO Green conceded to Institutional Investor earlier this year that many analysts thought B&B had let its competitive spirit “run away a bit,” adding, “I think that time will show we paid a full price, but not a crazy price.”
Investors eventually took a dimmer view, however. By early last month, Babcock’s share price and that of its two funds involved in the transaction had each lost more than 90 percent from their July 2007 peaks as the fallout from the global credit crisis fanned concerns that the company and its funds would be unable to sustain their high debt loads. On August 21, Green and Babcock, who co-founded the firm in San Francisco in 1977, bowed to investor pressure and resigned.
“We allowed our leverage to get too high in an environment where the market moved very quickly,” says Elizabeth Nosworthy, a director who replaced Babcock as chairman. “The world changed, and we didn’t change quickly enough.”
Now the changes are coming thick and fast at Babcock. CFO Michael Larkin will replace Green as CEO, and B&B will wind down its corporate and structured finance divisions, sack a quarter of its 1,600 staff and focus on infrastructure, property and aircraft leasing.
In effect, Babcock is abandoning the specialist fund model, under which it had reaped lucrative fees by tapping outside investors and raising cheap debt to finance big deals. One fund, retirement home operator B&B Communities, has bought out its management agreement with B&B for A$17.5 million and has effectively put itself on the auction block. B&B Capital and B&B Infrastructure are doing the same, and other Babcock funds are selling assets worth several billion dollars.
“They pushed the model to the limit,” says Ian Macoun, a managing director of Sydney-based Pinnacle Investment Management. “The incentives were not aligned with investors because the incentive of the model was to keep adding assets with more leverage and generate more fees.”
Analysts and investors quickly turned their attention to Macquarie, which invented the specialist fund model. Jonathan Mott, an analyst at UBS, issued a report last month questioning the strength of Macquarie’s balance sheet and its ability to maintain earnings growth, which depends on its capacity for deal-making. The report helped knock Macquarie’s shares down 10 percent in a single day. The stock was trading at A$45 at the end of last month, off 40 percent since the start of the year and 60 percent since July 2007.
At that price, after subtracting the value of its principal investments and banking operations, the market was ascribing zero value to Macquarie’s investment banking business, says Brian Johnson, an analyst with JPMorgan Chase & Co. “It suggests that the Macquarie business model is perceived to be broken,” he says.
Macoun argues that the infrastructure projects should be held by unlisted investment vehicles with a long-term view rather than by listed funds. Macquarie is already moving in that direction. Responding to the poor share performance of one of its listed funds, the company is taking private Macquarie Capital, a private-equity-style fund that owns stakes in car wash operators, telephone directory publishers and nursing home operators, after shareholders approved an A$800 million buyout last month. And Macquarie Airports said it would sell assets to fund a A$1 billion share buyback.
