Knowledge@Australian School of Business Finance and Investment Research Article

Knowledge@Australian School of Business

Macquarie Group has surplus capital on the balance sheet and continues to seek businesses which meet its acquisition criteria, as chief executive Nicholas Moore highlighted at the annual general meeting of Australia's only listed investment bank in July. In the wake of the financial crisis, the group made successful acquisitions in funds management but – with its sharp eye on shareholder value and the risk-return equation – finds quality assets are in short supply. Volatile times may have impacted on the home-grown financial giant, which now operates in 28 countries, but as Moore explains in an exclusive interview with Knowledge@Australian School of Business, Macquarie's risk management framework has served it well through a range of market cycles.

An edited transcript of the interview follows.

Knowledge@Australian School of Business: Nicholas, let's look at your overarching approach, how do you manage risk within Macquarie Group?

Nicholas Moore: Risk is the essential element that we need to manage within Macquarie. The risk-return equation is something we have to look at with every business decision we make. Every dollar we put out the door – that is, every person we hire, every new system that we bring on, every new product we develop to sell to the marketplace – has a built-in risk.

Our job obviously is to work out what that risk is and price it. Self-evidently, you get a return for pricing risk appropriately, so if you get that wrong – one way or the other – the business will not be successful. Macquarie has had a long history in terms of pricing risk and we think we're quite good at it in a range of ways and in a range of different marketplaces. We've developed a whole way of looking at risk and how we see the world. For us, the key point upfront is that taking a risk is essential, so what's the return? It's about getting that matching right. On that path today you can take no risk if you just buy government securities – that's assuming it's an Australian government, which delivers very high credit but obviously very, very low return, and certainly below our cost of capital. We need to step up the risk to provide our shareholders with an appropriate return on the capital they have invested.

So the first point we consider is how much we can afford to lose. And we size every transaction accordingly. (That's looking beyond a situation where we just won't take the risk under any circumstances – there's a whole range of risks we won't take because we see them as being too bad.) But if it's something that we are happy to consider, we say: "Okay, how much can we lose?" And we look at how much … exposure we'll take to the particular transaction or market, depending on the product.

The second thing we consider is the return. "If we can lose this much; what's the return we're getting?" If the risk is too small, you'll probably find you're not making anything on the outside so there has to be that trade-off. Pricing that trade-off right is what determines the underlying profitability. So that's the way we look at it. We make sure that we focus very clearly on the worst possible case outcome; make sure we can afford it as an organisation from an earnings viewpoint rather than from a simple capital viewpoint. Then from an organisational perspective, we aggregate that risk across the organisation and make sure the organisation can afford something going wrong across a whole range of different businesses.

Knowledge@Australian School of Business: Do those calculations change with time? After all, we're talking about the risk you're willing to bear and also the profit that you would like to get. Has that changed as we have been going through quite turbulent economic times recently?

Nicholas Moore: Absolutely. It changes. It doesn't change in terms of the amount of loss that we're prepared to take because that's tied to the amount of earnings that we think we're making as an organisation. From an organisational viewpoint, we always need to be profitable so when we are taking a risk in terms of a business, we're mindful that if it goes wrong we still need to be profitable. There still needs to be sufficient income being made across the group.

In terms of how it changes over time … the events that could give rise to the loss will change, but if we think something is going to give rise to a greater loss then we'll take less exposure to it – that is, unless we're seeing it corresponding with a higher return coming from the transaction.

One of the interesting things with the risk-return equation is that, prior to the financial crisis, we weren't seen as a lender in the marketplace because the spreads on credit were basically fairly low, below what we thought was a fair return on capital. With the benefit of hindsight, we were obviously right about that. Now, the world has changed and we're getting good return on credit so we might be taking more exposure to credit than we were before the crisis, but we actually see a much more healthy return coming from that after the crisis. The amount of risk we take won't necessarily just be about shrinking the exposure, but about the return we're getting for taking that risk and whether can we afford to take it.

Knowledge@Australian School of Business: And are you willing to vary the level of risk you will take for different types of investments?

Nicholas Moore: The amount of exposure we will take will depend upon our perception of the future variability of the income. With something like infrastructure, we always were attracted to that as an asset category because the income was relatively certain and that was always an attractive character.

It is a GDP-plus style of income stream without a lot of volatility. It suits Macquarie's banking mindset.

However, if you're looking at early stage start-up "greenfield" activities which, in various areas, have a lot more risk and entrepreneurial flavour to them, we're not all that suited (to such activities) across the whole organisation. Some parts – a relatively small part actually – of the organisation have been very successful in that area. Things like infrastructure are more suited to the underlying banking mentality. That said, an area that we've been very successful with is resources and commodities. We've been able to build up a very longstanding track record and experience of almost 40 years in that area. Our teams have been able to really understand the physical and financial drivers of resource projects and they have been able to step up to lend and provide capital to a whole range of resource projects.

Knowledge@Australian School of Business: How do you invest on a resources project? It may be a very long-term investment and, with calculations of risk, 30 or 40 years on we may be in a very different world.

