The extraordinary empire built by the gang at Babcock & Brown has exactly the same problem as that of Christopher Skase, Robert Holmes à Court, John Spalvins and just about every other corporate empire-builder that eventually went bust.
Every layer of the cake is geared; shareholders, directors (probably), head company and the funds that hold the assets. Total debt: More than $45 billion.
That’s fine as long as investors and banks view each of the bits as a separate ongoing entity.
But the moment they start looking at the forest instead of the trees it is very difficult to recapture the illusion and see the trees again. More importantly it becomes impossible for any of the layers to recapitalise the others in times of stress.
It happens every time. It’s like Centro; the bottom companies have borrowed against the assets and the top has borrowed against contracts to manage the bottom companies.
Babcock & Brown manages a bunch of geared funds that own assets around the world and, according to the 2007 balance sheet, has $11.5 billion in debt itself. As Martin Lawrence of Riskmetrics wrote in Business Spectator this week, those management contracts are virtually unbreakable and very lucrative for B&B, so no problems there for its banks.
If each Babcock & Brown vehicle stays out of default and generates enough cash from its own assets, and the share prices behave accordingly, then the illusion can be preserved and there is no problem.
But if, like girls in a dormitory, the funds all start to cycle together then the magic can quickly disappear. To dredge up yet another analogy, it’s like The Wizard of Oz, when Dorothy goes behind the impressively massive curtain and discovers a rather pathetic old man with a megaphone.
Of course here is nothing pathetic, or old, about Phil Green and the rest of the team at Babcock & Brown.
They have assembled an extraordinary collection of assets and devised a very lucrative and innovative way of harvesting money from them – often without the need for operational cash flow, merely asset revaluations that auditors are prepared to tick.
But the announcement from B&B Power that it has a debt-refinancing shortfall of $300 million that will require either assets sales or some new capital appears to have broken the spell.
Investors may have started looking at the empire not as a self-perpetuating funds management machine but simply as one big collection of assets, and started to wonder – what if?
What if all the assets had to be sold? Would there be any equity left?
As with Centro there may only be equity in the head company as long as the assets are not sold and the management contracts continue.
The 27% fall in Babcock & Brown’s market capitalisation yesterday to $2.3 billion triggered a “review event”, which means the bankers get to sweat and fidget inside Babcock’s offices instead of their own.
If the market cap is still below $2.5 billion in four months, it’s all over; two-thirds of the lenders would have the right to serve notice on Babcock to pay the money back in 90 days.
This would be impossible and the banks would be in the same situation as they were with Centro – holding fund management contracts that would evaporate if they triggered a default, except with Babcock their exposure is much greater.
But it’s not the banks in Babcock & Brown that will be the problem. Their assets – management contracts and shares in the funds – can’t be sold, so there’s no point trying.
It’s the banks down the line that will be the real problem. Their security is over the real assets, and there is a fair chance they will now start trying to get their hands on them.
As a result those funds will progressively need to be recapitalised, and in its present state Babcock can’t do it. It doesn’t have the capital and can’t get it, and presumably its own major shareholders can’t either because they’re also heavily geared.
Can they get Babcock’s market cap back above $2.5 billion and hold a farewell party for the fidgeting bankers camped in their office? Very difficult. Some short hedge funds might buy now to crystallise their profits, but they’ll probably only be replaced by other shorts who believe they are in for the kill.
This story first appeared in Eureka Report