Joining the dots on risk

One of the more absorbing debates being played out among infrastructure investors and practitioners is around the best strategy to unlock value in the current market environment.

Much of the focus centres on core brownfield infrastructure, the ‘haven’ preferred by most investors according to a recent Probitas Partners survey. Core infrastructure is, to some extent, being viewed as a victim of its own popularity – in the same survey, the overwhelming concern among investors was too much money eroding returns in the sector.

While there appears to be broad agreement on these fronts (the preferred characteristics/investment outcomes and the current state of play), investors are more divided on what the appropriate response is.

On the one hand, some investors are moving along the risk curve (either to higher-risk segments such as greenfield or emerging markets, or to lower-risk segments such as infrastructure debt). Others are content to accept lower returns in some segments of the core market (particularly large assets), but there are questions over whether they are adequately pricing risk in these instances (for example, by pricing relative to bonds).

Clearly risk (or perceptions of risk) is at the heart of this disarray. Here, we offer some perspectives on risk – a dynamic and nebulous concept at best – from a core infrastructure perspective.

HEADLINE VERSUS RISK-ADJUSTED RETURNS

A useful starting point in considering risk is to move away from a focus on headline returns and instead consider volatility-adjusted returns.

While data is limited in this area, we are able to draw on a database of eight available unlisted Australian-domiciled but globally-invested funds. The sample encompasses fund strategies ranging from social infrastructure to growth (e.g. GDP-correlated) assets.

The chart on p. 47 shows the five-year total return and volatility performance of the eight funds, along with the ranking of the fund based on a return/volatility ratio.

Quarterly observations are used to calculate volatility to correct for the fact that some managers benefit from artificially lower volatility by having less frequent valuations.

Once volatility is factored in, the resulting hierarchy looks quite different from one on a pure headline-return basis. For example, the highest – and lowest-returning funds are now ranked 3rd and 5th respectively. And two funds that would not have been considered top-quartile on a total return basis emerge as the most attractive on a volatility-adjusted basis.

This is not to suggest that volatility alone is an adequate measure of risk.

For example, the lowest-returning fund in the sample is more income-oriented than the other funds, with a yield nearly 500 bps (basis points) higher than the average fund over the same period (as measured by the Investment Property Databank or ‘IPD Index’, which we return to later).

To the extent that volatility-adjusted returns address risk in a quantitative sense, we view this as a step in the right direction.

MOVING ALONG THE RISK CURVE

One of the most vexing aspects of risk – in an infrastructure investment context – is that it is very often qualitative in nature. Compounding this is that the development of the sector to date seems to suggest an almost ex-post process of discovery when it comes to risk.

Going back a few years, the financial collapse of several Australian toll roads served as a resounding example of greenfield – and in particular ramp-up demand – risk. This subsequently shaped investor appetite among Australian pension funds.

While the current shale gas revolution is rightly seen as a game-changing opportunity, it is perhaps easy to forget that investors in some US power utilities were caught on the wrong side of falling gas prices. Again, this was a reminder of merchant risk (and perhaps also of leverage risk).

Even the unwinding of patently generous subsidies in the Spanish renewable energy sector highlighted the difference between what are probably best described as ‘subsidised’ assets and the more classic price-regulated (monopolistic) assets. It also showed that these were far from immune from economic conditions.

And as if to underline the point that sovereign risk wasn’t the decisive factor at play, regulatory ‘shocks’ occurred in Germany (Amprion) and Norway (Gassled). Both jurisdictions would have been considered low risk ex-ante.

These examples are very deliberately picked from several years ago, which reflects the difficulty in judging the merits of a deal (and by extension, the managers) until several years have elapsed.

In the current climate, investors seeking to re-allocate away from core infrastructure into other strategies need to ask themselves a few questions:

First: are they fully cognisant of the different risk-return profiles of different strategies? Or is there perhaps too much focus on the more observable return side of the equation?

As we highlight in a recent research paper1 – and echoed by this magazine in a recent editorial – the asset class is really a collection of discrete strategies (see illustrative excerpt below left). Therefore the decision to re-allocate from one strategy to another may be suitable for some, but not all investors.

Second: if they are happy to move up (or down) the risk-curve, are they doing so with a manager that has demonstrated experience, comfort and capability in this space? In the case of direct investors, do they have these attributes?

As the previous ‘horror story’ examples demonstrate, the last thing investors need is for their manager to be learning on the job with them.

IS CORE INFRASTRUCTURE OVERPRICED?

Which brings us to core infrastructure. Conventional wisdom at present seems to be that the underlying assets remain attractive, but at current prices do not make great investments.

From a helicopter view, it is easy to agree with this assessment. Certainly value is not as easy to find as it was a few years ago.

However, this blanket narrative does some investors a disservice as it shrouds potential pockets of value. Our view is that pricing pressure is most acute in large, heavily-contested auctions, where direct investors are prevalent.

This is, of course, difficult to prove, but comparing different infrastructure indices may provide some support for this view. The chart below compares the IPD Index with our own ‘CFSGAM Infrastructure Index’2.

The NAV (net asset value)-weighted IPD Unlisted Infrastructure index is naturally biased towards larger funds (which predominantly play in the large-cap space). The CFSGAM Index, on the other hand, is equally-weighted and is therefore more representative of returns across a broader sample of managers, including mid-market and PPP (public-private partnership)-focused managers.

While the IPD index has exhibited a much stronger run-up in recent years (peaking at 25 per cent for the year to March 2014), there is less evidence of price pressure in the CFSGAM Index, which peaked at just over half this level (13 per cent).

REGULATORY RISK

Among the various guises of risk, regulatory risk is arguably the most arcane. Comparing regulatory regimes involves not only an assessment of current design, but the likelihood that the architecture could change materially. In some sectors, economic and/or political pressure has resulted in tweaking of existing settings, while other sectors are undergoing once-in-a-generation regulatory overhauls.

