Blown away

Cezary Podkul takes an insider’s look at how infrastructure financier Babcock & Brown amassed – and lost – an A$14 billion empire built on debt.

Shortly before noon on Friday, March 13, investors in New Zealand banged home what could prove the final nail in Babcock & Brown’s coffin: holders of NZ$225 million (€90 million; $120 million) of Babcock’s subordinated notes voted 58 percent in favor of administration rather than receiving one cent for every NZ$1,000 they invested.

Administration, or the management of a company on behalf of creditors, may well result in Babcock’s liquidation. But it won’t change much for the noteholders. Babcock’s syndicate of 25 senior lenders are owed around A$3.2 billion (€1.6 billion; $2.1 billion) in total. They must be repaid before the noteholders see a penny, and so the noteholders will likely recover nothing.

But as one angry investor told a local TV station in New Zealand, if he was going to lose most of the NZ$1.3 million he invested in the notes, he jolly well wanted to know how Babcock managed to make the money disappear. The same can be said of Babcock staff, who made up 40 percent of the share register.

For many of them, the fall of the Australian financier – at its height an A$14 billion enterprise by market capitalisation – was rooted in Babcock’s aggressive deal-making culture, which grew out of its partnership roots and greatly outpaced the evolution of tight risk management protocols. That vulnerability came to a head in the aftermath of Babcock’s A$8 billion take-private of Alinta, Australia's largest energy distributor. This triggered a downward spiral that ended up in Babcock’s appointment of an administrator following the vote in New Zealand.

The fate of Babcock’s affiliated funds is not as bleak, because they have an escape hatch built into their structure. But even if they survive, few believe in the long-term viability of listed fund empires like the one Babcock amassed – and lost.

Humble beginnings

Babcock’s roots date back to 1970s San Francisco, where Jim Babcock and George Brown founded the firm as a partnership focused on arranging US leveraged leases. Throughout the 1980s, the business continued to expand as a specialty financial advisory shop focused on aircraft leasing, with new offices in Sydney (1982) and Tokyo (1986) fostering lucrative cross-border leasing deals.

Former chief executive officer Phil Green joined Babcock in 1984. In the early 1990s he led the firm into principal investment by raising money from wealthy Sydney families for Australian real estate deals. In 1996, the firm closed its first infrastructure deal – a UK private finance initiative – and evolved from investing partners’ money to using its own.

Breakneck growth continued until October 2004, when Babcock, then a 500-strong shop with offices in 22 countries, raised A$550 million on the Australian Stock Exchange in an initial public offering.

Risky business

Throughout it all, pressure to meet growth targets kept escalating, and that meant taking on more leverage and more risk. By the end of 2007, Babcock’s main operating entity, Babcock & Brown International, was leveraged 83.5 percent and had a majority of its borrowings concentrated in an A$2.5 billion, three-year facility owed to its 25 senior lenders. The facility left Babcock materially exposed to its lenders, but allowed it to continue financing seed assets on its balance sheet with minimal equity.

With a deal-driven partnership mentality ingrained in its culture, Babcock executives found it hard to slam the brakes on and introduce rigorous risk controls that might slow growth. As one Babcock executive alleged in a memo leaked to Australia’s BusinessDay last year, risk management had been called a “burden” by a very senior person at the firm. “Independent risk control does not delay deals,” the memo continued, “but allows the board to make better judgments. And it is business wisdom that some of the best deals are the deals you do not do. But our corporate culture is such that you never say no to a deal”.

Analysts, perhaps unaware of the internal soul-searching over Babcock’s risk controls, took a slightly rosier view. In an August 2008 credit rating report, Standard & Poor’s called Babcock’s risk management “satisfactory” but acknowledged that it was “susceptible to an aggressive ‘deal-making’ culture, which could result in the company over-paying for an asset or acquiring an asset without thorough due diligence”.

Barbarians at Alinta’s gate

That culture was on full display during the battle for Perth-based energy distributor Alinta in mid-2007. Insiders overwhelmingly call it the deal that sunk Babcock. Its aftermath put the firm’s weaknesses on full display at a time when investors’ and creditors’ confidence was being rattled by wider market disruptions.

Babcock had spent about A$400 million dollars amassing a preemptive stake of just under 5 percent in Alinta. Then news broke in January 2007 that senior Alinta executives were working on a management buyout proposal with Macquarie. The revelation effectively put the company up for sale to the highest bidder and pitted Macquarie and Babcock, long-standing rivals for infrastructure assets in Australia, in a very public head-to-head contest.

After two rounds of bidding, in June 2007 Alinta’s board endorsed a sweetened cash and stock offer of A$16.06 per share from Babcock and Singapore Power that valued the company at A$8 billion.

“I've said to a few people that we don't run our business as a competition against [Macquarie] but, you know, it's nice to be appointed the preferred bidder,” Trevor Loewensohn, Babcock’s deal maker behind the transaction, told local media after the board initially backed Babcock over Macquarie.

Still, the satisfaction came at a heavy price: to ward off Macquarie, the Babcock consortium ended up paying a premium of nearly 50 percent over the average price of Alinta shares in the 30 days leading up to the announcement of a potential buyout in January.

