For much of the 2000s, Macquarie Group confounded expectations. A Sydney-based international investment bank with a vibrant infrastructure funds business, it reported big and fast-rising profits.
Then came the global financial crisis (GFC).
The years since have been far tougher for Macquarie. It has experienced several years of declining net income, thanks largely to a slump in profits from its ‘markets facing’ businesses Macquarie Securities and Macquarie Capital.
But it is also keen to grow its annuity-style businesses, particularly its global asset management operation Macquarie Funds Group, which provides a platform for its international ambitions. This includes seeking out more acquisitions in fund management.
“There’s not much we can do about the markets,” Greg Ward, Macquarie’s deputy managing director and former chief financial officer said. “But we’re not just sitting here waiting for markets to improve.”
Observers credit Macquarie with working hard in this area to turn its profitability around.
“There’s definitely a refocus of the business into annuity-type business streams, which is going to continue,” says Christopher Hall, senior investment officer at Argo Investments, which owns a stake in Macquarie. “Funds management particularly is going to be a real focus for the group. They’ll also continue to cut costs in Macquarie Securities and Macquarie Capital until they ensure they’re profitable in this new kind of environment.”
But while the annuity-style businesses provide stability and growth opportunities, they are unlikely to be enough to return the bank to its pre-GFC earnings in the medium term.
“Those annuity-style businesses are at least providing some protection for downside,” says CommSec analyst Ben Zucker. “But growth is very much leveraged to the market and markets-related businesses, and it’s a tough environment out there.”
Macquarie’s challenge is to turn around its multi-year declining profit trend despite uncooperative markets. It won’t be easy.
Macquarie began in 1969 as an offshoot of British merchant bank Hill Samuel, and was transformed when Alan Moss led a management buyout in the mid-1980s. The bank’s subsequent success under Moss led it to be dubbed ‘the Millionaire Factory’.
It had a smart and aggressive reputation and expanded globally, culminating in its failed £1.5 billion (US$2.3 billion) bid for the London Stock Exchange in 2005.
Moss retired in May 2008, replaced by long-time colleague Nicholas Moore. A former tax accountant, Moore is described as “quietly informal” and “pleasant and smart”, although he also elicits comments such as “you wouldn’t want to cross him; he’d be pretty ruthless”.
Macquarie’s explosive profit growth peaked in the fiscal year to March 31, 2008 with net profit of AUD1.8 billion (US$1.7 billion) – triple the AUD494 million profit it reported in 2004.
Then, in late 2008, the GFC happened. Macquarie initially took advantage of the market upheaval with opportunistic acquisitions.
Some, including US-based asset manager Delaware Investments, have been particularly successful – bringing quality assets at cheap prices.
Others – such as the equity derivatives and structured products business of German private bank, Sal. Oppenheim Jr, bought in 2010 – haven’t worked out, and led the bank to exit and consider closing some operations when conditions did not improve.
The failed acquisitions and subsequent exits highlight how the investment-banking world has changed. Volatility and uncertainty has dominated the markets for years now, hitting Macquarie’s bottom line.
The bank’s income was AUD1.05 billion in the 2010 fiscal year, slipped to AUD956 million in 2011, and dropped further to AUD730 million in 2012 – a 26% drop on the previous year. Return on equity (RoE) has also sunk to just 6.5%, versus 23.7% in 2008.
The drop in profits and RoE has been structural and cyclical. A big chunk of the bank’s profits were driven by the ‘Macquarie Model’, in which it would buy an asset, revalue it and sell it into a listed fund (such as Macquarie Communications Infrastructure Group), then earn huge performance fees.
In the post-GFC climate, that model is dead with asset price growth stalling and borrowing difficult. Macquarie’s listed funds have been restructured, sold or internalised by management.
The perils of market making
In cyclical terms, Macquarie’s worst-hit operations have been its markets-facing businesses.
Its equity operation remains the best among the domestic houses in Australia, as we note in our domestic bank awards on page 26, but overall it has taken a beating.
Macquarie Securities lost AUD194 million in 2012, after a profit of AUD184 million a year earlier. Analysts don’t expect a return to the black for years.
“The markets are very fragile, that’s for sure…” Macquarie’s Ward says. “That does make it difficult for some parts of the business – the investment banking and institutional equities side…But I don’t think we’re alone in that experience.”
