I was surprised at the low key response in the Australian media to an amazing recent article in Fortune on Macquarie Bank. This included the claim, attributed to Jim Chanos, who earned worldwide fame for being an early critic of Enron, that Macquarie's is engaging in an old-fashioned Ponzi scheme.
Chanos quotes the Sydney Morning Herald: 'The Macquarie model is justly famous around the world. It is quite possibly the most efficient method of legally relieving investors of their money ever conceived'.
Macquarie is of course highly profitable – in its fiscal year ended in March 2007 the firm's profits were almost A$1.5 billion, up 60% from the year before and up from just A$250 million in 2002. The base management fees from its funds amounted to A$785 million. The high level of Macquarie fees have often been commented on as well as its overly complex financial structure.
But, according to Chanos, Macquarie has a 'perverse incentive to serially overpay for assets' because the assets are owned not by the bank itself but by the shareholders in its funds and shareholders pay Macquarie management fees based on the size of the fund. This means Macquarie has an incentive to add to its collection. The funds also pay fees based on their performance, but as Macquarie gets bigger, those are dwarfed by the base fees.
According to Fortune:
‘Macquarie uses debt of as much as 85% to purchase an asset and pay for the necessary capital expenditures. This debt is hard to see, because it doesn't reside on Macquarie's books. You won't even see it by looking at the financial statements for the funds’.
‘Over time the debt held by assets has often increased, not decreased, because Macquarie adds to it partly to pay shareholders their promised dividends. That's because the assets themselves don't deliver enough cash. Indeed, if you look at individual assets, from the Skyway to the M6, they may lose money after their interest expense.
So Macquarie borrows more money and uses it to pay the dividend now, much the way a homeowner might take out a home-equity line to pay a credit card bill. "Borrowing future growth to pay investors today bears the hallmarks of a Ponzi scheme," said Chanos’.
In addition, according to Chanos, there are substantial issues of what is euphemistically called 'structural complexity':
‘ 84% of the deals on which Macquarie was an advisor involved another Macquarie entity - which would imply that much of the parent company's ostensibly third-party advisory business was actually driven by the funds'.
Apart from relying on mountains of debt to fund acquisitions and using additional debt to pay current dividends, Macquarie faces dramatically increasing interest repayments in the future:
‘For instance, on both the Indiana Toll Road and the Chicago Skyway, interest payments are very low in the early years, which increases cash flow at first but leads to much higher interest in out years - akin to a mortgage with a low teaser rate. In 2007 the Skyway will pay interest of just $129,000 on $961 million of debt. But the interest payment for 2018 is to be $480 million - that's not a typo’. (my bold)
If Macquarie crashed its shareholders would lose as would the shareholders of the funds it has created to hold the assets. So too would shareholders in a lot of large banks that provide lending.