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21 Australasian Finance and Banking Conference 1. Title Competing in global niche markets: the case of Macquarie Bank 2. Primary Author Dr. Cameron Gordon 3. Co-Authors (separate with comma)

4. Prizes Select the prizes for which you would like to be considered (you may pick more than one). (For more information about prizes please see the conference web site: www.banking.unsw.edu.au/afbc) Prize Barclay's Global Investors Australia Prize

BankScope Prize

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Sirca Research Prize Australian Securities Exchange Prize

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5. Journals Select the journals for which you would like to be considered (you may pick more than one). Journal Journal of Banking and Finance Journal of Financial Stability

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6. Conference Proceedings

Would you like your paper (if accepted) to be published by World Scientific Publishing Co Ltd as a review volume compiling selected papers?

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0 Electronic copy available at: http://ssrn.com/abstract=1251362

TITLE: Competing in global niche markets: the case of Macquarie Bank AUTHOR: Cameron Gordon, Senior Lecturer in Banking and Finance University of Canberra, Faculty of Business and Government Bruce, ACT 2601 Australia ABSTRACT: This paper examines the value creation model employed by Macquarie Bank, the worldwide leader in private infrastructure finance. Macquarie, an Australian firm, uses an infrastructure investment model that has been the subject of much imitation. A combination of merchant bank and venture capital fund, along with asset operator and funds manager, the firm has been a leader in transport and infrastructure privatization, first in its home territory of Australia, and now across the world. The Macquarie case is interesting because the firm has internationalized by developing a unique market expertise; transformed this expertise into a set of core capabilities; and leveraged both of these components within a structure of corporate entrepreneurship. As such the Macquarie case may offer a new hybrid model for financial services globalization. However, the turbulent events surrounding the subprime crisis have shown the limits of the model as well and raise questions about the sustainability of strategies that make have leveraging as a central component. Keywords: internationalisation; infrastructure; infrastructure finance; Macquarie Bank; MBL JEL Codes: G21, G24


TITLE: Competing in global niche markets: the case of Macquarie Bank ABSTRACT: This paper examines the value creation model employed by Macquarie Bank, the worldwide leader in private infrastructure finance. Macquarie, an Australian firm, uses an infrastructure investment model that has been the subject of much imitation. A combination of merchant bank and venture capital fund, along with asset operator and funds manager, the firm has been a leader in transport and infrastructure privatization, first in its home territory of Australia, and now across the world. The Macquarie case is interesting because the firm has internationalized by developing a unique market expertise; transformed this expertise into a set of core capabilities; and leveraged both of these components within a structure of corporate entrepreneurship. As such the Macquarie case may offer a new hybrid model for financial services globalization. However, the turbulent events surrounding the subprime crisis have shown the limits of the model as well and raise questions about the sustainability of strategies that make have leveraging as a central component. Keywords: internationalisation; infrastructure; infrastructure finance; Macquarie Bank; MBL JEL Codes: G21, G24


Introduction The financial services industry has become increasingly globalized and competitive. Large financial institutions based in large economies would seem to have the advantage in this environment. Yet a relatively small investment bank by the name of Macquarie Bank, based in the relatively small economy of Australia (approximately 14h in GDP, less than 2% of the world’s total), has rocketed to a place of prominence in the field of infrastructure finance. In 2006 the company successfully led consortiums that took over leasing and operation of the Chicago skyway and the Indiana toll roads in the United States, the largest surface transportation privatizations in that country’s history since the building of the Intercontinental Railroads. In 2007 the firm successfully bid to take over Thames Water in London. Even its failed bids, most particularly its attempt to buy the London Stock Exchange, point to an internationalized powerhouse. And these were only the most prominent of an ongoing slew of such transactions throughout the world. This paper examines the value creation model employed by Macquarie Bank, the worldwide leader in private infrastructure finance. Macquarie, an Australian firm, uses an infrastructure investment model that has been the subject of much imitation. A combination of merchant bank and venture capital fund, along with asset operator and funds manager, the firm has been a leader in transport and infrastructure privatization, first in its home territory of Australia, and now across the world. The Macquarie case is interesting because the firm has internationalized by developing a unique market expertise; transformed this expertise into a set of core capabilities; and leveraged both of these components within a structure of corporate entrepreneurship. The strategy also appears to be replicable since it has spawned a number of competitors. As such the Macquarie case may offer a new hybrid model for financial services globalization. However, the turbulent events surrounding the subprime crisis have shown the limits of the model as well and raise questions about the sustainability of strategies that make have leveraging as a central component. Competing in international financial markets Globalization is the universal trend in economic markets and the market for financial services is no exception. Although there is no simple measure, data on cross-border financial claims, foreign currency denominated claims, and offshore activity have all trended upwards over the past ten years, showing the increasing world-wide scope of banking. Similar trends can be seen in activities such issuance of debt securities on

