THE WIZARD OF OZ?
An unconventional Australian investment bank provides a good model for growth and risk management.
By Abe De Ramos

About eight times a year, Greg Ward puts on a tracksuit and races his white Porsche GT3 sports car in rallies across Australia. A relative newbie, the 38-year-old Macquarie Bank CFO has had his share of serious speed bumps, such as the time he took a loose turn and failed to finish a round at a tour in Sydney last June, and then hit a wall at a practice drive in Queensland a month later. Quick to recover, Ward has since finished second in a state championship, and looks forward to the next race as his job allows.

In between, he pumps adrenaline off the tracks, blazing other trails at breakneck speed. In the last six months alone, Ward looked after eight major acquisitions around the world, from a water-distribution facility in the United States to a cable-TV operator in Taiwan. His biggest detour so far has been a very public attempt to acquire a stodgy British institution called the London Stock Exchange. That one failed, but as on the racing circuit, Ward is not harping on the injury. “We’ve moved on,” he says. (See box, “Aussie Shrug for British Snub”)

That probably makes Ward a perfect match for what his employer wants to achieve. Macquarie Bank is known as an investment bank, but that business as we know it accounts for just 35% of revenues. (See chart, this page.) Its range of activities and the speed with which it pursues them make the Sydney-based firm an unorthodox banker. While Macquarie tails bulge-bracket Wall Street players in the race for bond and IPO mandates – it barely ranks in the global league tables – it is busy creating its own business model. If analysts are right, Ward might say next month that nearly half of the bank’s revenues in the just-concluded fiscal year, ending March, came from an asset-management business that invests in ventures its peers once thought had no potential. And it’s a model that’s hard to fault. Merrill Lynch predicts that the bank will post a record A$4 bn (US$2.8 bn) in revenues and A$908m in profits, for a tenth consecutive year of growth since it started the asset-management business in Australia in 1996.

Outside of its investment-banking franchise, think of Macquarie as a private-equity firm that makes old-economy assets look attractive again. Until recently, it was the only investment bank in the world that invested in and managed – on its own and on behalf of clients – toll roads, ports, and airports. Macquarie had been doing it quietly outside Australia in the last few years, but it made a splash last year when its infrastructure assets under management soared to about A$45 bn as of January from under A$20 bn in 2004. It now manages 131 assets in 25 countries, from airports in Europe to hospitals in Canada to tunnels in Korea. Investors don’t normally touch these assets, which are traditionally perceived as low-growth. But Macquarie tells a different story; its listed infrastructure funds have yielded a compound annual return of 19.4% for the last 11 years, outperforming even major stock-market indices.

Banking on infrastructure

In short, Macquarie is building a case on how to grow a new business model – one that worked well in the home market and that it is now rolling out globally. To be sure, it has built a strong overseas platform. In the six months to September, revenues outside Australia were double those from a year ago and accounted for 46% of the total, while international staff grew 32% to over 2,300. But that’s just the beginning. “I see Macquarie as turning into a fully integrated investment bank-slash-infrastructure fund manager,” says Brian Johnson, analyst at JPMorgan in Sydney. In terms of size and profile, “its long-term aspiration is not to be some small Australian investment bank. It’s to be a global presence,” Johnson adds. Ward chooses not to put it that way. “We don’t spend a lot of time focusing on [whether we’re Australian or global],” he says. “We really see ourselves as just a diverse financial institution with a large full-scale business in Australia.”

Nonetheless, Ward is at the nexus of managing this transformation, aiming to reach targets without compromising governance. “The biggest challenge is just making sure that we manage growth carefully,” says Ward. As Macquarie tries to carve out niches in its markets, he also sees the risk that its growing workforce, spread over 23 countries, poses to control – that big book of processes and frameworks that determine how the entire group operates it businesses, from making sure regulations are complied with, to meeting the daily capital requirements of the securities business, to controlling the cash movements in the dealing rooms. “We spend a lot of time thinking about new markets, new transactions, and new products, so we need to get the control environment right at the source,” says Ward, who was an accountant at PricewaterhouseCoopers before joining Macquarie in 1996.

