16/05/2006 - 22:00

Rising rates change the game for all

16/05/2006 - 22:00

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It’s a brave man who calls ‘game over’ these days, especially in Fremantle. But, the game to which Briefcase is referring is not an Aussie Rules bash, it’s the game of ‘engineered investments’, those highly leveraged companies created by the likes of Macquarie Bank and Babcock & Brown, which have been some of the hottest stocks on the market.

Until now, only a handful of people has dared question the structure on which an engineered investment, and its multitude of fees, is based. Most people seem to believe that the concept is in the category of financial miracle, which will produce a never-ending stream of revenue and rising share prices.

Briefcase was never a subscriber to that nonsense, simply because there is no such thing as perfection in an investment. There is always risk, which can be a tricky thing to measure, and might even be compared with beauty which, as we all know, is in the eye of the beholder.

The English translation to all that is that risk varies, different investors have different appetites for risk, and when the rules change, the risk and potential reward changes.

Over the past few weeks the rules for engineered investments have changed for a very simple, but very big, reason – interest rates are rising. They are not just rising here, they are rising in the US, Europe, China and Japan.

Everyone, apart from savers, feels the pinch when rates rise. Engineered investments feel the pinch more than most because they are heavy users of debt.

In a typical structure, an engineered investment buys an asset, generally from an associated business. Alinta selling some of its gas pipelines to Alinta Infrastructure is a case in hand.

The new owner (the infrastructure fund) borrows heavily to pay for the asset, and also pays an ongoing management fee to Alinta (3 per cent of its revenues), and an incentive fee (0.25 per cent of its market capitalisation, rising to 0.5 per cent in 2007 and 1 per cent in 2008), and a performance fee (20 per cent of outperformance of the ASX 200 accumulations index), and may pay development fees.

There is a valid argument that because the debt is a tax deduction the new ownership structure is highly efficient. Perhaps it is, when interest rates are low, and perhaps even more so if there weren’t so many fees.

There is also an argument that says buy the fee taker, not the fee payer, though as we will see even that theory does not always work when the cost of money (debt) starts to rise.

Apart from rising interest rates there are two other factors at work with the engineered investment sector: how the stock market is reacting; and how two top-flight investment banks see the sector.

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Right now, the market is not a pretty sight for three leaders in the field of engineered investments. It might even be said they are starting to look a little worn out.

Last September, September 7 to be precise (an important date for later reference), Macquarie Bank shares were trading at $65.50, Babcock & Brown was at $18.53, and Alinta was at $11.42.

In early May this year, just after the latest 0.25 per cent interest rate increase, MacBank was trading at $69.51, a rise of $4.01 over nine months, or 6.1 per cent. By comparison, the much more conventional, National Australia Bank was up 16.8 per cent over the same period, Commonwealth was up 21.5 per cent, and Westpac was up 18.8 per cent.

Not too much can be drawn from that selective comparison, but it is interesting that conventional banks have done better than Macquarie, a highly entrepreneurial bank heading into a period of rising interest rates, and rising risk aversion by investors.

Babcock & Brown has performed even more poorly. From September 7 to early May its shares rose a paltry 32 cents, or 1.7 per cent, from $18.53 to $18.85. Alinta, with a share price clouded by the inconclusive AGL deal, is down from $11.42 to $11.

So much for the leaders of the engineered investment sector. What about the views of the chaps who sell their services as professional advisers on these matters?

•••

This is where things get really interesting, because two of the world’s biggest and best investment banks, Goldman Sachs and Deutsche Bank, seem to be heading off in different directions.

Goldman is the critic. Deutsche seems to like the engineered finance sector, if a recent buy tip on Babcock & Brown is a guide.

According to Deutsche, in its first report on B&B, the stock is “funds plus”, offering “an almost pure exposure leveraged to specialist funds success and with forecast earnings growth well ahead of comparable peers”.

Goldman, however, is not a believer. It was the gang who blew the whistle on engineered last September 7 (which Briefcase uses as the starting date for the count down) with a report sub-titled “financially engineered investment performance: private investors beware”.

That Goldman report was a devastating analysis, which addressed the question of the fee structure and the real costs associated with an engineered investment – plus, who wins and who loses.

On February 3 Goldman was so convinced it was on a winner that it came back for a second bite, posing (in part) the question: “Can these structures continue to flourish”, with the clear inference being that they can’t. Some of the reasons listed were:

• an ongoing reliance on high debt levels;

• an inherent growth-by-acquisition strategy which can, over time, dilute the quality of the asset portfolio;

• high equity issuance (more shares being issued);

pay-out ratios of more than 100 per cent, requiring a refinancing capability; and the

• management and performance fee structure absorbing a significant part of annual profits and cash flows.

Briefcase will leave the reader to decide who to follow, Deutsche or Goldman, but with this rider. Rising interest rates here, and in the US, and China, and Japan, are a game changer for everyone in business.

•••

“The faults of the burglar are the qualities of the financier.” George Bernard Shaw

STANDING BY BUSINESS. TRUSTED BY BUSINESS.

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