The price of safety

The flight to safety and search for alternatives to low-yielding fixed income is reducing returns for large-cap, core infrastructure assets in developed markets.

Partners Group’s Navigator report for the second half of the year underlined a trend many in the infrastructure industry have been noting – and grumbling about – over the last few months: the price of large-cap brownfield assets in perceived safe havens is going up, as everybody tries to pile into them when they come up for sale.

There is a clear logic behind this phenomenon, especially in Europe, where divisions between the ‘stable and virtuous’ north and the ‘unstable and delinquent’ south are becoming ever more pronounced.

This has put pricing pressure on a number of assets, leading to sharp decreases in government bond yields in perceived safe havens and sharp increases in prices for the bonds of so-called peripheral economies. But it has also had another side-effect: it has reduced returns for core infrastructure assets in these safe markets and exposed these investments to certain frailties.

Buyers are more vulnerable to regulatory changes or, indeed, to any other unfavourable events.

As Partners noted, internal rates of return (IRR) for brownfield core infrastructure assets in developed markets are hovering around the 8 percent to 10 percent mark. 

“While these returns continue to offer a reasonable premium over record low government yields, they have clearly contracted, particularly in the large-cap space, where large premiums to regulated asset base (RAB) expose equity valuations heavily to changes in regulatory returns,” Partners said in its recent report.

Partners points to Open Grid Europe as an example. Germany’s largest gas transmission network was bought in May by a Macquarie Infrastructure and Real Assets-led consortium for an eye-popping €3.2 billion, a price tag the Swiss private markets specialist estimated to be “significantly above German energy producer E.ON’s reserve price and should translate into a high single-digit base case return expectation”.

Increasingly, this sort of large-cap, regulated brownfield deal involves pension funds that are not averse to taking a hit on returns to get exposure to the stable cash-flows these assets provide. But as Partners points out, the buyers are more vulnerable to regulatory changes or, indeed, to any other unfavourable events that might hit their investments.

As Alain Rauscher, chief executive of Antin Infrastructure Partners, told Infrastructure Investor in a May interview: 

“If you say, I’m prepared to buy at a low IRR because I’m a pension fund, and you buy at 7 percent or 8 percent IRR, and then anything adverse happens, you lose everything. If you buy at an IRR of 14 percent or 15 percent and something adverse happens, you then have a buffer and you still continue to make some decent money.”

Price ratchets are also pushing premiums in some sectors to pre-crisis levels, with Partners pointing out this is already the case in the UK water sector, where the recent acquisition of a 90 percent stake in Veolia Water UK’s regulated business by a Morgan Stanley/Infracapital Partners consortium was made at a 30 percent premium to RAB.

This is all great news for sellers, who can expect to get more bang for their buck going forward. But buyers should beware that their quest to mitigate risk in the here and now doesn’t end up augmenting it in the long term.