Getting it right from the top is crucial given the risk-management system of the bank. To foster a culture of entrepreneurship, Macquarie gives its business groups a great degree of autonomy in decision-making. “We give people all of the incentives that they would have as owners of the business to grow the business for themselves,” says Nick Minogue, chief risk officer of the bank. “We also require them to own the risks, and they will be visited on their own profit-and-loss account.” But beyond certain levels, a sign-off from Minogue’s risk-management division – there are 225 risk specialists across the globe – is required. Analysts see this balance of centralized and decentralized risk-management structure as one of the engines that drive Macquarie’s growth. “Maintaining this balance will become increasingly challenging – and at the same time important – as the bank becomes ever more diverse and international in its operations,” say analysts at rating agency Moody’s in a report.

A serious lapse in either control or risk management could get in the way of growth, as it could harm Macquarie’s reputation, says John Miles, credit analyst at Fitch Ratings in Canberra. “A lot of the work around the infrastructure model uses the Macquarie name, and there is a potential for contagion should one of these assets encounter difficulties and result in losses for investors,” says Miles. “That could hamper their progress in rolling out the model.” That’s something the bank could not afford to let happen, given that Wall Street has started to copy its business model. If imitation is the greatest form of flattery, then Macquarie’s getting a lot of it from Goldman Sachs, Merrill Lynch, UBS, Credit Suisse First Boston, and Morgan Stanley – each have been reported to be in varying stages of forming their own infrastructure funds. That would mean competition for Macquarie in its search for good assets going forward.

How it works

This is how the infrastructure-fund business model works. Macquarie identifies an asset that fits its investment criteria – whether it’s a toll road or an airport-baggage services provider, it must ideally be a monopoly that brings a steady amount of cash flow. Macquarie acquires the asset and “seeds” it in its balance sheet for a few months – that is, until it has established a trust with a group of investors to whom it would then sell the asset for a profit. In most cases, the bank itself retains a certain amount of equity in the trust, and in all cases it runs the asset by hiring third-party managers. Macquarie gets an annual base fee of 1% to 1.5% of the asset under management. Like any private-equity fund manager, the bank also charges a performance fee – typically 15% to 20% of the upside above a certain benchmark agreed with investors. Stapled with other similar assets, the goal is to then list them under one fund, via an IPO underwritten by Macquarie’s investment-banking business.

The biggest of these funds, the A$9 bn Macquarie Infrastructure Group, for example, is composed of toll roads – among them the M6 Toll in Birmingham in the UK; Dulles Greenway in Washington, DC in the US; and the Western Sydney Orbital in Australia. Listed on the Australian Stock Exchange, the fund charges a base fee of 1.1%, and performance fee of 15% of out-performance against an S&P industrials index. Macquarie currently has 20 listed funds, the latest being the Korea Infrastructure Fund, which includes 13 toll roads and a subway rail project. Established in 2002 as a joint venture with the local Shinhan Bank, the fund was listed on the London and Korea stock exchanges, and raised 492 bn won (US$966m), making it only the second listed infrastructure fund in Asia, after an earlier one Macquarie listed in Singapore.

Since Macquarie funds its seed acquisitions – now numbering 32 – by leveraging its balance sheet, analysts have become concerned that its rapid growth is beginning to stretch both its finances and ability to execute. Macquarie “has dramatically increased its equity exposures through regearing the balance sheet, and despite the continued introduction of new investment partners, the bank is taking longer to on-sell the assets,” says Matthew Davison, analyst at Merrill Lynch. These, he adds, could hurt its return on equity, expose it to interest-rate risks, and reduce its flexibility with regards to future deal flows. Analysts fear that with interest rates on the rise, Macquarie is risking a decline in the value of the assets on its balance sheet.

