Thursday, March 30, 2006

Too sexy

In the prior post, I mentioned the "Macquarie model", and Jeff Mathews' and Alan Kohler's take on it. In this post I extend the discussion into this sexy model.

The engine of this humming little sexy model is the ability to syphon off fees from every conceivable angle. It is user pays run rampant. The bank gets fees going into the deal, during the term of the deal and going out of the deal. They don't have to make a zack on the selling price (though that doesn't stop them from trying), because their main course is the fees.

When they acquire an asset, such as a toll road, they "package" the asset, set themselves up in a management facility, do the contract between the asset package and the management facility that sets their own fees, and often provide for a fabulous payout should the asset owners decide to sack them. Oh, and they get performance fees. They are getting hedge fund payments for running a municipal road.

As it works, most of the fees they pull out of a project are front loaded; they're no strangers to the present value concept. So, once a project "matures" they bail out. Then they move on to more assets. It's a great little earner for them, and a means to part pensioners, mainly, from their pension returns.

In explanation of that last statement, let me go back to the "friction" concept the Warren Buffet recently wrote about and which was discussed in Skim, scheme, scam and some Greek letters. This is how Buffet tells it:
How to Minimize Investment Returns
It’s been an easy matter for Berkshire and other owners of American equities to prosper over the years. Between December 31, 1899 and December 31, 1999, to give a really long-term example, the Dow rose from 66 to 11,497. (Guess what annual growth rate is required to produce this result; the surprising answer is at the end of this section.)

This huge rise came about for a simple reason: Over the century American businesses did extraordinarily well and investors rode the wave of their prosperity. Businesses continue to do well. But now shareholders, through a series of self-inflicted wounds, are in a major way cutting the returns they will realize from their investments.

The explanation of how this is happening begins with a fundamental truth: With unimportant exceptions, such as bankruptcies in which some of a company’s losses are borne by creditors, the most that owners in aggregate can earn between now and Judgment Day is what their businesses in aggregate earn. True, by buying and selling that is clever or lucky, investor A may take more than his share of the pie at the expense of investor B. And, yes, all investors feel richer when stocks soar. But an owner can exit only by having someone take his place.

If one investor sells high, another must buy high. For owners as a whole, there is simply no magic – no shower of money from outer space – that will enable them to extract wealth from their companies beyond that created by the companies themselves.

Indeed, owners must earn less than their businesses earn because of “frictional” costs. And that’s my point: These costs are now being incurred in amounts that will cause shareholders to earn far less than they historically have.

To understand how this toll has ballooned, imagine for a moment that all American corporations are, and always will be, owned by a single family. We’ll call them the Gotrocks. After paying taxes on dividends, this family – generation after generation – becomes richer by the aggregate amount earned by its companies. Today that amount is about $700 billion annually.

Naturally, the family spends some of these dollars. But the portion it saves steadily compounds for its benefit. In the Gotrocks household everyone grows wealthier at the same pace, and all is harmonious.

But let’s now assume that a few fast-talking Helpers approach the family and persuade each of its members to try to outsmart his relatives by buying certain of their holdings and selling them certain others. The Helpers – for a fee, of course – obligingly agree to handle these transactions.

The Gotrocks still own all of corporate America; the trades just rearrange who owns what. So the family’s annual gain in wealth diminishes, equaling the earnings of American business minus commissions paid.

The more that family members trade, the smaller their share of the pie and the larger the slice received by the Helpers. This fact is not lost upon these broker-Helpers: Activity is their friend and, in a wide variety of ways, they urge it on.

After a while, most of the family members realize that they are not doing so well at this new “beat my brother” game. Enter another set of Helpers.

These newcomers explain to each member of the Gotrocks clan that by himself he’ll never outsmart the rest of the family. The suggested cure: “Hire a manager – yes, us – and get the job done professionally.” These manager-Helpers continue to use the broker-Helpers to execute trades; the managers may even increase their activity so as to permit the brokers to prosper still more. Overall, a bigger slice of the pie now goes to the two classes of Helpers.

The family’s disappointment grows. Each of its members is now employing professionals. Yet overall, the group’s finances have taken a turn for the worse. The solution? More help, of course. It arrives in the form of financial planners and institutional consultants, who weigh in to advise the Gotrocks on selecting manager-Helpers. The befuddled family welcomes this assistance. By now its members know they can pick neither the right stocks nor the right stock-pickers.

Why, one might ask, should they expect success in picking the right consultant? But this question does not occur to the Gotrocks, and the consultant-Helpers certainly don’t suggest it to them.

The Gotrocks, now supporting three classes of expensive Helpers, find that their results get worse, and they sink into despair. But just as hope seems lost, a fourth group – we’ll call them the hyper-Helpers – appears. These friendly folk explain to the Gotrocks that their unsatisfactory results are occurring because the existing Helpers – brokers, managers, consultants – are not sufficiently motivated and are simply going through the motions. “What,” the new Helpers ask, “can you expect from such a bunch of zombies?”

