Sailing through the fog

These days, the UK seems to be making history on a weekly basis. On Wednesday 12 October, sterling reached its lowest-ever level on record, on a trade-weighted basis, amid renewed alarm that the country could soon be heading for a “hard Brexit”. But in truth, nobody really knows whether they should expect such a possibility. When Theresa May ascended to the premiership following the 23 June vote, she was pretty clear that, in the eyes of her new government, “Brexit means Brexit”. But she did not elaborate much beyond that, leaving investors and businesses to infer from her statements and speeches what she has in mind.

As we reach the 41st floor of London’s Gherkin on a Tuesday afternoon, we gain altitude but not much clarity on the country’s political future. Fortunately, the industry professionals we find there actually look fairly sanguine – at least until they are told they should try to relax before our photographer immortalises the moment with a group cover shot. A few snaps later, we get stuck in.

Few investors had placed a high probability on the EU referendum delivering a leave vote and our hosts are no exception. “At the time of the vote, we were both trying to raise money from euro-denominated and Canadian dollar-denominated investors, and we also have currency exposure through the fund because we’ve made investments in euros. So I would be lying to say it didn’t come a bit as a shock. It’s not the outcome the financial services industry expected,” says Dominic Helmsley, managing director for infrastructure at SL Capital Partners.

Although the market did notice a pause in the aftermath of the referendum, a sense of normality soon started to come back. “There were certainly a few weeks, a month-and-a-half perhaps, during which people treaded water. And then people got on with life,” says Spence Clunie, managing partner of Ancala Partners. 

Jonathan Ord, investment manager for private markets at the Local Pensions Partnership, notes that prior to 23 June the market was perhaps a little too confident in its pricing. But he says his organisation’s portfolio did not suffer much from the short-term ruckus. “At the asset level, we’re also pretty diversified across regions and asset classes with limited exposure to the UK economy. Our largest exposure is equities and our portfolio is roughly 50 percent weighted towards the US, which helped.”

He discounts the initial turbulence as hiccups, after which industry players got back to their day jobs. “At a specific infrastructure level, we saw some people step back from transactions we’re working on, but it’s possible they used Brexit as an excuse because they didn’t want to get involved. And also perhaps the summer was coming into it and people wanted to step back anyway.”

STILL HUNGRY

As autumn sets in, it is becoming increasingly clear that Brexit volatility has yet to dampen investor appetite for infrastructure. “There are one or two high-profile transactions in the UK I could think of where there’s been a conscious decision to delay, but those have come back. Most encouragingly for us, since the vote, we’ve managed to secure commitments from Germany, registered strong interest from Danish and Swiss investors, and we’re on a roadshow in Canada next week. So there’s a very positive sentiment towards the UK in particular and infrastructure more generally,” says Helmsley.

What probably will not come back, notes Clunie, is greater support for solar and onshore wind. “Just before Brexit went through, the government announced significant incentive changes,” he says, hinting at a package of cuts that included measures to end subsidies for new onshore wind farms and reduce support for household rooftop solar by 65 percent. “The idea was that this would pave the way for more clarity over the government’s energy policy. But this has been swallowed up by Brexit and there’s more uncertainty than there’s been for a while over long-term policy. As a result, as far as renewables are concerned, we have to take the worst-case assumption.”

Ord is more lenient. “I agree investors would like to see greater consistency in energy policy, but policy does have to evolve as new technologies are established. The UK is likely to hit its 2020 target on renewable electricity but miss those on renewable heat and transport. On the electricity side, I think there is a lot of interest in scalable technologies and government has made it fairly clear that they want to attract more investment into offshore wind. There is a lot of focus on meeting the renewable heat targets for 2020. The government seems to be spending a lot of time talking to the private sector to understand what investors want from the asset class.”

THE RISK SIDE

Still, our panellists think there is more the government can do to put investors on a surer footing, especially when it comes to sponsoring greenfield projects. “There’s always been a mismatch between what the government wants – that is, big cheques for their greenfield trophy assets like HS2 and Crossrail – and what investors are looking for, which by and large are operating, smaller-scale assets that deliver the predictable returns they want. If the government wants to get the private sector more decisively on board, they need to provide more guarantees, like the ones they offered to support the Thames Tideway Tunnel,” Helmsley says.

There is another risk Westminster is unlikely to help mitigate, however: currency risk. “We invest in infrastructure in the UK and outside the UK, so foreign exchange risk certainly comes into play. That’s something we’ve been trying to get our head around. As far as investing directly is concerned, that’s one reason why we tend to put a premium on UK assets, to a certain extent. We value the linkage with UK inflation and the yield they can bring,” Ord explains.

A weaker local currency could also mean cheaper assets for foreign firms, translating into greater competition in the market. But Clunie does not think that is really happening. Nor does he believe sellers from overseas are holding off and waiting for the pound to rebound. “We are looking to buy an asset from a US company. After Brexit, we thought they would pull back. But they haven’t. For such companies, showing that they can sell assets is more important than the 15 percent reduction in price they are getting due to exchange rate changes.”

Lenders are not fretting either, he says. “European banks have lent to our investments without Brexit being a major issue. And they’re lending in sterling and haven’t used Brexit as an excuse to withdraw, change their pricing or ask for better terms.”

Should managers even consider amending their strategy then? Helmsley thinks not. “Maybe economic growth will slow down in the UK, but it’s not clear what the quantum will be. We’re not steering away from GDP-linked assets, and we wouldn’t look away from ports and airports just for that reason. Given the core mandate we have, we have to take a very hard look at anything with a significant demand risk. But if the right opportunity comes up we will consider it.”