Miles of Fitch Ratings cautions the bank against further compromising the balance sheet, saying these seed assets – on top of the treasury and derivatives positions of the commercial-banking operation – are what prevent Macquarie from getting a credit-rating higher than the current A-plus. The Moody’s analysts add: “Several such assets are now simultaneously on the books at once, creating significant, although diversified, exposure concentration.” Some individual seed assets have occasionally run up to 10% of capital, they add, constraining the bank’s liquidity. Having so much capital committed to seed assets also limits the potential fees Macquarie could get. Indeed, Ward has warned that there were to be “no significant performance fees” in the second half of the 2006 fiscal year, prompting analysts to adjust their earnings estimates.

Ward brushes off such concerns, saying Macquarie remains financially strong – its regulatory Tier 1 capital, at 13%, is well above the industry average of 7% – and that most of the assets it owns have a natural hedge. “A lot of the revenue is inflation-linked,” he says. “Toll-road charges go up with inflation, while air travel rates are strongly correlated to GDP, so the businesses are themselves quite well-protected.” Likewise, Ward believes that any near-term movement in interest rates will only have a marginal negative impact on Macquarie’s balance sheet – something it has factored into its interest-rate hedging strategy.

“As for the bank’s own borrowing, credit spreads are almost at an all-time low, and that suggests the pricing of risk looks out of step with the historical model,” says Ward. “We would be expecting spreads to go up over time; that will be negative for us, but only marginally.” Johnson of JPMorgan agrees that the interest-rate scenario will not hurt Macquarie over the long term. “To the extent that [higher interest rates] lower future asset values, it doesn’t actually impact the model going forward at all,” he says. “Values of assets will do what they do, provided you buy them at some value relative to what you can sell them at.”

But there is another reason analysts would like to see Macquarie find investors to sell the estimated A$2 bn in seed assets that it currently holds. Competitors, although in their early days, are coming from Wall Street with much stronger brand recognition – and in some cases a higher credit rating – than Macquarie’s. Goldman Sachs, for example, is launching a US$3 bn infrastructure fund. They will be competing for capital for an asset class that has largely been ignored by institutional money. Even pension funds, which are drawn to assets with stable returns, have little exposure to infrastructure: less than 1% of pension assets under management in Europe are allocated for infrastructure, while those in the United States have even more negligible exposure. While the absolute size is big, pension funds have yet to be educated about infrastructure funds.

Ward is undaunted by the threat of competition. “It’s good that the sector is becoming better known,” he says. “That’s a very positive thing, partly because of the flows of money and interest in the sector, but also because we’ll then be able to distinguish ourselves more from our competitors.” He also banks on the fact that Macquarie has a ten-year lead against its peers from Wall Street. The infrastructure group boasts an intellectual capital of 400 specialists, backed by a group-wide advisory team of 500 people whose job is to work on a range of deals around the world.

“It will take people a long time to replicate the extent of investment that we’ve made in this sector,” says Ward. Adds Johnson of JPMorgan: “The bank has got capital for seed assets, but what people forget is that the funds that they own themselves have the power to go and buy assets as well, so they’ve got much more capital power than even the global players at the present time.”

Business tests

Macquarie came up with the idea of an infrastructure fund in 1996 when the Australian government privatized the M2 toll road in northwest Sydney. By then, pension funds had significantly built up their assets, since the government increased the required amount set aside for superannuation in 1992. Macquarie, which was initially approached for a simple project-finance loan, packaged the asset into a separate vehicle and raised equity. “The investor response was quite positive, and there didn’t seem to be any reason why we could not begin to do this for ourselves as a principal,” says Minogue. Since then, Macquarie has diversified its portfolio to include airports, railways, and radio stations.

Moving to other fields was never on a whim. “One of the dangers of the breadth of activity of the bank would be that we’d make a move too far,” says Minogue. “We apply these tests to new businesses and new products: is it something sufficiently nearby to something we already do, and do we have the relevant competency?” As such, before getting into a new sector, Macquarie acquires the expertise to run the business by, among others, buying consulting firms or forming joint ventures with experienced operators. In October 2000, Macquarie bought the UK-based consulting firm Portland Group, 18 months before making its first airport purchase.

