The use of public-private partnerships (PPPs), known as the Private Finance Initiative (PFI) in the UK, accelerated from the late 1990s onwards. These contracts have not been without their controversies (mainly from the perspective of cost to government) but they have become fixtures of many governments’ financing repertoires and more governments have adopted their use over time.
The London Stock Exchange listed PPP/PFI infrastructure investment company universe has flourished over the last eight years, driven by favourable demand and supply characteristics. Total net assets in the sector now amount to £3.6 billion (€4.4 billion; $6.0 billion) across four companies: HICL Infrastructure (£1.4 billion in net assets), International Public Partnerships (£0.9 billion), John Laing Infrastructure (£0.8 billion) and Bilfinger Berger Global Infrastructure (£0.5 billion).
However, the success of these strategies, combined with a more developed track record for the asset class and managers, has attracted more capital to the sector (directly or indirectly), at a time when the dynamics of available investment opportunities has also changed. The sector faces new challenges and investors face some additional risks.
Demand and interest rates
Weighted average discount rates have remained largely unchanged over the past few years, resulting in expanded PPP/PFI project risk premiums as reference sovereign interest rates have collapsed. Similarly, over the same time frame, publicly traded corporate credit – whether investment grade or sub-investment grade – has seen significant yield and spread compression. The consequence of both of these factors has been significant appetite for the equity of listed PPP/PFI infrastructure funds. Over £2 billion has been raised in the last three years. The amount of capital that could be raised in any period was very much driven by ability to deploy it.
The 30-year-long government bear market appeared to reach its trough between mid-2012 and mid-2013. The UK 20-year gilt yield was just above 2.5 percent in May 2013, but subsequently rebounded to 3.5 percent, its highest level since mid-2011, and currently sits at 3.4 percent. Meanwhile, valuation discount rates have decreased marginally and quoted shares have consistently traded significantly higher than net asset values; all of which means that the effective risk premium being priced into the shares of listed infrastructure investment companies is closer to 300 basis points (bps). The continued normalisation of long-term interest rates will further reduce the relative attractiveness of investment companies at current valuations.
Nevertheless, current discount rates remain elevated enough that they can to an extent absorb further increases in interest rates, and a strong argument can be made that the asset class has matured to such an extent that risk premiums on PPP/PFI infrastructure assets should be materially lower than pre-crisis levels. Therefore, on a fundamental view, we believe that current valuations are resilient for long-term interest rates of 4.5 percent or below.
However, there are some technical risks associated with this, as the resilience of investor appetite for the asset class in the listed sphere, in a rising interest rate environment, remains largely untested. While the listed infrastructure companies are large and liquid, if large investors reduce exposure simultaneously, there is likely to be volatility in share prices for a prolonged period and there is very little action that companies will be able to take. What they can do is continue to educate investors in advance about their valuations and likely future performance characteristics in different economic environments.
Supply of investment opportunities
Secondary investing in PPP/PFI infrastructure was, until recently, largely the preserve of specialist fund managers, well versed in the sector’s development and contractual nuances. The listed investment companies had been able to take advantage of their manager’s expertise to source investments. Typically the sellers of these investments were a mixture of banks selling non-core assets, construction companies recycling capital for new investments and primary infrastructure investors taking profits after the completion of construction.
Over the past few years, there has been a consistent supply of assets from third-party sellers to the listed infrastructure companies, especially minority stakes in projects they already owned. The nature of the dynamics of the market has enabled the buyers of secondary PPP/PFI assets to maintain pricing discipline while also deploying the capital raised in the listed market.
The supply and demand market dynamic for secondary PPP/PFI project assets has, however, changed significantly over the past year or so. The strong returns and the more established track record of the asset class have attracted more capital to the space, largely from institutions (pension funds and insurance companies), which, directly or indirectly, have invested through the launch of new private investment funds. The increased competition for assets has put pressure on pricing, especially where portfolio sales are conducted through auctions.
At the same time, the supply of assets from the most motivated sellers (those with pressure on their balance sheets post-financial crisis) has been gradually worked through and the slowdown in new PPP/PFI deals being closed has started to impact on operational project deal flow in the secondary market. Recent commentary and anecdotal evidence suggests that pricing, especially in the UK, has increased considerably. While this is positive for current valuations, it is proving hard for investment companies to make non-dilutive acquisitions.
The lack of transparency on the pricing of new transactions, not just limited to the discount rate but the conservativeness (or otherwise) of the assumptions on cash flows, means that it is hard for investors in the listed companies to judge whether acquisitions are in their continued interests. Independent boards of directors need to ensure that companies do not grow for the sake of assets under management (and the additional fees paid to the investment manager) at the cost of future performance.
The other risk is that companies broaden their investment remits to maintain returns by investing in riskier parts of the infrastructure universe. Investment manager skill sets and deal flow may be less established in some of these areas and the resulting blended portfolio may demonstrate different return characteristics compared with a pure PPP/PFI portfolio.
Fine lines of differentiation
In a period of consistently strong performance and plentiful supply of new assets, investors did not need to distinguish between companies in the peer group. In the evolving tighter environment, differences between companies become much more important. This has resulted in a greater degree of focus on total expenses, deal flow, corporate governance, foreign currency exposure and portfolio risks.
Companies are gradually responding to the greater degree of scrutiny of valuation assumptions, including life-cycle costs, construction asset premiums, discount rates and cash flow timing assumptions. Investors are challenging investment managers on related-party fees, special purpose vehicle (SPV) director fees and the terms of related-party transactions.
In an asset class where it can take many years to see the performance differences from investment decisions, investors are having to base their assessments on managers’ and companies’ approaches. Companies that wish to continue growing need to be able to demonstrate that they can source attractive deals and provide sufficient transparency around these transactions and the existing portfolio.
Tom Skinner is head of research at Dexion Capital, the London-based boutique investment bank