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international markets.1 TABLE 1: SELECTED MEASURES OF FINANCIAL SERVICES GLOBALIZATION a. Countries of origin for the world’s ten largest banks (by assets) 2005: US (3); UK (2); Germany (1); Switzerland (1); France (1); Japan (1) 1990: Japan (7); France (3) b. US banks with foreign branches/number of foreign branches in US 1990: 122/833 2006: 37/713 c. Stock Market capitalization of selected countries -- % of world total 1990 2005 US 32.6% 39.0% UK 9.0% 7.0% Japan 31.0% 10.9% HK 0.9% 2.3% India 0.4% 1.3% China --1.8% Australia 1.1% 1.8% d. Banks reporting cross-border claims (total US $) Q1 2007: $28.5 trillion (up $2.2 trillion from Q1 2006) Q1 1995: $345 billion Sources: (a) American Banker, 1991 and 2006, “The World’s largest banks”. Data are for 31 December (b) Board of Governors, US Federal Reserve System (c) Standard and Poor's, New York, NY, Standard & Poor's Emerging Stock Markets Fact book 2006 (d) BIS Quarterly Reports, September 2007 and August 1996

Scale and scope of operation have long been important in building successful financial intermediaries, especially in international settings. Most academic banking studies find that existing banks often could improve their financial performance by increasing their scale of operations, either overall or across specific product categories. Findings on scope, i.e. diversification, are more mixed but for many institutions a strategic expansion in the product mix could offer definite payoffs.2 Successful financial institution internationalization tends to take two routes. One strategy is to build up a broadly diversified set of financial service offerings. This is the path chosen by most international banks such as Citigroup, UBS, Deutsche Bank and so forth. Most of these institutions are either based in very large economies 4

where the home institution has been able to build diversification domestically first (e.g. the US and Germany), or are based in small economies that have long been financial entrepots (e.g. Switzerland and the Netherlands). These institutions tend to be well-capitalized and use their wealth as a base for going offshore in a substantial way. Another strategy to build up scale is to specialize in a global niche. Credit card processing is a prime example of such a strategy where banks such as MBNA have developed specialties in credit card branding and IT management to become global leaders in the field. In investment banking activities specialty leaders have long been common, with firms such as Goldman Sachs and Morgan Stanley being world leaders in services ranging from underwriting, mergers and acquisitions and fund management. The general pattern in niche plays of this sort is to take an established financial function and deliver it ‘better’ than anyone else, typically through some sort of innovation. The niche strategy is particularly useful, but not exclusively limited to, institutions based in smaller economies. As discussed further below, Macquarie Bank of Australia has used the niche strategy to build into an institution of global prominence. The bank has invented an essentially new niche market – infrastructure finance – and has built it up through an evolving set of processes that have allowed the firm to reap economies of scale, and in certain ways, scope, within that niche. Its strategy, however, also has raised some issues about risk management, issues which the bank says it has addressed and which the current crisis is testing Key elements of financial services internationalization: theory Financial services provision is a unique business in many ways. First and foremost, the role being offered is one of intermediary: value is added indirectly through the facilitation of funds movements from surplus funders to deficit funders. Second, a significant driver of the business involves the strategic use of financial leverage to earn a spread of one sort or another; this is the basic driver of firm-specific return. Third, there is significant system externality to most financial intermediation functions. Provision of overall liquidity is a public good and this means that individual credit and lending decisions can sometimes be driven by or have potentially significant systemic impacts; this is a key driver of downside risk (in the event of negative externality) and non-firm specific synergy (in the event of positive externality)). All three elements combine to make this an industry in which regulation (and deregulation) plays a significant role. In a sense, any party with access to surplus capital could be a financial intermediary

