Friday, June 21, 2024

John Baron: It’s time to buy infrastructure trusts

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Previous columns have commented on the extent to which higher interest and discount rates have adversely affected sentiment across a range of alternative asset classes, including the infrastructure sector. The prospect that private finance initiative (PFI) and public-private partnership (PPP) projects will expire over the coming years, together with an erroneous cost disclosure regime inflicted on investment trusts more generally, also weighs on the sector. This has created a perfect storm. Yet there are reasons to believe such concerns are overplayed, and the fundamentals remain sound. As such, wider than average discounts and handsome yields represent an attractive opportunity for patient investors – particularly at this point in the interest rate cycle.

 

The risks

Rising interest and discount rates have proved a strong headwind to several alternative assets, including infrastructure. Higher interest rates and bond yields are competing for the attention of those investors seeking income. Higher discount rates have raised market concerns about the validity of asset values. Poor sentiment is casting a long shadow. Add in the ill-judged cost disclosure regime that is making investment trusts look unduly expensive (‘When is a cost not a cost?’, IC 29 December 2023), particularly those managing physical long-term assets such as infrastructure, and this in large part accounts for the reason discounts have widened significantly.

Yet, as highlighted in previous columns, interest rates have now peaked. While I believe inflation will continue to be ‘stickier’ over the medium term than the markets became used to prior to the recent spike, it will fall further in the coming year. The scale at which sentiment is shifting is perhaps illustrated by the Office for Budget Responsibility (OBR) halving its forecast for later this year from 2.8 per cent to 1.4 per cent. Having been behind the curve on the way up, and being stung by criticism for being so, the Bank of England (BoE) risks doing likewise on the way down. It should be cutting interest rates now given the direction of leading indicators, including money supply figures.

Pressure will mount as the need to cut becomes increasingly obvious. Sentiment towards the infrastructure sector will be helped when the market gets a better sense of the timing. Modestly falling interest rates, together with accommodating bond yields and discount rates, will not only lessen the competition of income but also allay concerns somewhat about asset values. Focus may even shift onto the reasonable number of asset realisations above carrying value which already suggest credibility. The relevance of the sector’s predictability of earnings, robust cash flows and inflation-linked revenues will also come to be revisited and acknowledged.

However, this is not the full story. Each asset class also has its own tale. Perhaps a key concern for infrastructure is the prospect that PFI and PPP projects will need to be handed back to procuring authorities, typically the government, as their contracts end in the coming years and decades. These contracts usually relate to the managing of hospitals and schools, which generate robust and government-backed revenues that are often inflation-linked. As such, when the contracts end, the assets (usually buildings) no longer form part of companies’ portfolios, and asset values will decline subject to investment elsewhere.

By way of context and timescale, the concessions usually run over 20-25 years and recent figures suggest there are more than 500 PFI contracts in operation. The number of expiries will climb steadily in the coming years, and as we approach mid-century few contracts will remain. New investments can no longer be considered given the UK government said in 2018 that it would not use the PFI model in future. This is despite history suggesting the private sector is far more efficient than the public sector in running such projects – HS2 immediately springs to mind. Indeed, these projects are regularly assessed by the National Audit Office to ensure taxpayers’ money is being well spent.

Further concerns relate to the fact that the return of some very large assets is unchartered waters for investment companies. They will certainly command managers’ resource and time. Furthermore, new investments of whatever variety are unlikely to come to fruition in the short term given discounts are historically wide and so the issuing of equity is unlikely while this remains the case. Indeed, many companies are committing to share buybacks to reduce discounts, and this is taking money out of the sector – the misguided cost disclosure regime again being a contributory factor.

 

The opportunities

Yet many of these concerns are somewhat overplayed. If political dogma and popular misconception were to be circumvented, operators would be granted contract extensions or offered some form of equivalent. Investment in many infrastructure projects in this country and around the world is sorely needed and heavily indebted governments are already finding it difficult to meet required demand. With other spending commitments, including defence, assuming greater importance, this reality will remain unchanged. Pragmatism will eventually triumph given the private sector’s good track record of managing large projects.

However, perhaps shorter-term factors suggest optimism. The expiry timetable will be gradual. For example, over the next decade HICL Infrastructure (HICL) will return an estimated 11 per cent of its portfolio at current values, while International Public Partnerships (INPP) is not set to return its first concession until next year. Despite the current level of discounts, this allows time for the managers to seek alternative investments. HICL is already conserving cash resources somewhat to that end by not growing its dividend despite the high correlation of its revenues to inflation.

Meanwhile, these companies are diversifying both by geography away from the UK and by projects without concession, but which still possess strong long-term cash flows. Some offer higher returns and risk while being regulated investments. HICL’s largest is Affinity Water, a water-only company supplying the home counties (c8 per cent of the portfolio), while INPP’s largest is Cadent, a gas distribution company supplying more than 10mn homes and businesses in the UK (c15 per cent of the portfolio). Such investments typically possess a longer life than PFIs but are more economically sensitive with less inflation correlation. This is where the experienced management teams in the sector will come into their own in the interests of shareholders.

Additionally, there is every reason to believe that cash flows will remain robust in the final years of these contracts, which should assist dividends and other distributions. Courtesy of prevailing discount rates, the current value of future cash flows already factor in the concessions ending. Furthermore, in the short term, the asset prices achieved when being traded suggest the net asset values (NAVs) are robust, if not conservatively valued. As such, given the poor sentiment and historically wide discounts, investors should not rule out corporate actions including buyouts.

Finally, further to my recent update on the cost-disclosure campaign, pressure is building on the government to put things right. The FCA believes it has gone as far as it can without legislative cover. The draft statutory instrument (SI) on packaged retail and insurance-based investment products (Priips) and subsequent consultation resulted in an unprecedented industry response of over 300 individuals and investment houses suggesting investment trusts are removed from the consumer composite investment category – meaning trusts would no longer have to state a cost in the European Mifid template feed used by institutional and retail investors alike. An FCA consultation on this SI and a further SI on Mifid is forthcoming – but these now risk failing to reflect the urgency required.

As such, further discussions with Treasury ministers ensue and last week I asked the chancellor at a Treasury Select Committee evidence session to introduce a further SI encompassing the 300-plus industry response. The FCA would not need to be involved, which would save time. The chancellor promised to consider this ‘at pace’. Meanwhile, Baronesses Ros Altmann and Sharon Bowles recently received good cross-party support for their private members’ bill in the House of Lords, while investment trust managements have written directly to the chancellor. The resolution of the misleading cost-disclosure issue would help to close discounts and encourage a resumption of the tens of billions that have previously been invested into infrastructure through these companies.

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