Investing in infrastructure can produce attractive returns for those looking beyond equities and bonds. It’s not too late to follow the crowd, says Max King.
Everyone is in favour of infrastructure investment. The trouble is that it has to be paid for and, once completed, it has to be maintained. In past times, infrastructure was almost exclusively the responsibility of the government. The assets, often dating back to Victorian times, were in need of replacement, but the government was always short of money. Outdated assets meant a declining quality and increasing cost of the services they provided.
The initial solution of Margaret Thatcher’s government to this problem was privatisation. First British Telecom, then British Gas, followed by the airports, ports, water companies and electricity network were sold off. In the private sector, companies had access to capital independently from government, with costs to be recouped over time from customer charges. Left behind were assets that provided services for free, notably the NHS, education and roads. These badly needed investment, but the government was always short of money, and when investment was carried out, it was invariably late, of poor quality and way over budget.
The final straw was the construction of the Chelsea & Westminster hospital, built in the wrong place for double the budgeted cost and delivered late. This, together with another budgetary crisis, caused the Chancellor of the Exchequer, Norman Lamont, to launch the Private Finance Initiative (PFI) in 1992. Initial results were promising: projects were completed on time, on budget and, because of the obligation to maintain and repair the assets for 25-30 years (after which they reverted to the public sector), their full availability was guaranteed.
Diminishing returns send funds overseas
The Labour government, elected in 1997, was so enthused that it accelerated the programme. MPs worried about “profiteering at the expense of taxpayers”, but Alan Milburn, the minister for health at the time, quoted his predecessor, who had said “the only thing which will be privatised through the PFI is the cost overrun and the time overrun”. What ministers had underestimated was just how inefficient public sector procurement had been, which made the risk of PFI overruns small and the profits large.
Also, with the benefit of hindsight, falling bond yields made the returns offered to PFI providers very generous. But high returns attracted new operators, while the public sector became a tougher negotiator. PFI returns in the UK have fallen steadily and, as the supply of projects diminishes, companies have increasingly turned their attention overseas. They have also become more willing to take on more complex projects.
Once the risky construction phase is over, the prime contractors want to realise their profit and release their capital by selling the project to more risk-averse investors. These investors recoup the construction costs over 25-30 years and undertake the maintenance of the assets over that period in exchange for an inflation-linked payment stream. Financing comes from long-term borrowings supplemented by a relatively thin layer of equity. The appropriate vehicles for providing this equity are pension funds, for whom the dependable cash flow is an attractive way to match their long-term liabilities, and also listed investment companies.
The first of these, HICL (LSE: HICL), was floated on the stockmarket in 2006. Babcock & Brown Infrastructure, now called International Public Partnerships (LSE: INPP), followed a few months later, and 3i Infrastructure (LSE: 3IN) the next year.
While the first two stuck to PFI investments (now rebranded public-private partnership, or PPP) with their minimal revenue risk in the early years, 3i Infrastructure targeted a higher return (10% rather than 8%), with a portfolio that included utilities. Since demand is predictable and prices are largely determined by regulators, the risks involved in utility investment are still low, but are higher than for PFI, and there is more capital investment to manage.
At launch, 3i Infrastructure’s portfolio included a stake in Anglian Water and an oil bunkering business, Oystercatcher, while businesses added later included electricity transmission and railway rolling stock. In subsequent years, GCP (LSE: GCP), John Laing Infrastructure (LSE: JLIF) and Bilfinger & Berger Global Infrastructure (LSE: BBGI), with a majority of its portfolio outside the UK, have come to market.
As the scale, experience and expertise of the companies increases, their ability to control this risk improves, but investors need to keep a careful watch on the assets being acquired. Utility investments are not all equally risky; water companies, for example, are slowly growing natural monopolies, but with airports there is competition and growth is faster.
The risk that subsidies to companies focused on renewable energy will be cut is low, but there are other concerns. Pricing may be guaranteed, but the supply of electricity is variable. Equipment needs regular replacement, though advances in technology should make the new solar cells or wind turbines more efficient. As a result, shares in the six listed funds specialising in renewables yield about 1% more than those of conventional peers.
Shares across the sector habitually trade at significant premiums to net asset value (NAV), but investors should not be put off. Asset values are arrived at by discounting future cash flows at rates which were originally over 8.5% and are still 7.5%-8%, though 3i Infrastructure uses 9.9%. The yield on 30-year gilts has fallen from 4.4% to 1.8% since 2011, so the risk premium has risen from 4% to a generous 6%. This means that discount rates are excessively high, even if gilt yields rise, which mean conservative NAVs.
The premiums reflect investors’ less cautious view of their true value. This suits the infrastructure companies because it enables them to issue new shares to pay for acquisitions without diluting NAV. However, a high discount rate also constrains management to seeking acquisitions with a return similar to the existing portfolio.
On the acquisition trail
Over £1bn has been raised for acquisitions so far this year. HICL invested £269m in Affinity Water, INPP invested £274m in National Grid’s gas distribution network and 3i Infrastructure invested £185m in a generator of electricity from landfill gas, while GCP, John Laing Infrastructure and BBGI have also issued equity for acquisitions. The prices they are paying are not bargains, but their assurances that they will get the expected returns are credible.
Moreover, the companies no longer need to expand; as INPP’s manager says, “we don’t need more assets, we will only invest to de-risk or enhance returns”. All the companies continue to exceed their targeted returns on both PPP and other assets. This is the result of efficiency gains and economic factors beyond their control, such as falling tax rates.
This leaves investors with an annualised return, assuming they buy shares at a 10% premium, of around 7% (9% for 3i Infrastructure). Much of the return comes from a dividend yield ranging from 3.8% for 3i Infrastructure to nearly 5% for JLI. GCP yields over 6% but, since it invests in debt rather than equity, has much less potential for added value. These yields should rise at least in line with inflation and are likely to be supplemented by steady capital appreciation. Since the investment returns have low economic sensitivity, their volatility relative to equity markets should remain low.
The sector has become highly popular with investors, but is it still worth buying? Compared to equities and on a net asset value basis, infrastructure companies may look expensive but that’s not the case compared to bonds, as Paul Cattermull of wealth manager Brewin Dolphin notes. Long-term, government-backed, inflation-proofed cash flows and a prospective yield of around 5% make them a good alternative to corporate or government bonds. New share issuance regularly provides attractive opportunities to initiate or add to holdings – recently this has reduced the HICL and INPP premiums to 10%. In this sector, it pays to follow the crowd.
Where to invest beyond infrastructure
Attractive alternatives to the infrastructure funds are the investment trusts that focus on the utilities sector. Because they invest in listed shares which trade daily, their performance appears more volatile than that of companies investing in unlisted assets, but the underlying businesses are becoming increasingly similar. Ecofin Global Utilities & Infrastructure (LSE: EGL), with a £115m market capitalisation, trades on a 14% discount to net asset value and yields over 5%, while Utilico Emerging Markets (LSE: UEM) trades at an 8% discount and yields 3%.