The transaction also heavily indebted Babcock and its power-focused fund, Babcock & Brown Power (BBP), at a time when cracks were starting to appear in credit markets. When the deal closed in August 2007 – widely regarded as the starting point for the credit crisis – BBP was left with an A$2.1 billion acquisition bridge loan that it would have to refinance in the next 12 months. Including asset-level project finance debt, BBP’s total Alinta-related debt load topped A$3 billion.

As credit markets continued to deteriorate, refinancing proved a tall order. BBP was only able to attract A$2.7 billion in commitments from a club of 11 banks. In May 2008, Babcock came to its rescue, extending an A$190 million loan to BBP to tide over a remaining A$275 million funding gap in its refinancing and proposed asset sales plan.

Barbarians at Babcock’s gate

The news touched a raw nerve with Babcock’s shareholders and creditors. It directly contradicted Babcock’s stated policy of not providing explicit financial support to its managed funds – a crucial missive given the A$50 billion that Babcock held across its empire of listed and unlisted affiliated entities, or so-called “satellite” funds. Worse still, the loan came from money that Babcock didn’t have: it had just expanded its senior lending facility from A$2.5 billion to A$2.8 billion to preserve its liquidity. It could not afford be seen as the lender of last resort for its managed entities’ debt.

But just when Babcock needed to clarify these issues to the market, its communications efforts faltered. A poorly-phrased press release last May was supposed to calm concerns over the BBP refinancing. Instead, it caused even more confusion by declaring that “in addition to the $3.1 billion of corporate debt facilities, BBP’s current capital commitments are approximately $3.4 billion”.

While markets wondered whether BBP was in fact A$6.5 billion in debt, Babcock went into damage control, hosting a conference call the next day to clarify BBP’s capital structure. But in many ways it was already too late: bloodthirsty hedge funds seized on yet another golden opportunity to sell off Babcock shares aggressively, knowing that if its market capitalization fell below A$2.5 billion, it would trigger a review event with its senior lenders.

As Babcock came close to crossing that threshold, it negotiated with its banks a removal of the market capitalisation covenant. But from there on, it was at a point of no return. Management lurched from crisis to crisis, putting out fires in one place only to see new ones spring up elsewhere.

From September 2008 onwards, as credit markets deteriorated even further after the fall of Lehman Brothers and the rescue of AIG, Babcock’s creditors rejected one restructuring proposal after another. It became clear Babcock would not emerge from the negotiating table as a even a fraction of its old self.

On 13 February 13, 2009, after nearly six weeks of tense negotiations during which trading in its shares was frozen, Babcock reached an agreement with its lenders to wind down its business to pay off its a$3.2 billion of debt over two to three yeas. A month later, the subordinated shareholder vote in New Zealand forced it into administration.

Bleak house

But even as Babcock joins the ranks of Allco Finance Group – another Australian financier that gobbled up infrastructure assets using high levels of debt and ended up appointing administrators late last year – the fate of its wider empire is not as bleak.

“The difference between the two is that the Allco appointments were made by the board right across the group after they formed the view that they would be unable to meet their scheduled debt repayment,” explains Joseph Hayes, a board-appointed administrator of Allco and a partner at Australian restructuring advisory firm McGrathNicol.

“With Babcock, the appointment only happened in one company and because the liability to [subordinated] noteholders only exists in that top company, it is possible, but unlikely, that that appointment will pervade the group”, Hayes added. This means that some of Babcock’s subsidiaries may well avoid liquidation, though Hayes cautioned that it is still too early to tell.

The outlook isn’t as bleak for its publicly traded affiliates satellite funds. Flawed as it was, Babcock’s structure provided them an escape hatch if the mother ship went under.

Typically, the firm had three ties with its listed entities: an equity stake of 8 to 10 percent in their shares, long-term management and advisory agreements, and some level of debt between the two.

Babcock is free to sell its equity stake as it sees fit to repay its senior lenders. The management agreements can be sold back to the satellites to raise cash. And the satellites can do their own asset sales to pay back their loans to Babcock. Once all three are accomplished, the satellites are completely free of any affiliation with Babcock, except for their names. But that’s an easy fix.

The processes are already well under way at many of the satellites, including Babcock & Brown Wind Partners, Babcock & Brown Power, Babcock & Brown Capital and Babcock & Brown Communities. Others will surely follow, insiders say.

But even if the satellites survive their near-term deleveraging pressures and pull through the credit crisis, there is little faith left in external fund management models like that of Babcock or Macquarie. As shares at many of their satellites sold off 90 percent or more in the wake of the credit crisis, investors woke up to the reality that they had been paying millions in advisory, performance and base fees that in the end left them with huge losses while the fund managers profited handsomely.

“The Babcock & Brown experience should be a warning to any general partner who wishes to aggregate assets under management that you must really think through what is in the interest of the investors. If you put investors first, you will normally come out in the right position. But if you put the management company first . . . you will inevitably come out in the wrong position,” cautions John Campbell, co-founder of infrastructure and private equity fund consultancy Campbell & Lutyens.