Babcock & Brown: the gearing machine that couldn't survive the GFC

I've read a lot of administrators' reports over the years. Some are dry catalogues of misfortune. Others read like slow-motion disaster films where you can see the ending in the opening pages. The voluntary administration of Babcock & Brown Limited, filed in early 2009, falls firmly in the second category. The numbers are extraordinary, the structure is almost impossibly complex, and the underlying logic — borrow short, acquire long, clip the fee — was so widely copied during the boom years that its failure sent tremors through half a dozen satellite funds simultaneously.

This is the story of how Babcock & Brown built one of the most aggressive asset-accumulation machines in Australian corporate history, and how that machine consumed itself when credit markets froze.

Where Babcock & Brown came from

The firm traces its origins to San Francisco in the 1970s, founded by Americans Jim Babcock and George Brown as a specialist aircraft-leasing and tax-advantaged financing house. The Australian operation was established in Sydney in the 1980s and for a long time operated as a relatively contained, fee-generating advisory business focused on structured finance and infrastructure. Profitable, specialised, not exactly front-page news.

The transformation came in the early 2000s when Phil Green took the helm of the Australian and European operations. Green, a chartered accountant by training, understood the mechanics of infrastructure finance with unusual depth. He also understood — perhaps too well — the logic of the listed fund model that Macquarie Bank had pioneered: raise equity in a listed satellite fund, stack debt on top, acquire yielding assets, collect management fees on the gross asset value. Repeat.

Babcock & Brown listed on the ASX in October 2004, raising around $300 million. The float prospectus was confident, the institutional reception was warm, and the timing was almost perfectly calibrated to a period of historically cheap debt and voracious appetite for infrastructure yield. Within two years the stock was trading at multiples that valued the parent at several billion dollars.

The satellite fund model and why it worked (for a while)

The model deserves some explanation because it is central to understanding both the rise and the collapse. Babcock & Brown did not simply invest its own capital in assets. It established a constellation of separately listed funds — Babcock & Brown Infrastructure (BBI), Babcock & Brown Power (BBP), Babcock & Brown Wind Partners (BBWP), Babcock & Brown Capital and others — each of which would hold specific asset classes and raise their own debt and equity.

The parent company sat at the apex, collecting management fees, transaction fees, and performance fees from each fund. As each fund acquired more assets, fee income to the parent rose. The incentive was always to grow the gross asset base, because fees were calculated on assets under management rather than returns to investors. This is not a unique structure — Macquarie ran variations of it for years — but Babcock & Brown applied it with particular aggression and, critically, geared the parent company itself to fund its co-investments in the satellite funds.

At the peak in mid-2007, the group's satellites held assets across wind farms in Europe and the United States, electricity networks, gas pipelines, ports, and telecommunications infrastructure on multiple continents. The aggregate asset base across the parent and its funds ran to tens of billions of dollars. The parent's own balance sheet carried net debt in the billions.

For context on how concentrated Australian financial exposure became during this period, the collapse of Babcock & Brown sits alongside Storm Financial's implosion as a demonstration of just how thoroughly the leverage culture of the mid-2000s permeated different corners of the market simultaneously.

The debt structure that made everything conditional on confidence

Here is where the story turns. Every satellite fund carried its own debt. The parent carried its own debt. And critically, some of the parent's borrowing facilities contained covenants and rollover conditions that were, in retrospect, extraordinarily sensitive to market sentiment.

The parent had a corporate debt facility — widely reported at the time to be in the range of $2.7 to $3 billion — that required periodic refinancing. In a normal credit environment, a firm of Babcock & Brown's apparent scale would roll that facility without drama. Banks would line up. The 2007 to 2008 credit markets were not a normal environment.

When the US sub-prime crisis began to infect global credit markets from mid-2007 onwards, the first thing that happened was that the cost of wholesale bank funding rose sharply. The second thing was that banks became reluctant to extend or refinance facilities to highly geared entities with complex structures. Babcock & Brown was, by any measure, both of those things.

