Babcock's bungled recipe
In its rush to be the next Macquarie, Babcock & Brown overlooked problems with the quality of assets and its own risk management practices. Unfortunately, these were vital ingredients.
New Babcock & Brown chief executive Michael Larkin has neatly deconstructed the group to provide a damning insight into what went wrong in the once high-flying investment bank.
Larkin, who has displaced Babcock CEO Phil Green, says that over the past few years in particular, Babcock had been "very successful at achieving substantial growth based on the high levels of liquidity in the capital markets". This, he said, led to the group becoming too highly leveraged and not sufficiently focused.
He plans to focus capital on sectors where Babcock has a clear competitive advantage in both origination and asset management; to reduce the leverage and risk in the balance sheet; to reduce the level of principal investment; to target a lower return on capital; to adopt a more disciplined approach to allocation of capital and to enhance the alignment of interests between shareholders, investors in Babcock's satellite funds, limited partnerships and other co-investor interests.
Phil Green made no bones about what Babcock aspired to be, nor that after its listing in 2004 it was a real hurry to realise that ambition.
Babcock unashamedly sought to replicate the 'Macquarie Model', but only those parts of the model that made the most money. Babcock was proud of the fact that, for a while at least, its version of the model delivered more millions for its employees than the original 'Millionaires Factory' did for Macquarie Group staff.
In the cheap money, easy money environment of the credit bubble, Babcock's growth was jet-propelled. The key element of the Macquarie Model that it didn't emulate, however, was that group's famed risk management processes and structures.
While it is easy to draw superficial parallels between Macquarie and Babcock and conclude that Macquarie will be the next of the investment banks to come under the same kinds of acute pressures that have overwhelmed Allco, MFS and Babcock and that have destabilised the REITs that share some of the same features as that model, there are some distinct differences.
The most important of them is asset quality. While Macquarie does have substantial leverage within its funds, the quality of the assets in those funds is very high.
The parent organisation isn't highly-leveraged, is very liquid, has diversified income streams and has controlled its own balance sheet exposures to its funds and to principal positions. It also shifted the orientation of the model towards unlisted funds in recent years.
Whether that's sufficient to enable Macquarie to get through this crisis unscathed isn't certain – quality is a relative concept – but it is a significantly stronger and more disciplined organisation than its copy-cats.
Effectively Larkin is saying that Babcock used the cheap debt to go on a spree and buy indiscriminately and opportunistically and without a clear strategy for growth.
Certainly there were elements of simple arbitrage activity in Babcock's approach – buy something income-generating regardless of its fundamentals and lock in a yield differential predicated on lots of cheap credit. The leveraged German apartment joint venture with GPT springs to mind.
Babcock was prepared to punt with its own capital because, in that environment, it had plenty of capital, the downside appeared low and the upside was substantial – in almost every asset class.
The group's preoccupation with generating profit and employee remuneration was not in the longterm interests of the group or its fund investors, who were simply a source of cheap capital in a boom.
If that sounds pejorative, well at one level it is. The Larkin analysis, however, is one that could have been applied to almost any of the 1980s entrepreneurs. It is what happens when capital is cheap and there's profit everywhere. Discipline disappears.
A compounding factor is that the two big listed investment banks most severely affected – Allco and Babcock – were entities in transition from the private businesses that they were until quite recently to listed entities with the governance and controls the market demands and the vulnerabilities the listed environment creates.
What was acceptable, and what wouldn't have been as visible in the private sphere, was very visible in a listed environment and that exacerbated the pressures brought to bear.
Downsizing and focusing Babcock's sprawling and somewhat incoherent portfolio won't be an easy task. There are those who have already written off Larkin's chances of stabilising the group.
Interestingly, however, amidst all the blood and trauma, Babcock announced the appointment of the highly-respected former Westpac chief financial officer, Pat Handley, to the board. With Bob Joss, Handley saw Westpac through its flirtation with disaster in the early 1990s.