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channelling funds to those that need them; however, the most successful intermediary will be one that has built specialised knowledge that can be accessed and tailored to meet competitive needs and challenges; a key underpinning of that is an internal firm structure, culture, and set of systems that develops and embeds such knowledge in a flexible and nimble way. Note that these are general statements. It is possible for exceptions to occur, especially where there is some starting point of regulatory or wealth advantage. The Macquarie case is interesting because the firm has internationalized by developing a unique market expertise; transformed this expertise into a set of core capabilities; and leveraged both of these components within a structure of corporate entrepreneurship (which has various definitions but in this context is probably best captured by the statement that it is a process of “extending the firm’s domain of competence and corresponding opportunity set through internally generated new resource combinations,” i.e. internal reallocations of corporate skill, knowledge and resources that either alter existing competitive balance, create new industries or do both.3) These, then, will be the three themes of an analysis of the Macquarie Bank’s unique (but, it will be argued, replicable) model of financial services internationalization: specialized knowledge creation; transformation of that knowledge into dynamic capabilities; and the use of a corporate structure that allows for the interplay between the two. These factors will be discussed extensively after first briefly reviewing the firm’s genesis. Macquarie Bank – background and history As mentioned previously, Macquarie Bank is a company based in neither a large economy (Australia) nor a large financial center (Sydney). Nor has the firm excelled in the generally established financial intermediation functions associated with commercial and investment banking. For example, the firm consistently ranks below the top tier in most annual lists of leaders in traditional investment bank functions. Yet the bank’s income has risen from $757 million in 1998 to $7.2 billion in the latest quarter of 2007. In that same period its profits rose from $14 million to $1,463 billion. The firm now earns 55 percent of its income from abroad (compared to roughly a quarter 4 years prior). International staff members rose by 48 per cent over one year to 2,800 out of 8,600 total, spread across 24 countries. Although the firm has chosen for the moment to remain in Australia, it has considered a move of its headquarters to London and is in the process of restructuring itself to allow such a move to be easily made in the future (including applying to the Financial Services Authority in England

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for a banking license). All of this has been heavily (though not exclusively) driven by the Bank’s dominance of a niche that it invented: infrastructure finance.4 The firm’s origins did not suggest anything so grand. Macquarie Bank began as the merchant bank Hill Samuel Australia (HSA), a wholly-owned subsidiary of Hill Samuel & Co. Limited, London. Established in Australia in 1969, it began operations in Sydney in January 1970 with only three staff.5 These early operations took place in a context of an Australian financial system that was heavily regulated and protected and from the middle of the nineteenth century until the late 1960’s; internationalization of Australian banks consisted of branches in London, New Zealand and some Pacific islands.6 However, Australia’s membership of the Commonwealth and a strong bilateral economic, political and social alliance with Britain, allowed local firms to gain expertise in emergent Euro-currency markets and the operations of a major world financial centre without being subjected to the full force of international competition. Three external events then proved to be critical to the firm’s trajectory. The first critical event was financial market deregulation in Australia In 1981, in response to which, HSA proposed to become a trading bank. Authority for HSA to become Macquarie Bank Limited (MBL) was received from the Federal Treasurer on 28 February 1985. The reasons for this move were tied mainly to the fact that as a subsidiary of a foreign company Australian regulations prohibited establishment of full commercial banking services in the country and the deregulation being implemented made establishment of a trading bank (only the second created in Australia during the 20th century) the most sensible option for expanding domestic presence while simultaneously being open to international growth. That same year, and prior to being granted its trading bank authority, HSA had expanded into New Zealand. After being granted a license to become a trading bank, Hill Samuel reduced its share of the new MBL to 14%.7 The second critical event was the Australian law mandating superannuation contributions by employees. Ultimately set at 9% of an employee’s annual salary in a 1992 law strengthening the “super” system, this policy created a wave of surplus capital looking for investment opportunities with high but dependable returns. Macquarie Bank’s move into infrastructure finance was the result of a third accidental event: a request by the government of New South Wales, which was beginning to privatise the surface roads in and around Sydney, for the bank to arrange a simple project finance loan for the M2 toll road in northwest Sydney in 1996. (This was the same year that the firm first listed on the Australian Stock Exchange (ASX)).

