This week I thought I would have a look at the infrastructure sector. As you can see from the chart below, the ratings of these funds marched higher again over the course of 2014 as demand for these six funds went unassuaged despite the issuance of about £750 million of new shares.
Yields on the five funds that invest mostly in the equity tranches of infrastructure – 3i Infrastructure, BBGI, HICL Infrastructure Company, International Public Partnerships (IPP) and John Laing Infrastructure (JLI) – have fallen from an average of 5% at the start of 2014 to 4.6% today. The yield on infrastructure debt specialist GCP Infrastructure has fallen from 6.7% to 6.4% over the same period.
Comparing the various funds and keeping things simple by focusing just on the ‘equity’ funds, there are some marked differences in the performance and rating of the various funds. This is perhaps surprising for a sector you might think would be homogeneous.
The best performing funds over the past year have been 3I and HICL, up 17.6% and 15.6% respectively in net asset value (NAV) terms compared to just 6.7% for IPP and 6.9% for BBGI. BBGI is on the highest rating, on a premium of 17.4%.
The yields on the five equity funds are all around 4.5%, apart from JLI, which is trading on a yield of 5.3%.
HICL’s performance was partly driven by an uplift in the value of a ‘significant’ but as yet unnamed existing investment that it has contracted to sell into the elevated demand for infrastructure assets (see below). 3i Infrastructure’s NAV growth was driven partly by an uplift in the value of its rail leasing operations.
BBGI’s portfolio has a chunky exposure to Canada and Australia, which differentiates it from its peers a little but I am puzzled as to why it is rated so highly. It may be because it has not issued any shares in 2014 (although 37 million existing shares were placed with investors in April).
Likewise, it is not obvious to me how JLI squeezes out a higher yield from its portfolio than its competition. One exciting bit of news in the sector recently was JLI’s approach for Balfour Beatty’s £1 billion infrastructure portfolio.
JLI planned to finance this with an equity issue, potentially one of the largest secondary issues in the investment companies market. Balfour Beatty rejected the approach, saying it thought it could get more for its portfolio (which seemed odd at the time as JLI’s bid was based on Balfour Beatty’s own valuation of its portfolio). It will be interesting to see how the situation develops.
Is the sector too expensive?
People have been asking me whether I think the infrastructure sector is too expensive. Part of the answer is that depends on your view of the medium-term outlook for inflation and interest rates.
Most of the funds have investments that incorporate a degree of inflation protection. This does not amount to perfect hedging of the inflation rate. At the moment, with deflation more of an issue, they are beneficiaries of this situation, but rapidly rising inflation could pose a problem. This scenario seems unlikely however.
Likewise, an environment of rising interest rates in the UK seems as distant as ever – some commentators are now saying early 2016. However, I am convinced that, like the government bond market, as soon as interest rates start to normalise, some of the shine will come off this sector (though maybe not as violently as for gilts).
I do wonder whether investors are getting over-excited about the sector though. In HICL’s interim results statement, published in November, the board made reference to ‘continued strong interest in UK public-private partnership/private finance initiative (PPP/PFI) infrastructure investment driving up valuations and making sourcing of similar UK investments more challenging’.
Again in November, 3i Infrastructure quoted figures from Preqin saying 2,200 institutions invest in infrastructure now, compared to just 900 in 2010. It also said the allocation to the sector has increased: from 3.5% of the average portfolio in 2011 to 4.3% in 2014.
Unfortunately, in the UK at least, the additional demand has been met with a dearth of supply of new Private Finance 2 projects (the successor to PFI). This was an issue highlighted in GCP’s annual results statement in December.
GCP concurred with HICL’s view on the pricing of UK assets, and said it would look to invest in areas outside traditional UK PFI such as social housing (it announced a transaction in this area a few days ago) and renewable energy.
HICL’s answer is to look for suitable overseas projects and try to pick up the odd asset in the secondary market. So far this year it has announced deals to buy out the minority interests in Willesden Hospital PFI Project and Barking & Dagenham Schools PFI Project. IPP and 3i have been picking up interconnector deals – the link between offshore energy projects and the onshore national grid.
No pre-election commissions
It seems unlikely that the UK government will commission much infrastructure investment ahead of the election and thereafter much will depend on the make-up of the new administration.
The National Infrastructure Plan published in December has £189 billion of projects planned between now and 2021 but it represents an ambition rather than a firm plan.
There are projects available in Europe – 3i Infrastructure thought about £1 billion per annum of ‘equity’ investment opportunities. This is helped by a growing acceptance of the PPP model.
These funds do need to keep finding new deals, not just to deploy the additional cash they are raising from investors but also to reinvest some of the cashflow being generated on existing investments. (What they own, for the most part, are long-term concessions. If they paid out all cash receipts and did not reinvest, their NAVs would fall over time).
The biggest question mark on the valuations in the sector though is the premium that relatively uninformed investors in these funds are putting on the valuations that the experts (the fund managers) are putting on the assets themselves. If ratings continue to climb, I would be nervous.James Carthew is a director at Marten & Co