There seems to be a contradiction at the heart of infrastructure. For many, the asset class’s appeal lies in its ability to deliver above-par, stable returns in a predictable fashion. According to this view, infrastructure is essentially akin to fixed income on steroids – a low-risk asset class providing strong yield with little correlation to public markets.
“In theory, infrastructure shouldn’t be as cyclical as the rest of the market on the basis that it is what is says on the tin – a stable, steady series of cash flows irrespective of the market it is in,” says Richard Bibby, a director in Deloitte’s corporate finance practice and a senior member of the consultancy’s specialist valuation team.
And yet now and again we hear cries that infrastructure is “heating up” and “reaching a peak”, with valuations shooting up and corresponding returns going in the opposite direction. “As with any asset class, infrastructure goes through cycles,” says Andrea Echberg, a partner and head of European infrastructure investments at London-based fund of funds manager Pantheon.
There may be a root cause to this phenomenon. Frédéric Blanc-Brude, research director at EDHEC-Risk Institute, observes that there is no real index or database that tracks how valuations evolve over time. What’s more, the way these are arrived at is not always consistent. “Essentially we’re comparing oranges with apples,” says Christine Marchal, a director for aerospace, defense and infrastructure at Crédit Agricole CIB.
She adds that the wide spectrum of perceptions that exists may stem from confusion in terminology. Valuations, she says, are the outcome of a modelling exercise carried out on the basis of objective information. Yet, in everyday discourse, they are often confused with prices which – as an indicator of a given buyer’s appetite for a particular asset – incorporates more subjective elements.
But many think the distinction doesn’t really hold. David Larsen, a managing director at valuation and corporate finance advisory Duff & Phelps, explains that an asset’s ‘fair value’ can be defined as the price a potential buyer would be ready to pay for it in an orderly transaction. As such, he says, accounting standards require valuers to use “judgment” to come up with market-like assumptions.
Having established that valuations do carry a subjective element to them, it’s interesting to look back to try and understand why, in theory at least, these should be more stable in infrastructure than almost anywhere else.
Emmanuel Rotat, chief financial officer at Paris-based fund manager Meridiam Infrastructure, says the asset class is less cyclical than others because cash flows are determined and known from the day a transaction is closed. If all goes according to plan, he explains, shareholders and advisers should have good visibility on the revenues the asset will yield, meaning little volatility for valuations.
“What can impact an asset’s valuation is what happens to this asset, for example if there are any operational problems or issues with counterparties. But otherwise infrastructure is far less sensitive to wider economic cycles.”
Vincent Levita, chief executive and chief investment officer of French firm OFI InfraVia, thinks that the discount rate – the other key variable in the valuation formula – should also remain fairly stable. This is due to how the discount rate is actually calculated, being the addition of a risk-free rate, a standard risk premium (the one used on public markets), an asset class risk premium (to account for infrastructure’s illiquidity and complexity) and an optional top-up (to reflect an asset’s possible idiosyncratic risks).
As an essentially private asset class, adds Ryan McNelley, a director at Duff & Phelps, infrastructure is also sheltered from the volatility induced in public markets by derivative contracts and other structured products. “Sometimes you see volatility in public markets that is created by demand for volatility itself.”
Some fund managers think the theory is proving empirically sound. “When we look across our portfolio, the multiples we currently have for most of our assets are generally no higher than they were when we bought them,” says Richard Hoskins, head of Australia-based fund manager Hastings Funds Management’s global asset management team.
THE LAWS OF ATTRACTION
But more stable doesn’t mean immune to movements and trends.
McNelley underlines a partial misconception in the market that illiquid assets are necessarily less volatile. The fact that they don’t trade, he argues, gives people the impression that their value doesn’t go up or down. “For illiquid assets, including those which are infra investments, just because the volatility isn’t visible doesn’t mean it doesn’t exist.”
And in fact there are a number of variables – independent from an asset’s performance – that can make valuations change. The first obvious one, says Levita, is the level of benchmark interest rates: if the risk-free rate goes down – as it has done amid central bank measures to boost liquidity in the West – then, mathematically, valuations should move in the opposite direction.
This can happen with significant lag: Hoskins notes that until recently discount rates had barely budged; but he thinks the last cycle of valuations saw them slightly decrease, perhaps because investors are now pricing in easy monetary conditions for the longer term.
Yet more crucial than the level of general liquidity, Levita argues, is the liquidity within the asset class itself – the evolution of which will find its translation in the lower or higher risk premium used by would-be buyers in their models. In this case “liquidity” is a relative concept, boiling down to the balance between offer and demand for infrastructure assets.
A caveat applies to the greenfield market, notes Rotat, where prices are determined at the outset of a project and higher competitive pressures rather translates into lower expected returns.
But across brownfield infrastructure, one verdict seems to be commonly shared: investor appetite for infrastructure is high and unmatched by the current pipeline of projects. “Transaction opportunities are relatively scarce, while the sector is attracting huge amounts of capital. This tends to push multiples upwards,” says Marchal.
What’s more, says Blanc-Brude, the asset class is seeing growing interest from institutional investors such as sovereign wealth funds, which have few liquidity constraints, and insurers, which have a preference for long durations. These will typically apply a lower discount rate, pushing valuation upwards. “Valuations move partly in response to who’s in the market,” he says.
The question then becomes: how much higher are valuations likely to go – and are they likely to pause anytime soon?
On this point, opinions are mixed. Marc Meier, vice president in Partners Group’s private infrastructure team, thinks we may well be witnessing the completion of infrastructure’s first full cycle, with valuations now reaching levels comparable to the ones they touched prior to the Crisis. And while the question, for him, is whether the cycle will repeat itself, he has little doubt valuations are close to reaching a peak. “We see prices being paid which even significantly surpass sellers’ expectations.”
This view echoes that of Partners Group, which in July released a report warning on the toppy valuations being observed in the market. Inviting investors to try and “chart a course outside of crowded waters”, the asset manager expressed caution on the “optimistic assumptions” underlying the high prices reached during recent auctions such as the €2.55 billion acquisition of Fortum’s Finnish grid by a consortium including Borealis Infrastructure and First State Investments in December 2013 and the A$7 billion (€5 billion; $6.6 billion) purchase of Queensland Motorways by Transurban in April, which valued the assets at 27x and 17x EBITDA respectively.
For a number of observers, including Crédit Agricole’s Marchal and Deloitte’s Bibby, the high multiples observed in core brownfield infrastructure recently are sometimes explained by the buyers’ willingness to countenance lower IRRs, typically below 8 percent. Such valuations “don’t leave much of a cushion for things to go wrong,” cautions Echberg.
But buyers of seemingly high-priced assets have a clear line of defence. For Phillipe Taillardat, co-head of infrastructure investment management at First State, the price reached by Fortum’s Finnish unit is the reflection of a business plan that factors in positive regulation changes among other things. Hoskins also disputes the role of EBITDA as the only valid metric. He notes, for example, that while Hastings bought Port of Newcastle in April for 27x EBITDA, the price paid represented a significant discount to the facility’s regulated asset base.
“What really matters is the attractiveness of the market the asset operates in,” says Marchal, who advised on the acquisition of Portuguese airport operator ANA on a 15x EBITDA multiple last year.
Bibby agrees: “For the vast majority of transactions I’ve seen, there’s good supporting reasons for the prices that have been paid. These large investors know what they’re getting into.”