This concept of adjacency has been pushed several times, and one of its products is the Macquarie Media Group, which includes some small radio stations in Australia, and most recently, Taiwan Broadband for A$1.2 bn last December. “We did have some discussion as to whether this really fitted the Macquarie model,” says Minogue. “But we concluded that these had protected cash flows with a limited level of competition, and we could make it quite attractive for the same class of investors that we were already servicing in our infrastructure funds.” And what of the hostile bid for the London Stock Exchange? “It looked like an attractive asset at an attractive price, which would make a really good beginning to the idea of a financial-infrastructure class of funds,” says Minogue.

Going forward, Macquarie remains committed to traditional infrastructure assets – not least because they are expected to boom. Infrastructure funds work where governments are willing to establish public-private partnerships (PPP); under the terms of most PPPs, the government grants the private enterprises the concession to operate an asset for a certain number of years. Many in Asia and Europe have cottoned on to the idea, but to date, most of the private partners are infrastructure operators, as opposed to fund managers.

But regulations are changing across the world. Twenty-three US states have already enacted PPP-enabling legislation, and some have been quick to adopt it. Last year, Macquarie bought the Chicago Skyway with Spanish operator Cintra for US$1.83 bn, and the two have been named as preferred bidders for the US$3.85 bn Indiana Toll Road highway. In Europe, consulting firm John Laing estimates that 14.7 bn euros (US$17.7 bn) worth of projects are currently in tender and at the pre-approval stage. Asia, however, will remain a tricky area for Macquarie, save for the developed markets of Korea and Japan, both OECD governments that have shown their PPP commitments by rolling them out consistently, as opposed to one-shot deals.

Why not Asia?

Explaining why only 4% of Macquarie’s specialist-fund assets are in Asia, Ward says: “The major assets today have been in markets that have a high level of privatization and a high degree of sophistication in terms of legislation.” He also laments that some Asian countries restrict insurance companies, who are among Macquarie’s target investors, from investing in such assets. In Indonesia, for example, the Asian Development Bank estimates that only 2% to 4% of non-banking institutional funds can be tapped to finance infrastructure development, in spite of an estimated US$78 bn gap in funding needed to meet the country’s infrastructure demands until 2009. “It requires political will to involve the private sector,” says Ward.

A promising market for Macquarie in Asia is China, where it has bought retail property assets, as well as a river port – driven by investor demand. “We’re especially focused on the infrastructure and property side in China,” says Ward. “We’re not so focused on [underwriting] every IPO that comes out of that market; particular sectors like water will be very interesting.”

The bank’s investments are done separately by Macquarie’s specialist property funds, which are also looking to participate in the growing real-estate investment trust market in the region. Under a REIT structure, a property manager pools various assets and raises capital, promising to pay investors dividends from leases on those properties. “We’re seeing it a little bit in Hong Kong, Singapore, Japan, and Korea, but we think this will be quite important in Asia,” says Ward. Doing this, Macquarie already has a good platform with its 400-strong securities team in the region, following its buyout of the Asian equities business of ING Bank in 2004.

For now, other than the risks associated with Macquarie’s increasing holding of seed assets on the balance sheet, which affects the bank’s liquidity, analysts have few reasons to be skeptical of the bank’s capability to roll out its model globally. “They’re good at selecting quality assets, and also at managing them, which is reflected in their ability to consistently generate a good level of fee income from these management roles that they take on,” says Miles of Fitch Ratings.

Still, Johnson cautions the bank against hubris. “These guys have done remarkably well, and when you do incredibly well, you start to cut corners and don’t look at deals strongly enough, so you lose control over the business or pay too much for an asset.” Analysts at Moody’s note that the key challenge Macquarie now faces is its ability to contain operational risk, but they conclude: “We see the downside risk as low.” Provided that Macquarie doesn’t somehow take a loose turn.