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The invention of the infrastructure finance model These three sets of circumstances were what Macquarie used to build the first plank of a global model: creation of a specialized niche in which it was the only expert. The firm had a first mover advantage because it had invented a new game. Macquarie came up with the idea of an infrastructure fund in which it packaged the underlying asset into a separate vehicle and raised equity through the fund. “The investor response was quite positive, and there didn’t seem to be any reason why we could not begin to do this for ourselves as a principal,” said Nick Minogue, Macquarie’s Chief Risk Officer in a 2006 article.8 In this first deal Macquarie came up with the notion that with infrastructure there was not only money to made up front in the structuring of a privatized road deal but money to be made on an ongoing annuity basis, through creation of listed vehicles to carry the deal forward, with the bank itself managing the fund, and also on to operating the road itself for a generous fee and access to tolls and other revenues. Other Australian banks went after the superannuation money, but only Macquarie hit upon this particular notion of how to utilize it. At its core, the business model which made Macquarie a global entity is deceptively simple: the firm buys infrastructure; places the underlying assets in a series of interposed entities, usually with a unit trust issuing units to the public; leverages against its investments; produces returns in various ways from its control of that infrastructure; and then directly and indirectly uses the increased equity value to leverage some more, or at least pay out returns to its shareholders. But as with most successful models, the approach seems simple in retrospect. Coming up with the idea first obviously gave the firm a first mover advantage which it has built upon handsomely. Something of the bank’s approach is perhaps captured in the name and logo it chose for itself. The Bank’s name is from one of New South Wales’ early governors, Governor Lachlan Macquarie (1761 - 1824), who helped establish Australia's first bank. Governor Macquarie also introduced Australia's first domestic coinage, the “Holey Dollar” which serves, in stylized form, as the Bank’s logo. An 1813 currency shortage was overcome by purchasing Spanish silver dollars (then worth five shillings), punching out the centres and creating two new coins - the 'Holey Dollar' (valued at five shillings) and the Dump (valued at one shilling and three pence). Governor Macquarie thus doubled the number of coins in circulation and increased their total worth by 25 per cent in a single stroke.9

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In a way, this is what Macquarie has done with infrastructure finance, i.e. taken an asset with one perceived market value and broken it into interlocking pieces which end up having a different, higher perceived market value. This was a new idea at the time but Macquarie has not just made profit of the idea one-off. It has built the idea into specialized knowledge which it so far continues to profit from. The basic strategy of infrastructure finance Macquarie’s basic infrastructure model relies on the following corporate tasks: (1) Successful bids – traditionally higher than what the basic market thought was feasible – for existing infrastructure assets or the right to build new assets; (2) Picking of assets that have some sort of monopoly advantage (allowing maximum pricing power); (3) Bundling of the assets into listed funds (though with a fair amount of unlisted funds as well); (4) Raising of revenue from the sale of shares or units in those listed funds; (5) Collection of additional revenue from fees collected as fund manager; (6) Structuring of operating contracts and leases (often in a consortium) to manage the actual infrastructure assets, garnering management and other fees; (7) Creation of interrelated but notionally independent corporate and subcorporate entities to maximize fee-earning opportunities and, in some cases, reported income gains from asset revaluation as income without actual disposal of the asset. (8) Leverage across all of these entities and business elements. These tasks rely on the following core capabilities: (1) Asset valuation – Macquarie has been noted for deploying large numbers of financial analysts on each prospective deal to tease out every potential prospective cash flow, many of which might have been overlooked, before putting in a bid. The hope is that it can outbid competitors but still get a good price; (2) Deal structuring – following from the above, Macquarie is known for being especially sharp and hard-knuckled when it comes to putting together financial deals. Their strategy is not always to have the lowest bid, and the price the firm is often willing to pay for an asset can seem rich but in retrospect is sometimes seen as shrewdly cheap. For example, the firm bid, with consortium partner Cintra, $1.83 billion for the Chicago Skyway; the next bid was for $700 million. But what Macquarie does insist upon, and so far usually

