The Australian: Alinta's treasure hunt [February 25, 2006]

Like Macquarie and its other 'financial engineer' rivals, Alinta knows where the fee booty is buried, writes Michael West
February 25, 2006
LATE on Monday, after the markets had shut, a handful of senior stockbrokers from Macquarie Bank's dealing desk hit the phones. Armed with a mandate from the cocky Perth energy group Alinta to snare a $1 billion stake in AGL, they kicked off what is perhaps the most brazen share market raid since the 1980s.

"The ghost of Holmes a Court rides again!" scoffed a JP Morgan research note that night, referring to the famed corporate raider Robert Holmes a Court whose Bell Resources almost snatched control of BHP. "Reviving days of yore, a small West Australian company has bought 10 per cent of a company with three times its market capitalisation and foreshadowed a merger proposal".

Rarely are analysts this blunt. But the sheer chutzpah of the interloper from the west, plotting to swallow the 165-year-old Australian Gaslight (AGL) Company - and all its pipes and wiring which deliver a physical entree into four million east coast homes - will surely spark a tome of emotive language before the takeover battle is done.

Although AGL has kept mum on Alinta's audacious manoeuvre so far, and Alinta's chief executive Bob Browning is portraying its advance as "friendly", a bitter fight looms.

Before they go public these big corporate plays inevitably have their codenames. "Project Duckling" had been in the works for 14 months, said Browning, an American who formerly worked in human resources at Coca-Cola. The name denoted a "soft cuddly creature whose feet are paddling frantically below the surface".









"Shot duck" was the wicked response from one AGL minder, followed by a touch of nervous laughter. Alinta has generated four times AGL's shareholder returns since it listed in 2000 and will be driving that point home to AGL's shareholders when it comes to convincing them to accept Alinta paper in exchange for their AGL scrip. AGL cannot know how its shareholders will react or what Browning and his savvy advisers from Macquarie might have up their sleeves.

Alinta, a brash, leveraged, fee-hungry and entrepreneurial "financial engineer" epitomises the halcyon new world of infrastructure. Like its rivals, the satellite stocks which orbit the two dominant players Macquarie Bank and Babcock & Brown, it operates in a different galaxy from the stodgy state-run infrastructure corporations of old.

Pipes, gas, water, roads, ports, airports and power stations. They used to be dull and boring government assets. Now, infrastructure is the hottest thing on the market, churning out multi-million-dollar bonuses to a new breed of entrepreneur, the savvy financial engineers of the investment banks.

How do they do it? The model is the key. And as yet, it is little understood. As Goldman Sachs JB Were analyst Mike Hawkins puts it, their "investment performance is engineered". The yields are manufactured, in the most part paid out of capital that investors have already stumped up.

In layman's terms, the model is all about leverage - securing the "quality", reliable cash flows of an airport or a tollroad, borrowing heavily against it and, through that increased debt (gearing), delivering the high dividend which institutions and retail investors crave. Advocates and detractors put the proliferation of infrastructure stocks down to the model, the brainchild of Macquarie Bank, and the low interest rate environment in which investors thirst for yield.

But the "beauty" of the model does not end there. Having acquired the infrastructure asset, and borrowed aggressively against it to juice up the dividend yield, the bank will then spin it off, or float it in an infrastructure fund. Instead of managing the asset itself, such as an AGL or Wesfarmers does, the financial engineer creates the new, tax-effective vehicle which it controls and from which it can rake a suite of management, performance, advisory and other fees. Alinta has mimicked the Macquarie model with aplomb. And this is precisely its Achilles heel when it comes to the inevitable fight for the loyalty of AGL shareholders.

It effectively transferred, or spun-off, a $1.7 billion portfolio of its natural gas pipelines and electricity plants into a new company Alinta Infrastructure Holdings for $2 billion.

The management fees are 3 per cent of revenues, an incentive fee of 0.25 per cent to 1 per cent for an increase in market capitalisation, not to mention a 20 per cent performance fee also based on market value.

The point is, Alinta was supposed to be managing the assets in the first place, as any company. But via this financial engineering it can pocket a whole new portfolio of fees.

More worrying is that the fees are based on asset size and market value, which means Alinta gets paid more money, and its executives reap higher bonuses, just for buying assets. For size alone.

It gets trickier than this. Even experienced investors and accountants are bamboozled by the byzantine accounting in the infrastructure stocks.

Booking huge profits, not from operating cash flow - such as tolls, port levies, airport and aviation charges or energy generation income - but from revaluations is one tactic.