Line these up against some of the horror stories outlined earlier and it is easy to see why some investors – particularly less experienced ones – have been spooked by regulatory risk. But what is the alternative? In many ways, the ‘regulated versus GDP-correlated’ distinction is a false one, as investors may choose to have a diversified exposure to both.

In addition, several aspects of regulatory risk need to be understood.

The first is that the current pressures on regulated assets are hardly a surprising development.

Regulation is, after all, designed to mimic the competitive pressure of a dynamic market, and so softer demand should eventually be expected to manifest itself in the form of regulatory measures to lower the prices charged. Similarly, over-generous regulatory schemes will almost inevitably be wound back over time.

The structural robustness of a regulatory regime to these pressures is the crucial aspect. The UK water sector is currently undergoing a cyclical revision as it transitions to the next price review period, but its resilience up to this point is perhaps underappreciated.

Only a few years ago, the sector seemed besieged by proposed licence modifications, proposed changes to RPI (retail price index) calculations, and politically-motivated pressure to increase the corporate taxes paid by utilities.

Yet in part due to high transparency and the consultative approach of the UK institutions, the ultimate outcomes were far less drastic than originally envisaged.

Part of the explanation lies in the subtle but important distinction between regulators and politicians. The UK water regulator, for example, has a statutory responsibility to ensure the financeability of UK water companies. Contrast this with the more heavy-handed fate suffered by Gassled investors at the hands of the Norwegian government’s oil and energy ministry, and it is easy to see why rule-bound regulators are something of a shield from erratic politicians.

These features have made the UK water sector arguably less susceptible to regulatory shocks such as those seen in other parts of Europe.

The second point relates to the continued evolution of regulatory regimes to become more incentive-based.

Remaining in the UK, gas and electricity network businesses have moved from the (RPI –x) model to a new RIIO (Revenue = Incentives + Innovation + Outputs) model. RIIO offers the potential for greater outperformance by efficient companies (as well as underperformance by less efficient companies).

Consequently, we believe the gap between the best and worst performing companies in a given sector is likely to widen. Increasingly, regulated assets are less of a beta play and more of an alpha play, meaning investors will now need to place greater emphasis on the relative performance and efficiency of companies, rather than simply seeking, for example, ‘UK energy distribution exposure’.

It also highlights the importance of having additional value levers to extract value in regulated assets. Having significant ownership positions to exert influence, a long-term investment horizon (the new price control periods are eight years long), and active operational management capability are all desirable in this regard. Clearly, not all investors have access to/can claim these advantages, and so may find it prudent to exit the regulated sector.

PRICING

The final piece of the puzzle is around the optics of price versus value. High EV/EBITDA (enterprise value/earnings before interest, tax, depreciation and amortisation) or EV/RAB (enterprise value/regulated asset base) multiples are the most popular metrics used, but it is important to remember that these alone are a crude indicator of value.

Not all deals with high multiples are necessarily duds, just as not all deals with seemingly attractive pricing at acquisition turn out to be good investments. Again, we would emphasise that it often takes several years to properly judge a deal on its merits (good or bad).

A recent Partners Group report3 cited two of the larger deals to close this year – Queensland Motorways at 27x EBITDA and Fortum’s Finnish network assets at 17x EBITDA – as examples of deals that ‘imply returns at or below 8%’.

With regard to the Queensland Motorways deal, time will tell. On the one hand, traffic volumes will ultimately govern the success of the investment (as evidenced by Indiana Toll Road filing for bankruptcy recently, more than eight years after it was acquired in mid-2006). But on the other hand, if there was an investor that could justify the premium, it is Transurban, with its operational expertise and synergies from owning adjacent toll roads.

Less convincing is the 27x multiple paid on the Port of Newcastle, as it appears highly leveraged to economic growth and coal export demand in particular. The recent decision by the Chinese government to ban imports of lower-quality ‘dirty’ coal, such as those found in the mines in the nearby Hunter Region, could cast further doubt on the outlook for coal exports.

In the case of the Fortum deal, the prima facie high multiple obscures other forces at play. Finland was struck by two severe storms in late 2011 which affected over half a million households’ electricity supply – in some cases for weeks. Following this, the regulator imposed stricter requirements on network operators to maintain reliability of supply, with the expectation that significant capital expenditure would be required in order to convert overhead power cables to underground cables.

Far from the ‘gold-plating’ concerns in other countries’ networks, the regulator has introduced the power to fine companies that do not comply with this obligation to develop the network.

Underpinning the investment case are the expectation that RAB will increase significantly over the next decade and beyond (with the support of the regulator and public), and the potential to outperform on the delivery of the capex programme. In other words, the transaction wasn’t seen as a fixed-income proxy, but rather took asset-specific factors, the likelihood of continued regulatory support, and the need for active management into account.

Whether the same scope to add value exists in other utility transactions will depend very much on the deal specifics. The key point for investors being: look beyond the headline numbers – the devil is in the detail.

SUMMARY

Our view is that in the current environment, investors have the most to gain by sharpening their focus on risk. For those weighing a re-allocation away from core, considering both sides of the risk-return equation may shed light on whether a move up or down the infrastructure risk curve is appropriate given their objectives.

For others who remain focused on core, this may require looking beyond the optics of headline fund returns and transaction multiples to identify value. In both cases, this will require grappling with the more intangible, qualitative aspects of risk.

Infrastructure Comes of Age – First State Investments Research (July 2014).
CFSGAM stands for Colonial First State Global Asset Management, known as First State Investments outside Australia and New Zealand.
Private Markets Navigator Report (H2 2014).