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gets, is maximum freedom of action to do what it wants with the assets it obtains. In the case of leased assets (like the Skyway or Sydney Airport), these are often very long-term leases (75 year or 99 year) with minimal oversight by the lessor other than provision of a certain basic outputs. (3) Liquidity management – Macquarie is known for its shrewd oversight of the liquidity cycle, getting the most possible disposable (and cheapest) capital from each deal; (4) Risk management – an obviously central issue for any financial intermediary, especially one as organizationally complicated as Macquarie; (5) Knowledge management – the intricacies of the infrastructure finance model that Macquarie has created, in which financial intermediation and ongoing facilities management are combined and flung across a seemingly disparate collection of related entities requires keeping track and rolling up of ‘lessons learned’; (6) Corporate governance – a potentially weak link: how does Macquarie keep its hydra-headed organization working as one, with minimal abuse or mismanagement? (7) Infrastructure management – another difficulty, for it is one thing to structure and execute an infrastructure deal, another to effectively manage a physical facility. This basic niche almost requires the creation of both listed and unlisted entities to make it work. The entity known as Macquarie Bank Limited (MBL) is a universal bank is the home institution but it establishes itself in the infrastructure business (and in other businesses as well, not discussed here) through establishment of separate but related entities that are more specialized and focused than the bank itself. Some of the uniqueness of MBL can be seen in Table 2 which shows some key financial and share price performance measures for the bank itself and for one of its major infrastructure businesses, the Macquarie Infrastructure Group (MIG), compared with industry and market averages and 4 major investment banks. (Macquarie Airports, “MaP” is another important entity but a lack of data for some of the 5-year data series kept it from being included in the table below). Table 2: selected financial and share price data for MBL, MIG and key competitors Indicator Sales Growth % (5 year average) EPS % (5 year average) P/E ratio (9/22/07)

MBL 35.64

MIG 20.54

Industry*

14.50

S&P 500 13.75

UBS 10.98

GC 17.37

CS 3.53

MS 11.77

34.56

14.68

32.69

23.14

34.64

35.79

NM

17.52

13.51

4.62

19.19

20.38

9.15

8.63

8.82

8.40

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Beta 1.65 0.82 1.00 1.00 1.57 1.48 1.71 1.75 Operating 28.10 51.81 37.00 19.26 26.61 19.68 18.51 35.29 Margin (5 year average) ROA (5 year 1.29 6.98 5.40 7.10 0.46 0.97 0.40 6.69 average) ROE (5 year 23.10 10.29 16.80 18.51 15.00 21.02 8.33 16.47 average) Notes: • = Industry defined as “investment services.” Note that this is more properly the industry that MBL is in, not necessarily MIG. • UBS = Union Bank Switzerland AG • GC = Goldman Sachs • CS = Credit Suisse • MS = Morgan Stanley • Data source: Bloomberg.com, accessed 9/22/07

The data above are interesting in a number of ways. First there are some significant differences between MBL and MIG, even though these are closely related entities. Over the past 5 years MIG has had faster growth than MBL in operating margin and ROA, but lower growth in other indicators of return. MIG is less risky relative to the market (using beta as a measure) than MBL. And comparing the two entities to other major investment banks, one might conclude that they are in different businesses which in a real sense they are, and by design. MBL roughly aligns with 4 major investment banks in terms of beta, 5 year EPS growth and operating margin (though it is faster growing in terms of sales, has higher ROE and sells at a higher multiple), somewhat the opposite of how MIG compares to these same banks and to the industry as whole. As will be seen in more detail in the discussion of corporate entrepreneurial structure, MBL uses multiplicity of organizational form to both spread risk and generate return in the service of growth in its various niche businesses. The use of multiple entities in investment banking is by no means unique, by Macquarie seems to have taken it a particularly high level of refinement. One can then return to Macquarie’s position as an Australian bank. Various investment banking league tables, such as those compiled by Thomson Financial, almost never contain Macquarie in the top ranks. Yet Macquarie has combined the very limits that Australian banks came up against – small capital bases, small domestic markets and long distances from major capital and goods markets – with their unique strengths of long-term collaborations with London banks and later on largely non-competitive relationships with large banks from other countries postderegulation to be forced into developing firm-specific rather than country-specific advantages.10 11 1 1