Macquarie has responded to market conditions by exiting businesses including institutional derivatives in the US, UK, Asia and South Africa, and closing Macquarie Securities’ continental operations (Paris, Munich, Zurich and selected US operations).
Such cuts led the bank to reduce costs by AUD420 million this year. It also cut more than 1,000 staff and sent some back-office roles to India and the Philippines.
“We’re working extensively on the size of the platform,” Ward says. “We’re trying to be as efficient as we can.”
The bank is also taking advantage of its beaten-down share price to buy back stock.
Amid the market carnage, Macquarie’s annuity-style businesses have provided stability.
“You’ve really got to break the business down into two: the market-facing businesses, which is Macquarie Securities, fixed income, currencies and commodities (FICC), and Macquarie Capital,” says Brian Johnson, bank analyst at CLSA. “They have been hit by extreme dislocation of markets.
“But when you look at the other businesses, CAF (corporate and asset finance), Macquarie Funds and banking and financial services, they’re doing really well.”
This is borne out in the bank’s financial results for the year ending March 31, 2012. Macquarie Securities lost AUD192 million and Macquarie Capital only earned around AUD85 million; dismal results compared to AUD500 million average annual profits that each division earned between 2007 and 2012.
Of the markets-facing businesses, only FICC did well in 2012, reporting a profit of AUD539 million – down slightly on its AUD600 million average of the past six years.
In contrast CAF, the bank’s lending and asset-finance business, saw profits rise 22% to AUD698 million compared with just AUD66 million in 2009, highlighting Macquarie’s ability to generate new profit centres.
Meanwhile its banking and financial services division, which the bank also considers annuity-like in nature, earned AUD265 million, higher than the AUD200 million average of 2007-2012.Ward says the bank has strategically focused on opportunities in debt-nature businesses, where the margins are “predictable and good”.
“The environment over the last few years has been more supportive of those styles of activities, rather than equities-style businesses,” he says.
In April 2010, for example, CAF bought a AUD1 billion portfolio of retail auto leases and loans from GMAC Australia. This followed the purchase of Ford Credit’s AUD1 billion portfolio in October 2009.
“US banks and more and more European banks have been deleveraging and winding down lending activities,” Ward adds. “There are opportunities in that space to support clients if you have funding and capital to do that. We have the funding and capital.”
Macquarie did not respond to requests about CAF’s future returns, although the bank expects the division’s profitability to be “broadly in line” with 2012, according to its 2012 financial-year results briefing.
Macquarie’s other annuity stream is fund management, headed by rising star Shemara Wikramanayake, who is touted as a possible future CEO of Macquarie Group.
Macquarie has AUD324 billion of funds under management, up from AUD310 billion in 2011, and is the largest manager of infrastructure assets globally. Macquarie Funds Group’s profits rose 36% in 2012 to AUD655 million, in line with historical performance.
“They’re finding the margins in funds management are still okay; there’s a little bit of pressure, but nothing near the level of crunch seen in other divisions,” Hall says.
Like CAF, Macquarie Funds has been expanding. Ward says that demand for funds began in 2004 when pension funds became interested in infrastructure assets. He predicts “a continuation of those strong demand levels”.
“In an unlisted world, they keep on raising more funds,” Johnson agrees, adding that, unlike the listed ‘Macquarie Model’ assets, in the unlisted space Macquarie doesn’t buy the asset.
“They don’t have to put as much capital into it, but they don’t get one-off asset realisation gain or performance fees,” he says.
One of the company’s most successful post-GFC acquisitions was Delaware Investments for US$400 million.
“When we acquired this back in ’09/’10 it had about US$130 billion under management; today it has US$174 billion,” Ward says. “That’s been an outstanding acquisition. We’re absolutely delighted in the funds’ space.”
Delaware was recently ranked number one in Barron’s Fund Family Report for 2011.
It was a “very, very meaningful acquisition”, agrees Hall. “They will look to grow in that space…they’re doing it on a global scale. That will be a continued theme.
“But they want to make sure they’re getting better return from equity in those businesses than they are from buying back stock.”
Will Macquarie look at more acquisitions in fund management?
“Yes, where it makes sense for us to do so,” Ward says, declining specifics.
The income flows of Macquarie’s annuity-style businesses are a welcome source of reliability, and should keep the bank profitable.