When Macquarie Infrastructure Group (MIG) handed down its impressive half-year profit result on Thursday, a delve behind the headline $821 million profit figure shows the bulk of the "earnings" came from revaluations, that is MIG increased the value of the assets in its accounts and booked a profit from them. Toll road income was $153 million but revaluations amounted to a mammoth $693 million. Fees to Macquarie, the parent, were $45 million, modest by previous standards.

The critics charge that an apple remains an apple, no matter which way you slice it. There is a chorus of pundits warning the sector is a bubble waiting to be burst, debunking the view such assets are low risk. "We firmly believe that these entities are not 'low-risk investments'," wrote Goldman Sachs JB Were analyst Mike Hawkins in a recent research report.

"The deals will need to keep coming," says Hawkins, citing high debt, high equity issuance, a worrying growth acquisition strategy and, of course, the enormous fees as key causes for concern.

In cumulative management fees from 2000 to 2006, he calculates MIG fee-take at $729 million (65 per cent of EBITDA), Macquarie Communications Infrastructure Fund $153 million (37.7 per cent of EBITDA), Macquarie Airports $271 million (34 per cent of EBITDA), Babcock & Brown Infrastructure Group $26 million (7 per cent),

Babcock notched up $55 million in base fees, $82 million in performance fees, $123 million in advisory fees, $122 million in development fees, interest and profits, and $370 million in principal investment income when it announced its annual profit this week. Its chief executive Phil Green, responding to the critics on exorbitant fees, said "there isn't a fund manager in the world, including Goldman Sachs, which doesn't have fees based on assets under management". He cited AMP, Colonial and Peter Morgan's 452 Capital.

Morgan, a respected manager and critic of the infrastructure model, told The Australian: "Some people take their time to get there and other people get there as fast as they can."

"Don't they earn fees on debt as well, i.e. gross assets?"

Wilson Asset Management's principal and veteran broker and funds manager, Geoff Wilson, described valuations in the sector as "ridiculous" but said it was hard to know what the circuit-breaker would be.

"In 1987 they purchased assets at high valuations and they geared them up and they took large management fees," said Wilson in a comparison to the corporate raiders of the 1980s boom. "I'm a big believer in dividends being paid out of cash flow, not capital. Everything goes in cycles but the cycles are usually longer than you think," Wilson said. Rising interest rates were the obvious threat to infrastructure valuations.

Whatever the case, this is one issue which is not going away, and has now become critical to the market, even the economy.

In the past four months another five externally managed infrastructure funds have hit the bourse, each one raking in large fees to its promoter. Besides Alinta Infrastructure, there is Babcock & Brown Wind Partners ($33 million in fees for the first two months), Macquarie Media Group, SP Ausnet and Spark Infrastructure.

Meanwhile, the frenzy to buy infrastructure assets, across sectors and across state lines, and repackage them is showing no sign of abating.

Earlier this month, Wesfarmers sold its West Australian-based rail business to B&B and Queensland Rail for $1.3 billion.

And the offshore push has put Australia, and in particular Macquarie Bank, at the vanguard of global infrastructure `- a lucrative place to be for now.

The bank's recent purchase of an Indiana toll road saw it pull in fees of $US98.6 million, equating to 164 per cent of 2005 earnings before interest tax and depreciation. It even flagged its interest this week in the troubled $15 billion Chunnel were a distressed sale on the cards. In Australia, though, the infrastructure stock boom has thrown up a number of hard issues. Even if financially these structures continue to go from strength to strength, the sector is a prospective nightmare for the Australian Competition and Consumer Commission.

The allure of infrastructure in many cases is monopoly or duopoly rents. The Macquarie-controlled Sydney Airport, now among the most expensive in the world, has attracted increasing regulatory scrutiny, and other infrastructure assets are likely to find the the same as the tension between shareholder and consumer demands come to a head. And so it is that the flipside of a successful Alinta bid for AGL would be higher costs for AGL customers as Alinta sought to recoup costs and get its returns up.

But that's jumping the gun. Every funds manager contacted this week by The Australian believed the bid would fail. Just last week, AGL had finally handed down details of its own demerger proposal, a proposal generally well accepted by the market, whereby the group would be split into two vehicles, one housing infrastructure and the other the retail distribution business. Even AGL had caught the financial engineering bug.

The most likely outcome, said one funds manager, would be that AGL's demerger proposal would proceed, and Alinta would end up with 20 per cent of both companies and make a bid for the vehicle housing the infrastructure.

One thing is certain, that a fight looms. And in that fight, the debate over infrastructure stocks, their lofty valuations, and their aggressive structures and gearing, will be taken forward. As one AGL shareholder put it of Alinta, and its lookalikes, "Does the emperor have no clothes? At least the question will now be asked".