THE REWARD SIDE

With so much dry powder still floating around, it is no surprise that asset prices have not come down. But Ord is keen to put things in perspective. “Do things look as expensive when you look at where the risk-free rate is? Take secondary PFI assets, for example, where the margin above the risk-free rate has remained fairly consistent. Sure, pricing has come in materially at an absolute level, but when compared on a relative basis to the risk-free rate it doesn’t look quite as bad. Overall, though, prices across infrastructure assets in the UK look expensive, and we are seeing more and more people doing other things to increase their return; they look at greenfield, or perhaps they widen the boundaries of what infrastructure is or stretch their assumptions. We see quite a lot of stuff coming to our desk that is based on fairly heroic assumptions when it comes to passengers or throughput.”

While pricing continues to be buoyed by abundant liquidity, however, Helmsley suggests the resulting pressure does not apply uniformly to the asset class. “At the large-cap end of the market, it’s pretty clear there is a significant return compression. There, competition remains at a very high level, sustained by global mega-funds or very large direct programmes. But at the smaller end of the market, of course, there are a lot more transactions. It’s still competitive, but it’s a bit less intense and you’re still able to achieve returns of 8 to 10 percent.”

Clunie agrees. “As funds raise more capital, they don’t want to end up doing 20 deals. They want to do eight to 10, but bigger ones.” Although he notes this is not Ancala's case, he says this rationale sometimes leads certain funds to expand the definition of what counts as infrastructure. “Prior to 2008, people were laughing at some assets that others then called infrastructure. But now the asset class has become even wider than it was back then. In our discussions with investors, such mandate drift is often seen as an issue.”

Ord seeks to nuance that point. “The market has adapted somewhat. If you go back to pre-2008 funds, a small minority didn’t do the market any favours in terms of trustee perception [and] a number of underlying assets had a different risk profile from that was originally envisioned from a trustee perspective. A few of them got into problems. But when you speak to trustees nowadays they have a clearer idea. They’ve had more time to learn about the market and see it evolve.”


FAIR WEATHER AHEAD

In that context, has it become harder or easier to get them to commit to funds? And are our participants concerned that Brexit, which so far has mostly not affected dealflow and debt financing, will eventually impact fundraising?
Helmsley sounds resolutely positive. “Demand for infrastructure has continued to increase over the last 12 to 18 months, whether it’s driven by the shortcomings of public markets or the search for yield. We live in a world of low numbers and that’s driving capital to our space. Most of our fundraising activity remains focused on the UK, Europe and Canada, and I’m bullish on the prospects for fundraising in the near future.”

Clunie strikes a similar note and gives us an update on Ancala’s post-Brexit efforts at collecting funds. “We’ve been pleasantly surprised. We have raised circa £250 million since Brexit, and reached our sterling platform's fundraising cap.”

What does that mean for LPs themselves? Ord provides an answer. “Whilst our pension fund is still open the amount we have to pay to pensioners increases every year and infrastructure gives us something other asset classes don’t: there’s the yield and the inflation-linkage element to it. For us, it’s only growing in importance, with a tilt towards the core end given that it is this part of the market that best fits these attributes.”

KEEP CALM AND CARRY ON

Economic pundits had predicted apocalypse if the UK voted to exit the EU. The pound certainly took a beating, and even if the country may fare better than expected in 2016 there remains much uncertainty about its longer-term growth trajectory. Infrastructure deals, by contrast, do not seem to be recording much of a blip, at least for now. Here are a few highlights from the post-referendum era.

Last month, the Abu Dhabi Investment Authority snapped up 16.7 percent of Scotia Gas Network, concluding an auction for a chunk of the gas operator launched earlier by SSE. Insiders say the £621 million price paid by the sovereign wealth fund represents a significant premium to the company’s regulated asset base and an “incredible” multiple by UK standards. This does not much hint at a lack of appetite for UK assets on the part of direct investors from the Gulf.

Macquarie, meanwhile, is said to be in the pole position to buy the Green Investment Bank in a £2 billion privatisation that will see it face, in the final stretch, a consortium that includes the Pension Protection Fund, Mitsui, General Electric and John Hancock. If the firm was really worried about political risk, then it probably would have shied away, since the UK government is due to retain a special share giving it a veto on investment matters.
Other sectors are also proving popular, perhaps counter-intuitively. Singapore’s GIC and developer GSA, for instance, recently bought a 7,150-bed UK student accommodation portfolio from funds managed by Oaktree Capital Management. The deal was larger than the £417 million transaction, also in the student accommodation sector, clinched by fellow Singaporean sovereign Temasek in March.

The renewables secondary market enjoyed tailwinds as well. Dutch fund manager DIF bought the 26MW Wadlow Wind Farm in Cambridgeshire from 3i Infrastructure in September, while Cubico Sustainable Investment, a platform co-owned by Canadian pensions PSP Investments and Ontario Teachers’ Pension Plan, acquired a 50MW solar farm in southern England. In October, renewable energy firm NTR acquired three wind farms in Scotland and Ireland in a deal worth €150 million.

UK-based funds and investors are also busy growing their footprint in sectors they were already active in. SL Capital, for example, has become a skilled buyer of rolling stock, partnering with Rock Infrastructure and GLIL – the Greater Manchester Pension Fund and London Pensions Fund Authority joint venture – to buy 378 new trains for the Abellio East Anglia franchise in a £600 million deal.