Babcock & Brown inferno turns up the heat * Ian Verrender * June...

Babcock & Brown inferno turns up the heat

* Ian Verrender
* June 14, 2008


In his more wistful moments, Phil Green may be given to reflection on the fickle nature of stockmarkets and human behaviour in general.

A year ago, the Babcock & Brown boss was feted as a financial alchemist, constantly under the pump from punters pressuring him for information on his next big deal.

Now, as fires rage across the B&B empire, those same people are demanding to know when he will sell the next big asset, and how he will ever refinance the $46 billion debt that ignited the flames in the first place.

Phil Green, his company and his business model are seriously on the nose with investors. And the banks don't much care for him either, given one of the promises he made when he borrowed a lot of that cash was that the share price of the parent company wouldn't fall below $7.50.

On Thursday it dropped to $6.90, off 27.5 per cent on the day. Yesterday it crashed again, falling as low as $4.70, as fears gathered pace that its business model was fundamentally flawed.

Babcock & Brown is often referred to as the Macquarie Mini Me, largely because it has adopted what's known as the "Macquarie model".

So is the model dead? For Babcock & Brown almost certainly, although at the moment it's being preserved with liberal doses of formaldehyde.

For Macquarie, probably not, but there's only a faint heartbeat, and the patient will undoubtedly require radical surgery for any hope of survival.

Macquarie, too, has been hammered, although not to quite the same extent as Babcock & Brown, because while it has the same problems Macquarie has more options on how best to escape the inferno.

At its simplest level, the model involves buying assets like roads and airports, and then loading them into a tax-effective trust structure that delivers solid and steady returns. Mostly those trusts were listed separately on the stock exchange.

Macquarie perfected the structure - or rather worked out how best to gouge vast amounts of money from it. There were fees for finding the asset, fees for financing the purchase, fees for floating the trust, fees for managing the trust, fees for running the assets.

So why would anyone invest in these things? Because they paid handsome dividends. The only problem was that the dividends weren't real. Macquarie, B&B, and groups like MFS figured out a neat little trick. You simply told the auditors each year that the assets were worth far more than this time last year. And then you went along to the bank, borrowed more - not forgetting to pick up a fee for organising the loan - and paid that big dividend out of the extra debt.

That no longer works. Asset prices are falling. In fact, it's worse than that. The banks have stopped lending, so there are precious few buyers for any major assets at all.

Green and his senior executive team were busy this week dousing the flames with lines like: "The fundamentals of our business haven't changed."

Unfortunately, they're wrong. The fundamentals have changed. This is a bear market and the model - as applied by Macquarie and B&B - is a bull market invention.

As Babcock's share price plunged again yesterday, traders were running the sums on whether this had created an opportunity to buy.

With its share price at just two times earnings - making it one of the cheapest stocks on the market - there were plenty of brave souls who decided to take the plunge. But the problem with B&B is that its earnings are unsustainable, which puts a serious question mark over the validity of the price-earnings ratio.

B&B is a group that has relied on doing huge one-off deals for income. Those deals just aren't around any more, despite a $7.5 billion deal yesterday to buy a UK railway operator. B&B has bought that from the Royal Bank of Scotland - a bank with its own serious problems.

Macquarie is in a similar position, except that it has a far more diversified business. In addition to its specialist funds, Macquarie runs a huge international investment bank.

Until now, both B&B and Macquarie have adopted similar strategies to contain the damage. Both parent companies have poured hundreds of millions of dollars into buying units in their listed funds to prop up the prices.

But there is only so long you can continue doing that before you run short of cash. And when market sentiment turns against you, it can be like throwing money into a bottomless pit. B&B has been doing just that with some of its funds like B&B Capital, which owns eircom, the Irish telecommunications company.

It may well be that Macquarie has a completely different motive. Macquarie has a new chief executive, Nicholas Moore, who - unless he can pull a rabbit out of the hat - will be the first chief executive in the group's history to report a drop in profit.

That rabbit may involve privatising Macquarie's own listed funds, repackaging them and selling the assets all over again in unlisted vehicles.

Take Macquarie Infrastructure Group. It yesterday closed at $2.89, a price that was just five times earnings. But the assets alone within MIG are worth $4.50 a unit. Imagine the temptation. Moore, the compulsive deal-doer, may just find the idea irresistible.

But if he does, he will be presiding over the funeral of the "Macquarie model".