“There’s no real science and even less data on the topic. Today fund managers do produce valuations for their assets but everybody agrees that they don’t really mean much.”
This stark observation by Frédéric Blanc-Brude, research director at EDHEC-Risk Institute, conveys a certain frustration as to how inadequate infrastructure valuation techniques are at present. And while not everybody shares his diagnostic, industry practitioners themselves admit that existing approaches have not changed much since they were first designed a number of years ago.
“Other than re-assessing model and cost of capital assumptions during the financial crisis, I don’t think there’s been any great innovation or massively changing approaches. Fundamentally the methodology itself hasn’t changed,” says Richard Bibby, a director in Deloitte’s corporate finance practice and a senior member of the consultancy’s specialist valuation team.
That’s despite everything else changing. Since infrastructure’s emergence as an asset class about a decade ago, it has evolved from being a marginal area of investor interest to representing up to 20 percent of some of the world’s largest institutions’ portfolios.
“It was fine to carry out private equity-style valuations when infrastructure was only a very small part of investors’ portfolios. But we now have to get much more serious about it. We need to produce numbers that are comparable with the valuations, risk measures and performance figures that are produced in other asset classes,” comments Blanc-Brude.
There are a number of obvious reasons why, when it comes to valuation, infrastructure stands apart from other asset classes. For one, explains Christine Marchal, a director for aerospace, defense and infrastructure at Crédit Agricole CIB, most infrastructure assets operate on a long timeframe – an extended horizon that valuation models have to account for. Crédit Agricole, for example, was adviser on French developer Vinci and fund manager Ardian’s acquisition of ANA Aeroportos de Portugal, which has a concession of 50 years.
Olivier Jaunet, head of the bank’s infrastructure team in Paris, also singles out regulatory risk as being a distinct factor in infrastructure valuation. The exercise often has to account for revenues produced beyond the “explicit horizon” – the point in time until which regulated tariffs and related parameters are known, which across many industries is typically five years.
Notwithstanding these particularities, there may be an obvious reason why techniques haven’t had to change: everybody agrees on the basics.
Vincent Levita, chief executive and chief investment officer of French fund manager OFI InfraVia, explains that because infrastructure investors are mostly concerned with income streams it makes sense to value assets using a discounted cash flow approach (DCF).
This method consists in estimating the cash you’d receive if you were to hold an investment indefinitely and then adjusting for the time value of money. Practically, that involves discounting an asset’s yearly projected free cash flows using an estimation of your weighted average cost of capital (WACC) and adding them up until maturity.
Most fund managers, investors and advisers reckon that no other approach makes sense in infrastructure. “In this asset class valuations tend to be very asset-specific so the only way you could come to an accurate figure on most assets is to produce a DCF model,” says Andrea Echberg, a partner and head of European infrastructure investments at London-based fund of funds manager Pantheon.
Emmanuel Rotat, chief financial officer at French fund manager Meridiam Infrastructure, adds that the method makes all the more sense as the contracts and regulations governing most infrastructure assets give good visibility on future cash flows.
There are exceptions, of course. When an investor only holds a minority stake – or when an asset is publicly listed – a discounted dividend model (DDM) can sometimes be used. Echberg adds that the comparables approach, which compares a target to similar assets using various ratios, can also come in handy when pricing secondaries. That’s also the case when looking at investments in infrastructure companies managed under private equity-style strategies, where EBITDA [earnings before interest, tax, depreciation and amortisation] and other multiples are often used.
But by and large everybody agrees that comparables are not really suited to valuing infrastructure. First, Rotat argues, because infrastructure assets tend to have very specific risk profiles, linked to their location, political and legal context; and even when they look similar, risk can be shared in very different ways depending on how contracts are structured. Second, because accessing information, which in the case of private assets is not often willingly shared and doesn’t always materialise clearly upon completion of a transaction, is generally no easy task.
CHECKS AND BALANCES
So deciding which method to choose is not really where the hard thinking occurs. “It’s all very well to say I’m going to use a DCF model. But then you need to work out the cash flows,” says Levita.
The next step is to design a base case, which will generally rely on the assumptions used when the asset originally reached financial close. Gaining access to such information can be difficult when you’re an outsider – but if you’re a direct investor or a fund manager, says Echberg, the exercise should be relatively straightforward.
“That’s a big advantage of private markets. When you’ve got a decent stake in an asset you’ve got a seat on the board – so you have full access to a company’s information, resources, and management teams,” agrees Richard Hoskins, head of Australia-based fund manager Hastings Funds Management’s global asset management team.
Yet a model is only as good as the assumptions that go into it – and given that small variations on long-term cash flows can make a big difference to the final total, fine tuning to the base case will invariably be needed.
Marc Meier, vice president in Partners Group’s private infrastructure team, argues that this will first involve shaping an opinion on the evolution of future regulation, by carrying out due diligence in similar sectors and geographies and understanding what factors the currently-allowed returns rely on. GDP-linked assets, such as airports and toll roads, will also be subject to thorough traffic forecast analysis, often with the help of specialist advisers.