But it’s unlikely they will generate the explosive earnings growth of the past.
UBS analyst Jonathan Mott reports that the CAF business is likely to see a “tapering of its growth from recent years”. He forecasts that total profit contribution from CAF will remain stable at AUD698 million by 2014; and Macquarie Funds Group profit contribution to rise from AUD655 million in 2012 to AUD671 million in 2014.
CLSA’s Johnson notes that the bank will not be able to repeat one-off asset sales and is unlikely to enjoy strong fund performance fees, which “seriously reduces Macquarie’s near-term profitability”.
“However, this is not to say Macquarie can’t replicate an axolotl and miraculously regenerate its limbs [as the rare salamander does] by way of performance fees on its unlisted funds.”
Johnson adds that there is a 10-year gap between when Macquarie launches an unlisted fund and when it starts to earn performance fees. And as Macquarie’s unlisted funds “really only started in 2004”, performance fees from unlisted funds won’t be meaningful until 2014.
Macquarie recognises this. In its 2012 results briefing, the bank estimated that the income of the CAF and funds divisions in 2013 would be “broadly in line” with 2012 levels, but for the latter division it added the caveat “subject to performance fees.”
Careful cutbacks required
With Macquarie’s annuity-style businesses unlikely to generate a rebound in earnings, the bank is relying on cost-cutting and a market recovery to grow profits.
The risk is that cost-cutting and business divestments inhibit its leverage in a market upswing.
Ward acknowledges there is a danger that the bank could cut too hard.
“It’s something we have been very careful about,” he says. “The right sizing of that platform has been done in a very delicate and careful way. The last thing you would want to do is take away capacity in advance of a market upswing.”
UBS’s Mott notes that the bank’s revenue opportunities are split broadly evenly between cash equities, derivatives and prime broking.
“Macquarie is really only exposed in cash equities, which is only one-third of the revenue opportunity but carries the highest overhead in terms of staff numbers and cost [research and sales]. This fundamentally challenges the profitability profile of this business.
“It is unlikely that Macquarie can expand its offering into a meaningful prime broker globally given it lacks scale, operational capability and balance-sheet capacity.”
The only way is up
Despite Macquarie’s challenges, analysts anticipate 2012 to be the low point of its earnings, predicting a rebound from here.
Johnson forecasts Macquarie’s net profit will surge from AUD730 million to AUD1.06 billion in 2013 and AUD1.36 billion in 2014; Mott predicts net profit to rise to AUD894 million in 2013 and AUD1.09 billion in 2014.
Those numbers are still well below its 2008 peak.
Johnson believes that a profit turnaround will be driven by cost-cutting, and the non-recurrence of mark-to-market losses and restructure charges.
Ward is also optimistic, noting that Macquarie is performing well relative to global peers.
“When you look at our shareholder returns analysis, whether it’s the last three months, three years, or 10 years, we have done better than virtually anyone. RoE: it’s in line with anyone; if you look at market share, it’s very good.”
“We’re doing most of the things we would like to do,” Ward adds. “We have a very good Australian franchise. We have a good Asian franchise, which has grown significantly since we ramped it up back in ’07 when we bought the ING platform… The funds management business has been a stand-out for us in the last few years; we have a very successful infrastructure business that continues and we’ve added to that … and we have a good funds management business.”
All this is true. But a lot of Macquarie’s performance over the coming year rests with the markets.
“[Whether Macquarie’s earnings have hit a low point is] the million-dollar question,” Hall says. “The market’s looking for about a AUD940 million consensus for fiscal 2013, a 28% uplift. They’ll get some of that through cost-cutting. They’ve cut expenses by about 8%, or AUD400 million; they’ll get some benefit from that.
“But if conditions remain as they are by the time we get to the AGM in July, they might have to hose down those numbers again.”
Ward says it is impossible to predict what markets will do. “We’ve had a real flare up in Europe, which has really pulled markets back down again. It’s a period of tremendous volatility and tremendous uncertainty…”
Macquarie has been through a tough few years, which laid bare the vulnerabilities of the ‘Macquarie Model’. The bank is reconsolidating and refocusing, but the strength of its comeback still depends heavily on world markets.
Navigating them could yet prove to be one of Macquarie’s greatest challenges.