Handley, who will be an independent director and chair of the audit and risk management committee – both high-risk roles in a destabilised institution – presumably goes in with his eyes wide open and wouldn't have done so unless he thought Babcock was salvageable.
Larkin, who has displaced Babcock CEO Phil Green, says that over the past few years in particular, Babcock had been "very successful at achieving substantial growth based on the high levels of liquidity in the capital markets". This, he said, led to the group becoming too highly leveraged and not sufficiently focused.
He plans to focus capital on sectors where Babcock has a clear competitive advantage in both origination and asset management; to reduce the leverage and risk in the balance sheet; to reduce the level of principal investment; to target a lower return on capital; to adopt a more disciplined approach to allocation of capital and to enhance the alignment of interests between shareholders, investors in Babcock's satellite funds, limited partnerships and other co-investor interests.
Phil Green made no bones about what Babcock aspired to be, nor that after its listing in 2004 it was a real hurry to realise that ambition.
Babcock unashamedly sought to replicate the 'Macquarie Model', but only those parts of the model that made the most money. Babcock was proud of the fact that, for a while at least, its version of the model delivered more millions for its employees than the original 'Millionaires Factory' did for Macquarie Group staff.
In the cheap money, easy money environment of the credit bubble, Babcock's growth was jet-propelled. The key element of the Macquarie Model that it didn't emulate, however, was that group's famed risk management processes and structures.
While it is easy to draw superficial parallels between Macquarie and Babcock and conclude that Macquarie will be the next of the investment banks to come under the same kinds of acute pressures that have overwhelmed Allco, MFS and Babcock and that have destabilised the REITs that share some of the same features as that model, there are some distinct differences.
The most important of them is asset quality. While Macquarie does have substantial leverage within its funds, the quality of the assets in those funds is very high.
The parent organisation isn't highly-leveraged, is very liquid, has diversified income streams and has controlled its own balance sheet exposures to its funds and to principal positions. It also shifted the orientation of the model towards unlisted funds in recent years.
Whether that's sufficient to enable Macquarie to get through this crisis unscathed isn't certain – quality is a relative concept – but it is a significantly stronger and more disciplined organisation than its copy-cats.
Effectively Larkin is saying that Babcock used the cheap debt to go on a spree and buy indiscriminately and opportunistically and without a clear strategy for growth.
Certainly there were elements of simple arbitrage activity in Babcock's approach – buy something income-generating regardless of its fundamentals and lock in a yield differential predicated on lots of cheap credit. The leveraged German apartment joint venture with GPT springs to mind.
Babcock was prepared to punt with its own capital because, in that environment, it had plenty of capital, the downside appeared low and the upside was substantial – in almost every asset class.
The group's preoccupation with generating profit and employee remuneration was not in the longterm interests of the group or its fund investors, who were simply a source of cheap capital in a boom.
If that sounds pejorative, well at one level it is. The Larkin analysis, however, is one that could have been applied to almost any of the 1980s entrepreneurs. It is what happens when capital is cheap and there's profit everywhere. Discipline disappears.
A compounding factor is that the two big listed investment banks most severely affected – Allco and Babcock – were entities in transition from the private businesses that they were until quite recently to listed entities with the governance and controls the market demands and the vulnerabilities the listed environment creates.
What was acceptable, and what wouldn't have been as visible in the private sphere, was very visible in a listed environment and that exacerbated the pressures brought to bear.
Downsizing and focusing Babcock's sprawling and somewhat incoherent portfolio won't be an easy task. There are those who have already written off Larkin's chances of stabilising the group.
Interestingly, however, amidst all the blood and trauma, Babcock announced the appointment of the highly-respected former Westpac chief financial officer, Pat Handley, to the board. With Bob Joss, Handley saw Westpac through its flirtation with disaster in the early 1990s.
Handley, who will be an independent director and chair of the audit and risk management committee – both high-risk roles in a destabilised institution – presumably goes in with his eyes wide open and wouldn't have done so unless he thought Babcock was salvageable.
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