As a country, Australia has relatively few advantages as a base for financial services globalization. Overall Australian banking performance globally seems to confirm this. Despite domestic mergers and acquisitions, the largest Australian bank internationally (NAB) had a lower rank in 1999 (63) than the largest bank in 1969 (Commonwealth at 49).11 And Australian banks have not been innovation leaders post-deregulation. They lagged behind the British clearers in mechanisation and adopted bank credit credit cards and ATM’s years later than in the US.12 But while country-specific advantages are few, firm-specific advantages arising from Australia’s unique financial history, especially the long cooperative history with London banks, could be paramount. And this is what Macquarie has played forcefully, transferring London-based expertise to a specialized domestic niche, developing that expertise into generalizable knowledge and then building that knowledge into dynamic capabilities that can move to worldwide markets. Macquarie’s chairman, Alan Moss, encapsulated the bank’s systems approach in these 2006 remarks: “Firstly, we ensure that any initiatives are built on our existing skills and competencies, or alternatively that we acquire those competencies. This is achieved either through hiring or by joining with partners who understand local conditions intimately. Even then, we usually embark on such initiatives with only a small initial risk commitment. We also apply particular controls and standards in offshore offices. We ensure that we have strong local management and we also undertake frequent management visits and internal audit reviews. We employ experienced Macquarie bank staff in overseas offices, to ensure that our risk management culture is communicated and understood by new staff joining the team. And we maintain central oversight of risk management and centralised payment control.”13 Corporate entrepreneurial structure The Macquarie infrastructure finance business rests on a multilayered business model. How does it hold together and how is this successful business integrated with the rest of the bank's complex operations? The key element of Macquarie’s strategy is lateral structure. The firm itself describes itself in this way: “Macquarie's organisational approach is designed to be non-hierarchical. Management of the organisation is largely delegated to the Executive Committee, a central group comprising the Chairman, Managing Director, Deputy Managing Director, Head of Risk Management and heads of the Bank's six major business Groups.”14 The firm’s own organisational chart is provided in Figure 1.

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Figure 1

Recently retired Macquarie CEO Allan Moss has described MBL as a "federation of entities" in which individual business managers are given freedom to work within strictly defined risk criteria. Greg Mackay, head of the Bank’s Equity Markets group was quoted as saying that "the strategy is led bottom up, not top down," "That risk control framework affords the opportunity to manage the business as you see fit." In theory this approach has all the advantages of an entrepreneurial spirit, but backed by the support of a large institution with the risk-reward trade-off firmly put in central place.15 In infrastructure, the firm’s activities appear to be varied. Table 3 contains a list of some of the firm’s major investments in this area (noting that these investments are generally not made through MBL but related entities such as MIG and MaP).

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Table 3: Selected major Macquarie infrastructure investments TOLL ROADS (AUSTRALIA) M1 (Eastern Distributor) (MIG - 71.35% interest): 6km toll road linking Sydney CBD with southern and eastern suburbs and harbour crossing M4 (MIG - 50.6% interest): 42km toll road servicing Sydney's western suburbs M5 (MIG - 50% interest): 22km toll road servicing Sydney's south western suburbs EastLink (a Macquarie Bank subsidiary is the manager of the trusts): 45km toll road (under construction) connecting Melbourne's eastern and south-eastern suburbs Westlink M7 (MIG - 45% interest): 40km toll road (under construction) linking the M2, M4 and M5 in Sydney (CANADA) 407 ETR (MIG - 30% interest): 108km toll road in Toronto (USA) Chicago Skyway Indiana Toll Roads AIRPORTS Sydney Airport Brussels Airport Copenhagen Airport Bristol (UK) Airport Birmingham (UK) Airport UTILITIES Thames Water (UK) Aquarion* (MacBank/MEAP - 100% interest): Water utility business (water distribution and other related services) operating in the US New England region District Energy (Thermal Chicago and Northwind Aladdin [75% interest] consolidated) (MIC - 100% interest): District cooling business in Chicago and district heating and cooling in Las Vegas Michigan Elec. Transmission Co (MEAP - 36% interest): Electricity transmission grid in Michigan, US The Gas Company* (MIC - #): Regulated and non-regulated gas production and distribution in Hawaii, US One part of this structure is definitely unique to financial services internationalization and is a key part of Macquarie’s management thrust: the focus on risk management. Macquarie management often claims that whether it is an asset or a corporation that is being purchased, the firm’s intensive valuation process is designed to take all relevant cash flows and all associated risks into account. If there are issues of cash

