Utilities were traditionally seen as pretty boring investments – and with good reason. With their regulated prices and virtually guaranteed demand, electricity networks, water companies, gas pipelines, port operators and airports had predictable revenues and threw out huge amounts of cash. The only risk was that, in their desperation to sex up the business, management would go and blow the cash investing in something daft. Usually, their share prices tended to fluctuate in line with interest rates and according to whether the management looked to be cutting costs faster or slower than anticipated by the latest regulatory review. From the point of view of investors, the best thing about them was that they delivered a reliable chunky dividend, which is why the main buyers tended to be pension funds.
Utilities stocks: BAA and ABP set the standard
So what’s changed? On the face of it nothing. Utilities are still reliably throwing off cash and paying out dividends. But suddenly, they’re no longer boring. The utilities sector – or “infrastructure” as it has been glamourously re-branded – has suddenly become this year’s must-have investment. Competition to buy infrastructure assets is intense. AWG, the water group, recently admitted it had received a bid. Henderson, the fund manager, has just paid £800m for Laing, an infrastructure group specialising in private finance initiative projects. Bidders from around the world are queuing round the block to buy Thames Water from Germany’s RWE. And earlier this year, BAA and Associated British Ports fell to foreign bidders for jaw-dropping multiples.
Why the Australians are to blame
Blame it on the Australians. They started it. Two things happened in the mid-1990s in Australia to kick off the infrastructure craze. First, the government introduced compulsory pension-saving. That led to an explosion in the size of Australian pension fund money looking for a home. The country now has the fourth-largest funds under management in the world. Second, the government started to sell off the country’s infrastructure, which badly needed fresh investment beyond anything the state could provide. Sharp-eyed financiers, notably at investment bank Macquarie, spotted an opportunity. They bought this infrastructure, borrowing heavily against the stable and secure cashflows. It then repackaged the assets into listed infrastructure funds which it sold on to the pensions funds. Meanwhile, Macquarie made a fortune from fees.
How European utilities became involved
Before long, Macquarie and its imitators were running out of opportunities in their home market and started looking abroad. At the same time, governments in Europe and elsewhere cottoned on to the role infrastructure funds could play in modernising their outdated infrastructure. European governments embarked on major privatisation programmes. In the US, state governments awarded conces¬sions to build new infrastructure such as toll roads. Inevitably, Australian infrastructure funds such as Macquarie and Babcock & Brown, have played a prominent role. But their success has attracted the interest of the big investment banks. In the first half of this year, investment banks raised $30bn for infrastructure funds. Goldman Sachs raised a $3bn fund, Morgan Stanley is raising $1bn and Credit Suisse a further $1bn.
Utilities stocks: where is the money coming from?
And where is all this money coming from? Bizarrely, from the same pension funds that already invest in utilities. Why they would swap a direct investment in a utility for a share in an infrastructure fund that carries high charges – typically 1.5% plus 20% of any returns above an agreed rate – and probably a lower running yield, is a bit of a mystery. One explanation is that pension funds hope that infrastructure funds can bring a new management approach, free from the short-term pressures of quarterly reporting and maintaining the share price. Perhaps they are right. But where does this pressure for short-term performance come from? Pension funds, of course.
How should investors play the infrastructure boom?
Illogical as it may seem, the figures show the amount of pension money pouring into infrastructure funds is likely to increase. So how should investors play the boom? Prices have rocketed this year – but from a very low base. Infrastructure funds look at their investments in much the same way as a real estate investor. So long as the yield is sufficient to cover the cost of the debt, it is a good deal. In fact, it is usually a better deal than property, since tenants can move out and buildings can fall down, whereas everybody will always need water or electricity. Yet until recently, some utilities were trading at 12% free cashflow yields – compared to interest rates of 5%. Those gaps may have closed, but that won’t necessarily deter the infrastructure funds, who are long-term investors more interested in secure yields than making private equity-style returns. And even now, UK infrastructure still yields more than London commercial property, which yields as little as 4.5%. All of which suggests investors should hang on to their utilities shares – and wait for the bids to roll in.
Simon Nixon is executive editor of Breaking views.com