The share price, which had touched around $34 in 2007, began a decline that would prove irreversible. As the stock fell, the covenants on some facilities came under pressure. As the covenants tightened, rumours about the firm's refinancing capacity accelerated the stock's decline. It is a dynamic familiar from the HIH story — confidence and solvency are deeply intertwined in financial firms, and once the former goes, the latter follows quickly.

The unwind begins

Through 2008 the board attempted to stabilise the firm. Assets were flagged for sale. The satellite funds were encouraged to reduce their own debt. Discussions with the banking syndicate were ongoing. Phil Green departed as chief executive in August 2008, replaced by Michael Larkin in what was framed publicly as a planned transition but was broadly read by the market as an acknowledgement that the existing strategy had run its course.

The difficulty was structural, not merely cyclical. The assets inside the satellite funds were long-duration infrastructure — the sort of thing that takes years to sell at reasonable value, and which in a distressed credit environment attracted only deeply discounted offers. The liabilities, by contrast, had short-dated components that couldn't wait for an orderly process.

The firm explored a range of options through the second half of 2008. A recapitalisation. A partial sale of the management platform. A merger. None of these eventuated on terms that could satisfy the banks. In January 2009, Babcock & Brown Limited appointed voluntary administrators. McGrathNicol were appointed as administrators of the parent company.

The satellite funds had their own, separate fates. BBI and BBP both underwent their own restructuring and refinancing processes under considerable distress. Some of the underlying assets were eventually sold off; others were restructured into new vehicles. The process took years.

What the administrators found

The McGrathNicol reports, which are public record, paint a picture of a business whose value was almost entirely contingent on continued market confidence and continued access to cheap debt. The fee streams — which had looked so impressive in the good years — evaporated rapidly once the satellite funds stopped growing and began contracting. Without transaction fees, without growth in assets under management, and without a rising share price to facilitate equity raises, the parent's income collapsed at roughly the same time as its refinancing needs became acute.

I'll admit this is a structure I find genuinely fascinating, in the way that a watch mechanism is fascinating when you take the back off it. It was extraordinarily well-engineered for the conditions of 2004 to 2007. It was almost perfectly designed to fail in 2008. The same sensitivity to credit markets that had made rapid expansion possible made rapid contraction inevitable.

The creditors' process dragged on for an extended period. The ultimate returns to unsecured creditors were deeply disappointing, as is typical for a holding company collapse of this kind where the assets are several layers removed from the entity carrying the debt.

The broader lesson and the longer shadow

Babcock & Brown is sometimes framed as a story about greed, or about reckless management, and there are elements of both in the record. But I think that framing misses the more interesting and more transferable point, which is about structure.

The firm didn't fail because it invested in bad assets. Wind farms, gas pipelines, and electricity networks are durable assets that continued operating after the collapse. It failed because the financial architecture layered over those assets was brittle in specific and predictable ways — ways that were visible, in retrospect, in any close reading of the prospectus documents and annual reports. The fees were real. The assets were real. The debt was also real, and it had maturities.

The ABC Learning collapse, which was playing out in parallel, involved a similar dynamic in a completely different sector — the gap between the acquisition machine and the underlying operational reality eventually proved fatal there too. Gearing amplifies both good and bad outcomes. The GFC was the stress test that found every point of weakness simultaneously.

There is a reason that the Babcock & Brown model — the listed parent above a constellation of geared satellite funds — is no longer fashionable in Australian markets. It's not that the idea was inherently fraudulent or incompetent. It's that the experiment was run at scale, the results were observed, and the results were not good for anyone except the fee recipients in the years before the crash.

The firm's Collins Street offices are long since occupied by someone else. The funds have been restructured, sold, or wound down. Phil Green eventually re-emerged in various advisory roles. The assets themselves mostly kept operating, as infrastructure assets do.

But if you want to understand what a fee-extraction machine looks like when the music stops, the McGrathNicol administrators' report is still sitting in the public record. Well worth an afternoon.

Babcock & Brown is part of our ongoing series on Great Australian Collapses.

— Ray Petrakis, Corporate Collapses & Insolvency