Infrastructure blues

Previous columns have commented on the extent to which higher interest and discount rates have adversely affected sentiment across a range of alternative asset classes, including the infrastructure sector. The prospect that private finance initiative (PFI) and public-private partnership (PPP) projects will expire over the coming years, together with an erroneous cost-disclosure regime inflicted on the investment trust sector more generally, also weighs on the sector. This has created a perfect storm. Yet there are reasons to believe such concerns are overplayed and the fundamentals remain sound. As such, wider than average discounts and handsome yields represent an attractive opportunity for patient investors – particularly at this point in the interest rate cycle.

The risks

Rising interest and discount rates have proved a strong headwind to several alternative assets, including infrastructure. Higher interest rates and bond yields are competing for the attention of those investors seeking income. Higher discount rates have raised market concerns about the validity of asset values. Poor sentiment is casting a long shadow. Together with an ill-judged cost-disclosure regime which is making investment trusts look unduly expensive (see my column ‘When is a cost not a cost?’, 29 December 2023), particularly those managing physical long-term assets such as infrastructure, in large part accounts for the reason discounts have widened significantly.

Yet, as highlighted in previous columns, interest rates have now peaked. While believing inflation will continue to be ‘stickier’ over the medium term than the markets became used to prior to the recent spike, it will fall further in the coming year. The scale at which sentiment is shifting is perhaps illustrated by the OBR halving its forecast for later this year to 1.4% from 2.8%. Having been behind the curve on the way up, and being stung by criticism for being so, the BoE risks being likewise on the way down. It should be cutting interest rates now given the direction of leading indicators, including the money supply figures. Yet its own forecast still suggests inflation will rise to 3% by year end.

Pressure will mount as the need to cut becomes increasingly obvious. Sentiment towards the infrastructure sector will be helped when the market gets a better sense of the timing, given it still has one eye on the BoE inflation forecast. Modestly falling interest rates, together with accommodating bond yields and discount rates, will not only lessen the competition of income but also allay concerns somewhat about asset values. Focus may even shift onto the reasonable number of asset realisations above carrying value which already suggest credibility. The relevance of the sector’s predictability of earnings, robust cashflows and inflation-linked revenues will also come to be revisited and acknowledged.

However, this is not the full story. Each asset class also has its own story. Perhaps a key concern for infrastructure is the prospect that private finance initiative (PFI) and public-private partnership (PPP) projects will need to be handed back to procuring authorities, typically the government, as the expiry of their contracts end in the coming years and decades. These contracts usually relate to the managing of hospitals and schools, which generate robust and government-backed revenues that are often inflation-linked. As such, when the contracts end, the assets (usually buildings) no longer form part of the companies’ portfolios and asset values will decline subject to investment elsewhere.

By way of context and timescale, the concessions usually run over 20-25 years and recent figures suggest there are over 500 PFI contracts in operation. The number of expiries will climb steadily in the coming years, and as we approach mid-century few contracts will remain. New such investments can no longer be considered given the UK government said in 2018 that it would not use the PFI model in future. This is despite history suggesting the private sector is far more efficient than the public sector in running such projects – HS2 immediately springs to mind. Indeed, these projects are regularly assessed by the National Audit Office to ensure taxpayers’ money is being well spent.

Further concerns relate to the return of some very large assets being unchartered waters for investment companies. They will certainly command managers’ resource and time. Furthermore, new investments of whatever variety are unlikely to come to fruition in the short-term given discounts are historically wide and so the issuing of equity is unlikely while this remains the case. Indeed, many companies are committing to share buybacks to reduce discounts, and this is taking money out of the sector – the misguided cost-disclosure regime again being a contributory factor.

The opportunities

Yet many of these concerns are somewhat overplayed. If political dogma and popular misconception were to be circumvented, operators would be granted contract extensions or offered some form of equivalent. Investment in many infrastructure projects in this country and around the world is sorely needed and heavily indebted governments are already finding it difficult to meet required demand. With other spending commitments assuming greater importance, including defence, this reality will remain unchanged. Pragmatism will eventually triumph given the private sector’s good track record of managing large projects.

However, perhaps shorter-term factors suggest optimism. The expiry timetable will be gradual. For example, over the next decade HICL Infrastructure (HICL) will return an estimated 11% of its portfolio at current values, while International Public Partnerships (INPP) is not set to return its first concession until next year. Despite the current level of discounts, this allows time for the managers to seek alternative investments. HICL is already conserving cash resources somewhat to that end by not growing its dividend despite the high correlation of its revenues to inflation.