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flow quality, timing or size the firm will adjust price accordingly or perhaps not bid at all. Macquarie’s model is certainly high reward but it is also high risk. Perhaps this is why the firm spends so much time playing up its risk management and incentive processes. Alan Moss, recently retired as CEO and one who is seen as the father of the modern Macquarie, started in risk management and continued to emphasize it during his tenure. Recall Moss’s description of Macquarie as a “federation of entities.” How does one keep the flexibility of a federation and the discipline of a unity? “We give people all of the incentives that they would have as owners of the business to grow the business for themselves,” Nick Minogue, chief risk officer of the bank, said in an interview. “We also require them to own the risks, and they will be visited on their own profit-and-loss account.” Then, beyond certain levels, a sign-off from one of the 225 risk specialists in the bank’s risk-management division is required. On top of that, there is a large book of processes and procedures that bank operations, acquisitions and deals must adhere to. So while there is diversity in activity, there is, it is argued, relative uniformity in analysis and execution.16 This underlying uniformity seems to be the argument that MBL makes when claiming that its expansion into some seemingly different business enterprises is actually not all that far a field from its core infrastructure business. Minogue put it this way: “One of the dangers of the breadth of activity of the bank would be that we’d make a move too far. We apply these tests to new businesses and new products: is it something sufficiently nearby to something we already do, and do we have the relevant competency?” If the firm does not have the relevant expertise for a particular enterprise, it acquires it beforehand, either through its consortium partners or through the purchase of specialized consulting firms.17 Put another way, the firm exerts a certain type of control whatever the deal at hand: its value assessment; its risk management; its cash-flow management; its capital raising and disbursement; its management. If, indeed, MBL is seeking just a certain type of cash flow – steady, growing, protected through operation in a monopolistic environment – then perhaps “adjacency” is not the challenge that some see it to be. And in the core infrastructure business, the firm certainly has a well-established first mover and expertise advantage of a decade. Conclusions and lessons learned Macquarie Bank has internationalized and has done so from a domestic base that

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would seem to militate against doing so. Its process has been based on the following components: Creating a core of specialized knowledge: Macquarie’s model is remarkable in many ways but its core insight is simple: invest pension money (suddenly available locally in prodigious amounts) in ways that would please the investors of such money. In effect Macquarie started with the requirements of the investor – steady, above-market cash flow streams – and worked backwards toward the type of business that would generate such flows. Like many businesses, the firm stumbled into the solution by accident, but its genius has been in turning that initial opening into an ongoing and profitable niche in which it has become the more experience expert. Leveraging knowledge into dynamic capabilities: If all that Macquarie offered was expertise it would have likely been much smaller, and perhaps much more localized than it is now. The firm has managed to turn knowledge into a set of firm-specific capabilities – asset valuation, deal structuring, facility operation, portfolio management – that have allowed it to expand from its initial niche of road privatization to other infrastructure and on to ‘adjacent’ markets outside of infrastructure. Facilitating the process through corporate entrepreneurial structure: this is the key challenge – how to allow fast and creative strategic response without foundering on untrammelled risk taking or unfocused expansion. Thus far Macquarie’s ‘federation of entities’ seems to have allowed the firm to stay focused on and to refine what it does well while applying it broadly and profitably into activities that might at first seem unrelated but which are in fact part of the firm’s core financial operations. The firm has also been able to maximally leverage its different entities, either directly, as when creating a new unit trust to raise outside capital, or indirectly, through recognition of accounting gains or fee-for-service income that other more consolidated structures would not allow. Can Macquarie continue to dominate their niche, make steady profits and manage the associated risks? This is an open question that only experience will answer. But the current MBL experience does offer lessons, some cautionary, for executives and some interesting research questions for academics in the field of banking and finance. Adjacency can work as a strategy for internationalization but has pitfalls as well. For example, Macquarie started with Sydney Airport and has expanded to become a significant and thus far financially successful operator of a suite of airports in Europe. However there may be limits to adjacency if one moves to fields that seem similar but that are operationally quite different. The need for strategic development and

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implementation to be integrated is vital.18 Uniform management of risk and reward can be a firm foundation for successful diversification. This is not entirely new in financial services; indeed, spread and risk management are core functions of financial intermediaries. But MBL has pushed this model further than most. The unfolding subprime crisis, with its accompanying fall in cheap liquidity has been testing this model and it remains to be seen how well it will ultimately weather the storm. Inefficiencies in markets remain hugely profitable opportunities for those who see them. Of course the dream of every business person is arbitrage, i.e. seizing upon on information or other asymmetry before anyone else notices it. Macquarie seized upon two inefficiencies – one in the private market, which eschewed ‘staid’ assets such as roads and other infrastructure and the other in the public market, in which public sectors were relatively uninformed and unsophisticated about the underlying value of the assets they had control over. The firm’s experience also suggests that such inefficiencies may be more common that orthodox financial theory suggests. At the same time, there is the question of what the firm does next as these inefficiencies become exhausted, the answer to which is not clear. Profitable financial businesses can be built around the preferences of investors rather than trying to convince investors to provide capital to existing assets. This, too, is not a new dynamic in financial markets, but the MBL experience shows how widely it can be applied. Before MBL few thought of infrastructure as a suitable pension investment but now it is preferred in some instances. Specialized knowledge will remain localized if not transformed into actual capabilities. This is perhaps the key lesson that Macquarie has for those studying financial services internationalization. Australian banks were generally knowledge-rich because of their close relationships with London banks. But most Australian banks have failed to internationalize and none of them had the wealth that might have allowed them to try their luck overseas and become international players by acquiring foreign institutions or establishing their own ‘laboratory’ outposts. This is a position that many smaller institutions in smaller markets find themselves in. Macquarie demonstrates the importance of making the transition from specialized knowledge to dynamic capabilities and this remains an area of rich study. There are numerous hybrid approaches to financial services globalization that balance scale and scope and can be done on the cheap. Macquarie offers a unique blend of niche marketing and international scale operations. The firm didn’t just focus on a specific, existing skill set and try to do it better than anyone else. It invented a