Because taking a view on some of the macro issues at play will often require using judgment, investors will often try to check their assumptions are not too wide of the mark. They’ll work out several scenarios to nuance the base case and carry out stress tests. They’ll also try to get an external view by involving independent advisers; larger managers will also scan through their existing portfolio to try and challenge their assumptions.
But according to Blanc-Brude, this still isn’t quite enough – largely because, while managers generally manage to put together a reasonably good projection of future cash flows, they still don’t know exactly how volatile these are going to be.
Once again, the problem here largely lies in a lack of information. Calibrating the cash flow structure of a project, Blanc-Brude says, would require having access to the data of similar assets for which long-term cash flows have already been realised. But that means having access to several decades of financial history on infrastructure assets, which few managers – even the largest ones – actually have. And that’s without taking into account that projects completed 30 years ago were probably rather different than those of today, both in their nature and contractual arrangements.
The problem is even more acute when it comes to choosing the correct discount rate, which Blanc-Brude reckons most managers can’t help but “pull out of a hat”. Again the theory here is relatively simple: take the risk-free rate (say 2 percent), add the risk premium (say 6 percent) and top it up with a premium for illiquidity and complexity (say 2 percent) and an optional one for idiosyncratic risk (say 1 percent) to get your WACC (11 percent in our case).
In practice, however, ways to come up with the final number will vary: some managers will substitute the discount rate with their target internal rate of return (IRR), while others will use the WACC referred to in the relevant regulation (where the agreed cost of capital is sometimes explicitly mentioned).
Whatever the method chosen, it will likely involve personal judgment. “Most of it is pretty formulaic, but there are two subjective aspects to these calculations,” says Hoskins. “One is whether the classical CAPM discount rate truly reflects the risks in the cash flows of the business, in which case if it doesn’t you adjust; the second, more unusual, is what adjustment will I make to take into account the very low interest rate environment in the market at the moment.”
There’s no guarantee, adds Blanc-Brude, that the discount rate eventually chosen will be the same as the one used by the various limited partners investing in a fund.
It doesn’t help either that infrastructure projects often carry a lot of debt. “Investors often tend to have a very small sliver of equity and it is thus very challenging to get the right cost of equity. Valuations are going to be very sensitive to very minor changes in discount rate,” says Ryan McNelley, a London-based director at Duff & Phelps.
Valuers have tools to try and work around this uncertainty. For one, argues Marchal, advisers and managers regularly use a “rolling WACC”, whereby the cost of capital will change year on year as the financial structure evolves and a number of unknowns, such as construction risks, end up materialising or being removed. Rotat also says that there are number of points of reference throughout an asset’s life, for example when potential secondary transactions take place, that allow investors to check whether its estimated discount rate stacks up.
But without doubting most fund managers put their best effort into it, Blanc-Brude thinks today’s methods still look a bit like a patch-up job. Citing a paper published by Tim Jenkinson, Miguel Sousa and Rüdiger Stucke last year, he says private equity fund managers have been proven to apply valuation methods inconsistently and opportunistically, smoothing out volatility during the life of the fund and bumping up values as they prepare to raise a new vehicle.
That’s why the EDHEC researcher, who works within a chair co-sponsored by Meridiam and placement agent Campbell Lutyens, proposes a more drastic revision of traditional models.
As part of work supported by the Long-Term Infrastructure Investors Association (LTIIA), his team will soon release a paper on equity valuation that will try and introduce an academically sound model for valuing infrastructure assets.
The idea is the following: take the cash flow structure of today’s most predictable projects (such as public-private partnerships); calibrate it using data realistically identifiable (such as debt-coverage ratios, which most banks collect when they finance projects); and value the loan’s “tail” by taking the impact of workouts into consideration, which affect both equity and debt values.
Taking into account the now-calibrated cash flow volatility and the prices paid by investors for projects of a similar type in a given year, the said model will then be used to derive the implied forward curve of spot discount rates, from which the term structure of discount rates of future cash flows can be computed. By iterating the exercise over a concession’s lifetime, the aim is to obtain a market-based, granular rendering of expected returns, mean and extreme risk measures and duration of individual assets and portfolios of infrastructure projects.
Some are not quite convinced. “One could argue that differential discount rates over a long period is spurious accuracy although I can understand the theory behind the recommendations. Whether you look at one long-term discount rate or a number of short-term ones you should in the end get to the same answer,” says Deloitte’s Bibby. As far as valuation is concerned, he reckons infrastructure is more advanced than the wider private equity sector, because most fund managers seek external advice on the value of their investments.
This view seems to be shared by David Larsen, a managing director at valuation and corporate finance advisory Duff & Phelps, who notes that managers have already made progress. “Most firms are more rigorous in their approach to valuation. They’re doing a better job at articulating their judgment.”
Yet regardless of whether practitioners think drastic innovation is needed, limited partner (LP) pressure for fund managers to improve their valuation techniques and reporting shows no sign of abating. “Investors are getting more and more sophisticated and asking more detailed questions,” says McNelley.
“Historically it was customary that valuations were performed in-house, but now there’s often a level of involvement from an outside third party looking for transparency into how valuations are arrived at.”