Meanwhile, these companies are diversifying both by geography away from the UK and by projects without concession, but which still possess strong long-term cashflows. Some offer higher returns and risk while being regulated investments. HICL’s largest is Affinity Water, a water-only company supplying the home counties (c.8% of the portfolio), while INPP’s largest is Cadent, a gas-distribution company supplying over 10m homes and businesses in the UK (c.15% of the portfolio). Such investments typically possess a longer life than PFIs but are more economically sensitive with less inflation correlation. This is where the experienced managements in the sector will come into their own in the interests of shareholders.

Additionally, there is every reason to believe that cashflows will remain robust in the final years of these contracts, which should assist dividends and other distributions. Courtesy of prevailing discount rates, the current value of future cashflows already factor in the concessions ending. Furthermore, in the short-term, the asset prices achieved when being traded suggest the NAVs are robust, if not conservatively valued. As such, given the poor sentiment and historically wide discounts, investors should not rule out corporate actions including buyouts.

Finally, further to my recent update on the cost-disclosure campaign, pressure is building on the Government to put things right. The FCA believes it has gone as far as it can without legislative cover. The draft Statutory Instrument (SI) on PRIIPs and subsequent consultation resulted in an unprecedented industry response of over 300 individuals and investment houses suggesting investment trusts are removed from the Consumer Composite Investment category – meaning trusts would no longer have to state a cost in the EMT feed used by institutional and retail investors alike. A FCA consultation on this SI and further SI on MIFID is forthcoming – but these now risk failing to reflect the urgency required.

As such, further discussions with Treasury ministers ensue and last week I asked the Chancellor at a Treasury Select Committee evidence session to introduce a further SI encompassing the 300-plus industry response. The FCA would not need to be involved which would save time. The Chancellor promised to consider this ‘at pace’. Meanwhile, Baronesses Ros Altmann and Sharon Bowles recently received good cross-party support for their Private Members’ Bill in the House of Lords, while investment trust managements have written directly to the Chancellor. The resolution of the misleading cost-disclosure issue would help to close discounts and encourage resumption of the tens of billions that have previously been invested into infrastructure through these companies.

B&G portfolio holdings

HICL Infrastructure (HICL) provides exposure to a collection of infrastructure investments. These include water utilities, toll road concessions and student accommodation – primarily in the UK, but also in Europe, North America and Australia. PFI/PPP projects account for nearly 60% of the portfolio. The average life of the investments is typically c.25 years, which provides predictability of cashflows. Recent asset sales at a modest premium to carrying value confirm NAVs are credible. Meanwhile, company revenues with a 0.8 positive correlation to inflation, a yield of 6.6% and discount of c.22% all suggest sentiment trails fundamentals.

International Public Partnerships (INPP) seeks to provide stable inflation-linked returns via growing dividends and capital appreciation courtesy of a diversified portfolio of assets. Around 40% of the portfolio consists of PFI and PPP projects, with the UK accounting for c.70% of assets by value. The robust cash generative nature of its assets has allowed the company’s dividend to increase by 2.5% a year since 2006 – except last year when the increase was 5%. A recent management update was reassuring, while realisations again confirming valuations are realistic. A 20% discount and 6.4% yield adds to the investment case.

Sequoia Economic Infrastructure Income (SEQI) seeks income and capital appreciation from predominantly private debt infrastructure investments. These tend to be defensive given their low default rates and low correlation to other assets. Exposure is diversified both by sector and geography. Most of the portfolio is benefitting from its exposure to floating rate loans given the higher interest rate environment. The portfolio is relatively short dated which allows flexibility to capitalise on higher interest loans. A recent statement from the management suggests confidence. Meanwhile, the 6.875p dividend represents a 10% increase on last year and is expected to be fully covered. This equates to a yield of 8.5%.

Disclaimer: The information contained in this article does not constitute investment advice or personal recommendation and it is not an invitation or inducement to engage in investment activity. You should seek independent financial and, if appropriate, legal advice as to the suitability of any investment decision. Past performance is not a guide to future performance. The value of investment company shares, and the income from them, can fall as well as rise. You may not get back the full amount invested and, in some cases, nothing at all.

Return to News