Monday, June 04, 2007

Macquarie Bank's 'credibility problem.'

Macquarie's Secret Recipe

'Black Box' Valuation Model That Yields Profits for Funds Presents Credibility Problem


Edward Chancellor and Lauren Silva
The Wall Street Journal
Copyright 2007

Australia's Macquarie Bank has enjoyed success managing specialist infrastructure funds, which invest in everything from toll roads to airports. Yet its business model has attracted criticism. Recently its stock fell by some 10% after a well-known investor questioned the bank's valuation methods. The market reaction suggests Macquarie Bank needs to address a credibility problem.

Macquarie Bank's funds, many of which are publicly listed, tend to pay generous dividends. But these aren't always paid from profits, or even from cash flows of the businesses. Instead, Macquarie Bank revalues its investments every quarter, reporting increases in valuation as revenue. The funds sometimes borrow against these gains to finance their dividend payments. The Macquarie Infrastructure Group, a 9.5 billion-Australian-dollar (US$7.9 billion) fund that is listed in Australia and manages toll roads around the world, shows how this works.

Last year, Macquarie Infrastructure reported fiscal-year revenue of more than A$1 billion. Yet around 40% of this revenue came from revaluations of its toll-road stakes. Without these, Macquarie Infrastructure wouldn't have reported a profit. Furthermore, cash distributions to shareholders exceeded the fund's net cash flow by A$231 million. This shortfall was made up by borrowing money and selling new securities. According to Merrill Lynch, dividends exceeded operating cash flow at several other Macquarie Bank funds.

There's nothing illegal here. Revaluation profits on investments are allowed under so-called fair-value accounting rules. When assets have a market price, this practice is uncontroversial. But at Macquarie Bank's funds, the bank controls the valuation models that generate much of the profits. The models contain forecasts of future revenues, which are discounted back to the present. Although Macquarie Bank makes public the discount rate used in the models and provides updates on operations, the revenue projections remain secret. As a result, the models remain something of a black box.

This was the subject of recent criticisms lodged by hedge-fund manager Jim Chanos of Kynikos Associates. He alleges they allow Macquarie Bank to generate profits at will and can be used to justify overpaying for assets. Mr. Chanos, a professional short-seller, has an interest in seeing Macquarie Bank's stock fall.

Nevertheless, there are grounds for concern. Last year, Macquarie Bank and its Spanish partner Cintra acquired the concession to run the Indiana Toll Road for $3.8 billion, paying nearly $1 billion more than the runner-up. In this instance, Macquarie Bank used an Australian consultant, Maunsell, part of U.S. engineer Aecom Technology, to produce the traffic and revenue forecasts. Maunsell has a long relationship with Macquarie Bank and sometimes receives success fees when Macquarie Bank wins a toll-road deal. Such payments might seem to create a potential conflict of interest. Macquarie Bank says it often pays success fees to advisers.

In any event, Maunsell's forecasts for the Indiana Toll Road were higher than the projections of independent consultants employed by the state and by the banks financing the deal. Macquarie Bank says traffic consultants for creditors tend to be overly cautious. There's another concern. Macquarie employed a lot of debt in this deal, some of which came with low initial interest payments. The interest on these loans is set to rise over time, which could create a problem if the toll road's revenue forecasts are too optimistic.

Macquarie Bank defends its valuation models, which are signed off by its accountants and overseen by the independent directors at its funds. Macquarie Bank Chief Executive Allan Moss responded to Mr. Chanos's criticisms by saying that "informed investors" weren't concerned. The fall in Macquarie Bank's stock price suggests otherwise. There's one way to lay this issue at rest. Macquarie Bank should publish its models. The bank says they contain sensitive information and would overwhelm investors with detail. But infrastructure businesses have few secrets. As for information overload, investors are the best judge of that.

© 2007 The Wall Street Journal:

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