There is so much wrong with Babcock & Brown it is hard to know where to start.
On second thoughts, it’s easy; let’s start with the management contracts between Babcock and its funds. These contracts are the purpose of the business and the basis of the wealth of those who created it. They are 25-year, unbreakable contracts that provide Babcock a base fee that is a percentage of assets plus debt, plus performance fees. The structure is common to the entire group.
That investors accepted these absurd agreements is an indictment on those investors and their trustees and advisers.
It meant the managers of Babcock had an incentive to pay too much for assets and borrow to do it. While debt was easy to get and asset values were rising, it seemed fine. Now that debt is hard to get and asset values are falling, the system no longer works.
It’s a fair bet that Babcock’s 25 bankers now regret selling their market capitalisation protection clause for 50 basis points on 30 June.
That was a triumph of persuasion by Phil Green and his team at the time, but in the end they were not able to escape the consequences of their own past actions – buying over-priced assets with borrowed money. It seems the acquisition of Alinta last year has brought them undone.
As assets are now sold and revaluations are audited, two things become inexorably apparent; the disappearance of equity, and the downside leverage on management fees as performance evaporates and asset values decline.
This week panic set in that B&B Power may have no equity and Babcock & Brown will end up with little or no income. The only good news is that having agreed to waive their market cap trigger in June, the banks are stuck (although the reality is that they couldn’t have got out anyway).
All of which would normally mean a common or garden workout; the banks agree to a repayment schedule and the management and board agree to raise equity or sell assets to rebalance the books. If no new equity is forthcoming or the assets are consistently being sold below book value, receivers have to come in to wipe out the equity owners’ wealth.
But in Babcock & Brown something else is happening. Shareholders seem to be lending stock to hedge funds, which are then selling it to trigger margin calls on the management, although it is hard to know for sure because this disclosure is non-existent.
Leaving aside the strange notion that shareholders are conspiring to impoverish their executives, this ensures that raising fresh equity is totally impossible. There may have been only the faintest prospect of that anyway, but thanks to the hedgies it is out of the question.
Which leaves asset sales to meet debt repayments. But every time an asset is sold below book value, equity disappears. So, far from being acquired, equity is destroyed.
In desperation, it seems, the directors have now clambered out of their staterooms and on to the bridge to shoot the captain and put another one in charge – to see if that will appease the vengeful Gods of Capitalism and put an end to the storm.
This article first appeared on Business Spectator