The new arrivals offer a breathtakingly simple solution: Pay more money.

Brimming with selfconfidence, the hyper-Helpers assert that huge contingent payments – in addition to stiff fixed fees – are what each family member must fork over in order to really outmaneuver his relatives.

The more observant members of the family see that some of the hyper-Helpers are really just manager-Helpers wearing new uniforms, bearing sewn-on sexy names like HEDGE FUND or PRIVATE EQUITY. The new Helpers, however, assure the Gotrocks that this change of clothing is all-important, bestowing on its wearers magical powers similar to those acquired by mild-mannered Clark Kent when he changed into his Superman costume. Calmed by this explanation, the family decides to pay up.

And that’s where we are today: A record portion of the earnings that would go in their entirety to owners – if they all just stayed in their rocking chairs – is now going to a swelling army of Helpers.

Particularly expensive is the recent pandemic of profit arrangements under which Helpers receive large portions of the winnings when they are smart or lucky, and leave family members with all of the losses – and large fixed fees to boot – when the Helpers are dumb or unlucky (or occasionally crooked). A sufficient number of arrangements like this – heads, the Helper takes much of the winnings; tails, the Gotrocks lose and pay dearly for the privilege of doing so – may make it more accurate to call the family the Hadrocks.

Today, in fact, the family’s frictional costs of all sorts may well amount to 20% of the earnings of American business. In other words, the burden of paying Helpers may cause American equity investors, overall, to earn only 80% or so of what they would earn if they just sat still and listened to no one.

Long ago, Sir Isaac Newton gave us three laws of motion, which were the work of genius. But Sir Isaac’s talents didn’t extend to investing: He lost a bundle in the South Sea Bubble, explaining later, “I can calculate the movement of the stars, but not the madness of men.” If he had not been traumatized by this loss, Sir Isaac might well have gone on to discover the Fourth Law of Motion: For investors as a whole, returns decrease as motion increases.
* * * * * * * * * * * *
Here’s the answer to the question posed at the beginning of this section: To get very specific, the Dow increased from 65.73 to 11,497.12 in the 20th century, and that amounts to a gain of 5.3% compounded annually.
Alan Kolher, in the Skim, scheme ... post mentioned above identifies some of these "helpers" by another name, "platforms":
A system has now developed that involves financial advisers channelling money through platforms and master funds into wholesale fund managers who in turn partly invest in other funds called infrastructure trusts, which are paid extra performance fees [simply] for doing their job.
But the main purpose of them for the investment industry is to facilitate the extraction of an average of 2 per cent in fees, which are then divided between the fund managers, the financial planners and the platform provider (usually a bank). And as with supermarkets, the platform providers have the market power.

There are about 100 investment platforms and master trusts in Australia, but the top 10 have about 85 per cent of the market. They are, in order, NAB/MLC, AMP, CBA/Colonial, ING/ANZ, BT/Westpac, St George/Asgard, Axa (Summit), Aviva (Navigator), Mercer, Macquarie Bank. The vast majority of financial advisers has a relationship with one of these groups and most of their clients' money, whether it's allocated pensions, superannuation, or just private wealth to be invested, goes on the platform. The adviser then helps the client choose several of the often hundreds of options available within the platform.

The platform operators choose which investment products to have in their store and, as with food manufacturers dealing with supermarkets, the key job of a fund manager is to get onto the platforms.
All of this is pertinent to stories appearing in today's Herald. First off the cab rank is Stephen Bartholomeusz' comment, MIG spin-off should satisfy disaffected:
FOR the past six months shares in Macquarie Infrastructure Group have been languishing and the pressure on Macquarie to do something about it steadily increasing. This week it did.

Against the backdrop of rumblings of an attempt by security holders to strip Macquarie of its lucrative MIG-related fee streams, MIG announced plans on Monday to spin off three of its local assets, the M1, M4 and M5 tollways in Sydney, possibly through a $1.5 billion entitlements issue to MIG holders.

MIG has generated massive fee income for the bank in recent years - more than $700 million in the past five years. With the price in retreat, however, the bank wasn't going to collect any of the lucrative performance fee streams for a while. Thus it is as motivated as anyone to rekindle investor enthusiasm for MIG and to see the gap closed between its market price and its net asset value of $4.21 per share.

The restructuring announced on Monday may have been influenced by the market backdrop but appears to have been shaped by other factors as well - it is a logical step in MIG's progression.

The Sydney toll roads are the most mature assets in the MIG portfolio. MIG has added about as much value as it can. Not only does that limit their upside but it also undermines the case for the bank continuing to extract fat fees - they require little management attention.

The other characteristic the tollways have is that they are Australian assets, generating high quality cash flows and, importantly, franking credits.