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niche and then, perhaps more significantly, generalized the skills gained in those niche operations to enter new and seemingly unrelated markets. This raises the question of how markets are related and unrelated. Clearly markets are related in ways that are often not obvious and uncovering these subtleties can be very profitable, to say nothing of very interesting. Strategy and structure are not as distinct as they may appear. Macquarie’s blended approach demonstrates this. It is true that its business model came first, as they must. But on an ongoing basis, the distinctions between strategy and corporate entrepreneurial structure have blurred. As they must also to drive and maintain growth? References 1

Bank for International Settlements, International banking and financial market developments, BIS Quarterly Review, (14 March), 17-24 (2007). 2 Altunbas, Y., E. Gardener, P. Molyneux and B. Moore, Efficiency in European banking, European Economic Review, 45, 1931-1955 (2001). Molyneux, P., Y. Altunbas and E. Gardiner, Efficiency in European Banking, Chichester, UK: John Wiley and Sons (1996). 3 Burgelman, Robert A. (1984), “Designs for Corporate Entrepreneurship” California Management Review, 26, 154-166 (p. 154). 4 John, Danny, Lisa Murray and Kate Askew, “Up, up and away”, Sydney Morning Herald, Weekend Business Section, May 19-20, 2007, p. 41 5 Macquarie Bank, "History of Macquarie Bank", http://www.macquarie.com.au/au/about_macquarie/company_profile/history.htm# (2006). 6 Merrett, D.T. (2002). “The internationalization of Australian Banks” Journal of International Financial Markets, Institutions and Money, 12, 377-397. The discussion of Australian banking history which follows is drawn from this article. 7 "Macquarie Bank Ltd." International Directory of Company Histories, 69. St. James Press, (2005). Macquarie Bank, "History of Macquarie Bank", http://www.macquarie.com.au/au/about_macquarie/company_profile/history.htm# (2006). 8 De Ramos, Abe, The Wizard of Oz?, CFO Asia, April (2006) 9 Macquarie Bank, Holey Dollar Story, http://www.macquarie.com.au/au/about_macquarie/company_profile/history/holey_dollar.htm 10 Rugman, A.M., and A. Verbeke (1990). Global Corporate Strategy and Trade Policy. Routledge, London, New York. Rugman and Verbeke develop the framework of firm-specific advantage (FSA) and countryspecific advantage (CSA) with respect to banking. 11 Merrett, p. 388. 12 Merrett, p. 390. 13 Chairman’s address, 2006, www.macquarie.com.au/au/about_macquarie/acrobat/2006_mbl_chairmans_address.pdf 14 Macquarie Bank, Management and Organisation structure, http://www.macquarie.com.au/au/about_macquarie/company_profile/mgmt_organisation.htm 15 Parkinson, Giles, Wizards of Oz, Institutional Investor International Edition, Nov. 2006 31 i9 p98(6) 16 De Ramos, Abe, The Wizard of Oz?, CFO Asia, April (2006) 17 De Ramos, Abe, The Wizard of Oz?, CFO Asia, April (2006) 18 Johnson, G. and Scholes, K. (1999). Exploring Corporate Strategy. 5th Edition, Harlow, Essex: Pearson

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Education Ltd.; Hodgkinson, G.P. and Johnson, G. (1994). ‘Exploring the Mental Models of Competitive Stratgists: the case for a processual approach’. Journal of Management Studies, 31, 4, p525-551; Mueller, F. (1996). ‘Human Resources as strategic assets: an evolutionary resource-based theory’. Journal of Management Studies, 33, 6, 757-785.

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