Nicholas Moore: It's more likely that infrastructure will be long-dated, particularly where projects will take years to build – and then you're expecting the pay-off to take place, as you say, over 30 or 40 years. The resource projects that we're looking at financing usually have a shorter (timeframe). They're not immediate. It will still take 18 months or so, in terms of developing a small goldmine or a small metal mine. Even with oil and gas, there will be a short timeframe so you do need to make that trade-off in terms of developing the information you have about the underlying mining project, about the underlying resource. As you develop your information you're providing more capital. Then you reach the point of determining: "How much money do we need to bring this stage to development? What do we think the underlying reserve is worth? Can we effectively pre-sell it through hedging, and does that give us the confidence to advance capital to the underlying project?"

Knowledge@Australian School of Business: Is there a risk in giving individuals too much freedom to make those risk calculations?

Nicholas Moore: How the individual sits within Macquarie is at the heart of our culture. It sounds like a slightly contradictory view of the world, but we see it very much as a bottom-up driven organisation now with a very tight risk framework.

So, firstly we give people an amount of risk that they are able to take within the overall framework and secondly, they are very much accountable for the outcomes.

Knowledge@Australian School of Business: So the individuals ought to be concentrating on the core, doing one of those fundamental risk-return calculations and everything else is the extra risk that they're willing to take?

Nicholas Moore: They have to take responsibility for the outcome. An example is when people want to set up an international office, one of the issues we look at is global risk. There's a process that goes on – particularly with the low balance sheet areas where someone wants to go in and set up an advisory business or a funds management business, for instance. Basically we support them to pay their costs in terms of their own salary and wages and the office – and the costs in terms of what they need to spend to engage (in that location).

Knowledge@Australian School of Business: One of the problems we saw really from 2007 onwards, at the height of the global financial crisis, is that banks lost their funding. They weren't bringing in enough cash to spend on investments. How do you deal with that sort of risk?

Nicholas Moore: That's a very important risk from a financier's viewpoint. It comes from the underlying mismatch that many banks and financial companies over the years have engaged in, where they effectively borrow short and then lend long. It's a mobilisation of deposits and it's what's meant to happen in the financial system. Unfortunately, lending long predicates the ability to continue to access the short-term market. From a Macquarie Group viewpoint, we never actually adopted that mentality of borrowing short and lending long. We've always matched the books so it means that when we put on a term asset, we'll only put it on to the extent that we have term funding. If we don't have term funding we won't put a term asset on board.

As a consequence of that, when we look back at 2008, we were never in the position of people wanting to have their money back and us not having the cash available to give to them. We always were at pains to point out that we had match-funded our book. From a regulatory viewpoint, at the moment the regulators require people to be able to continue to run their businesses for 30 days assuming the financial markets have closed so they can't access new money from the market. The test we use at Macquarie is that we have to be able to run our business for a full year assuming the financial markets have closed. We assume that we won't be getting any money coming in the door for a year and then we still have to be able to meet all our commitments. Effectively, we pre-fund all our commitments for the next 12 months, including debt repayments and other costs.

After 12 months if we assume the markets have remained closed, we then do an analysis and say "Well, if they continue closed what happens after that?" And basically, with the matching of the assets and the liabilities, it means as our assets free up we will have the cash then to pay the liabilities down. So we're working on a worst-case outcome all the time from a funding viewpoint.

Knowledge@Australian School of Business: In some cases even the best risk analysis isn't really going to work so what do you do then? Do you just walk away from it? How can you get the best out of the situation?

Nicholas Moore: Of course, we don't know what the future will be and even with the best work sometimes you'll get things wrong. That said, we have been pleased so far that while we went through various financial crises, when we have lost money on positions, to date they have all been within what our expected loss amounts were. We obviously didn't like losing money in the 2008 crisis, but the losses that we did incur were within the limitations we had set for ourselves.

This reinforces that our approach is probably the right way. Will we always get it right? The answer is that the future is entirely uncertain and we probably won't – but we always have to try to make sure that we are focusing on what can go wrong and making sure that that loss is affordable.

Knowledge@Australian School of Business: So finally what are the challenges going to be for the year ahead? There's the risk of the unknown, but what else can you see coming?

Nicholas Moore: From a Macquarie viewpoint, the issue we're dealing with is that we have six different businesses across the group and three or four of those businesses are going very well indeed – they actually have record performances. Our lending, funds management and retail businesses are all going as well as they've ever done.  Our FICC (Fixed Income, Currencies and Commodities) business has a whole range of exposure to the commodities and the resources markets and we think this year it's going to be doing better than it did last year, albeit last year it was very, very challenged by the downgrade that took place in the US and the Greek crisis.

The two businesses that are challenged at the moment are our securities business and our advisory business within Macquarie Capital. Last year between the two of them they didn't make a contribution to the group and with both we're hoping this year will be better than last year.

To have a better year next year and the year after those businesses need more confidence in the equity market out there. Plainly the world has turned off risk dramatically; we've never seen such low prices for fixed income and such low prices for cash.The reason we're seeing such low prices obviously is that's where the capital's flowing; the capital isn't interested in terms of equity because equity is viewed as being too risky.

So the flow has all been against the equity market, which drives the securities business and the advisory business. For us for the year ahead, the big question is: How will that risk-return equation for the whole world actually play out? We are looking at the way the world's view on risk is moving and as long as the world's not taking risk in terms of equities those businesses will be subdued.