Both their quality and their franking credits are diluted within the massive, increasingly international, MIG portfolio. Separated from the rest, and offered to Australian investors, they should be assigned greater value than would be attributed to them within MIG.

For Macquarie, cashing out a mature asset within MIG isn't a new pressure-induced phenomenon. MIG has sold about $3 billion of infrastructure assets/securities in just over three years. Having quintupled the value of the capital originally invested in the tollways, generating an internal rate of return of 30 per cent in the process, selling them/spinning them off at a $1.5 billion valuation isn't an unpleasant option.

The bank might have a continued role as responsible entity for the new vehicle containing the tollways but the fee income associated with managing them will drop sharply, if not entirely. Where Macquarie generates about $15 million a year of fees from the tollways today it is probable it will collect $5 million a year at most in future.

No doubt it will also receive some one-off fees for advising the new entity on the restructuring and arranging/ underwriting the spin-off but more important would be the longer-term effect on MIG.

Macquarie isn't going to change course as its model has an insatiable appetite for growth that can only be satisfied by offshore expansion.

Given that the less mature and less competitive US and Europe markets are where the opportunities are, and where Macquarie has a greater competitive advantage in sourcing and consummating deals - the bank has more people offshore seeking infrastructure-style opportunities than any other financial institution in the globe - the Australian assets within the MIG portfolio would in any event become an increasingly small proportion of the whole. The assets to be divested represent about 13.7 per cent of the current portfolio.

While it will increase the risk profile of the residual portfolio, the remaining assets have greater potential upside because of their relative immaturity and therefore the spin-off could produce an outcome where both sets of assets re-rated because they will be held by investors who are more interested in their particular financial characteristics than in a blend of mature and immature and local and international assets.

Thus the foreshadowed restructuring of MIG is a typical Macquarie deal - potential for transaction fees, neat financial engineering to make one and one add to more than two and the pursuit of a "win-win" outcome for the investors and the bank, particularly the bank.
Macquarie is being as pragmatic as ever in its push offshore. Where it finds the going too tough to get a bite of the assets, it nevertheless knows how to get a slice of the fees:
MacBank out of race for airport operator BAA
INFRASTRUCTURE group Ferrovial has appointed Macquarie Bank as the co-adviser for its £8.75 billion ($21.6 billion) takeover bid for the world's largest airport operator BAA, effectively killing speculation that the Australian investment bank could make a rival offer.

Ferrovial announced it had also given Macquarie Airports preemptive rights to buy the Spanish company's 20.9 per cent interest in Sydney Airport, valued at $1 billion. The deal could ultimately allow Macquarie Airports and funds aligned with the bank to raise their interest in Sydney Airport to about 84 per cent. Ferrovial has also given MAp first option to buy its £106 million stake in Bristol Airport.

Macquarie Bank will join Citigroup as the adviser to the Ferrovial-led consortium, which includes the Singapore investment firm GIC and the Caisse de dépôt et placement du Québec. BAA, which operates London's Heathrow, Gatwick and Stansted airports, has already rejected Ferrovial's bid as inadequate. BAA recently outbid several other airport operators, including MAp, for Hungary's Budapest airport with a £1.26 billion offer.

Aside from withdrawing from the race for airports in Budapest and Exeter in England, MAp has gone quiet on its expansion plans in Europe in recent months.

There have been concerns that growing competition for airport privatisations in Europe is over-inflating prices. MAp's two key priorities are lifting the profitability of its Brussels and Copenhagen investments.

Reflecting MAp's success in boosting non-aeronautical revenues at Sydney Airport, the group has focused on increasing revenues generated by car parking and retail rents at Brussels and Copenhagen airports.
Some of the talk-back gripe in Sydney the last couple of days has concerned the Sydney Airport's continuing squeeze on anyone even thinking of having to use the airport. Today's letters to the editor included the following:
Ready for rip-off

Tony Williams (Letters, March 29), Sydney Airport needs to have a look at Melbourne and Brisbane airports. Both have one-minute pick-up bays with a security guard to move overstayers along. Out of the plane, a call to your friend picking you up, and a rendezvous at the pick-up point. Works a treat, but obviously would rob Sydney Airport of $7 for minimum parking. Stephen Jackson Lilyfield

I read with wry amusement Tony Williams's comments about corporate greed at Sydney Airport. The other weekend, my mother and I needed to transfer between the domestic and international terminal. Considering what we'd already forked out in various airport taxes, I thought it a bit rich that I then had to pay $4.50 each way for the bus trip between the terminals. Why is it that this service is free at every other airport I have ever flown through? Nicole Wilcock Penshurst
It may be that Macquarie's halo is slipping.

Click here to see other posts with references to Macquarie Bank

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Blogger Big Gav said...

I always love reading Buffett - simple wisdom - bit like Chomsky in that way - its all very straightforward when you look at what is happening clearly...

31 March 2006 at 8:55:00 pm GMT+10  

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