Moore the secret to Macquarie’s remarkable transformation

It was Nicholas Moore who was responsible for the core of the old Macquarie model and who re-engineered that model for the post-crisis era, leading the group to achieve the record profit announced today

Finally, eight years later, Macquarie Group has surpassed the earnings record it set in 2008, just before the financial crisis demolished the old Macquarie Model.

There are two remarkable aspects of the transformation of Macquarie that has occurred over that period. One is the radical change in the underlying nature of the group, which speaks volumes for the adaptability of the organisation and its people, and the other is that Nicholas Moore is still chief executive.

It was Moore, more than any other individual, who was responsible for the core of the old model, with its listed satellite infrastructure funds and layers of leverage that drove Macquarie to its record $1.89 billion of earnings in 2008 and an extraordinary 23.7 per cent return on equity. (Macquarie’s ROE had actually peaked at 28.1 per cent a year earlier). He was rewarded with the chief executive role in May 2008, just ahead of the crisis.

It was also Moore, however, who has completely re-engineered the model to suit the post-crisis era and led it to the $2.06bn profit it announced today. Very few, if any, bank CEOs could have survived the difficult era Macquarie has transitioned through, let alone come through with their reputation not just intact, but enhanced.

Moore and his employees are going to be very handsomely rewarded for the 29 per cent surge in the group’s earnings, given the way the Macquarie compensation model works, but shareholders will receive a big lift in income, with the annual dividend rising from $3.30 to $4 a share.

The extent of the changes to the corporate model is worth revisiting because it does show just how dramatically different Macquarie is today.

In 2008 Macquarie’s “market-facing” businesses — the Macquarie Capital investment banking division, its securities business and its commodities and financial markets business — contributed 93 per cent of its pre-tax earnings. Macquarie Capital which, under Moore, had developed the listed satellites strategy with its layers, not just of leverage but of fee income streams, was responsible for 63 per cent of those earnings.

Today, those businesses, while still substantial, contribute just over 30 per cent of the group’s earnings, with funds management — four per cent of earnings in 2008 — now accounting for more than 35 per cent of the earnings base.

Banking and financial services, which produced about five per cent of the 2008 earnings, now generate just under 10 per cent, while corporate and asset finance, which was created as a separate unit post-crisis, contributes about 24 per cent.

Combined, what Moore refers to as Macquarie’s “annuity-style” business, contributed about 70 per cent of its profits.

The continuing success of the radical changes to strategy can be seen in Macquarie’s post-crisis experience.

Where the market-facing businesses are still tracking around the averages for their contributions since 2008 (but well above their lows) in what has been a volatile and difficult environment for market-facing business, the asset management, corporate and asset finance and banking and financial service units are contributing roughly double their post-crisis averages.

They are generating solid growth — earnings of the asset management group were up 13 per cent in the year to March — but with a much lower risk profile and less volatility than the businesses they have displaced.

Macquarie’s balance sheet and its balance sheet strategies have also adapted to the times and, of course, the significant changes to the regulatory environment.

In 2008, Macquarie had total assets of $167.25bn supported by net assets of $10bn. Today it has total assets of $196.8bn and net assets of $15.7bn. There has been a dramatic reduction in leverage, with Macquarie co-funding its major acquisitions in its asset management and asset finance businesses with equity.

That more conservative approach has had an impact on the group’s return on equity, which fell to 7.8 per cent in 2012 before recovering strongly (but still only to a fraction of the pre-crisis peaks) to 14.7 per cent in the latest result.

The Macquarie ROE is, it should be noted, rising at a time when most other banks and big financial institutions are experiencing falling returns because of the weight of continually increasing regulatory capital requirements. That’s despite having a common-equity, tier-one ratio of 10.7 per cent and surplus capital of $3.9bn.

The cynics would say that it isn’t that Macquarie has been de-risked since 2008 but that the nature of its risks have changed, with the leverage and risk within its management and co-investments in infrastructure, for instance, obscured by their unlisted nature.

More recently, there has been a lot of focus on its corporate and asset finance group, and, particularly, its loan portfolio. Macquarie said today it has $10.2bn of capital committed to that portfolio, which it described as “mostly sub-investment grade.” Others have described it as a portfolio of junk bonds. The size of the funded part of the portfolio at 31 March was $9.2bn.

Macquarie is sensitive to criticisms of those exposures (and Labor’s threat that its proposed Royal Commission into the banking sector would inquire into them) and defended its activities within the presentation of its results today.

The portfolio comprised predominantly senior debt, both originated by Macquarie and bought on the secondary markets with a “hold to maturity horizon,” that was secured and well-covenanted, it said. The business had a strong risk-management framework, there was intense analysis and stress-testing of each loan, and all positions were “sized” to worst-case outcomes.

Average realised annual losses since the inception of the portfolio were, it said, about 0.2 per cent of loan assets.

One would expect higher losses from a portfolio of junk bonds from a portfolio of investment grade loans of similar size. Mike Milken, who pioneered the development of the junk bond market in the 1980s, however, established that the much higher yield from a portfolio of sub-investment grade bonds more than compensated for the higher default rate.

Ultimately, the quality of the assets within Macquarie’s larger corporate and asset finance business depends on the quality of its risk assessment and risk-management systems, which have in the past — after being severely stress-tested during the post crisis period — shown themselves to be very robust and effective, unlike most of the group’s global investment banking peers.