Faith Glasgow assesses the outlook for infrastructure investment companies.
Alternative assets have gained considerable popularity with private investors since the great financial crisis, as rock-bottom interest rates have undermined the old bond/equity counterbalancing relationship and pushed them to look elsewhere for ways to diversify and strengthen their portfolios.
Infrastructure trusts have become a popular choice, not just for diversification but also for their high and reliable cashflow. However, this is not the easiest sector to get to grips with, so let’s take a look at what these trusts invest in, how they are valued, and where the opportunities are at present. The AIC Infrastructure sector contains nine trusts, but they focus on different areas of the economy and operate in different ways. Two (GCP Infrastructure and Sequoia Economic Infrastructure Income) invest in infrastructure debt and pay among the highest incomes. The others invest mainly in the equity of infrastructure projects – one rung up the risk ladder, as the debt investors get their money first. A couple (Cordiant Digital Infrastructure and Digital 9 infrastructure) specialise in digital infrastructure such as wireless networks and data centres; two more (3i Infrastructure and Pantheon Infrastructure) concentrate on economic infrastructure projects that facilitate business activity, from transportation hubs to communication networks. The other three (HICL Infrastructure, International Public Partnerships and BBGI Global Infrastructure) invest mainly in social infrastructure projects typically backed by public sector clients, including healthcare and educational facilities. Clearly, they are operating in quite diverse fields, albeit with some overlap; but they do offer similar attractions for investors. Income is key, as Shayan Ratnasingam, an analyst at Winterflood, explains. “Historically, in the low-rate environment after the financial crisis when most of these trusts were launched, economic and social infrastructure trusts delivered a yield of 3% to 4% over benchmark ten-year gilts, and infrastructure debt 5% over the benchmark.” That made them a particularly attractive alternative to bond funds. Diversification, as mentioned, is another important driver. Because the underlying assets are involved in critical services, they are little affected by the ups and downs of wider markets and also provide well-defined and highly visible cashflows. This has led to the sector historically trading at high premiums to net asset value. A third benefit that has come into its own this year is the value of some infrastructure trusts as inflation hedges, because their underlying cash flows are at least partly inflation-linked.
"Think of the discount rate as the level of compensation that managers would need for taking on the risk of the investment. Lots of risk means a high discount rate; if the cashflows are very predictable the discount rate should be lower."
For investors, the share price discount or premium to NAV can provide some indication of value. But it’s also useful to understand how the underlying assets are valued by managers. Because returns are mostly about cashflow, managers typically use a discounted cashflow (DCF) approach that looks at future cashflows from a project and discounts them back to the present day using a discount rate. That discount rate is based on current market interest rates (the risk-free alternative for their money) plus a premium reflecting the extra risk involved, which is dependent on the particular infrastructure projects the investment company invests in. Mick Gilligan, head of portfolio services at broker Killik, says: “Think of the discount rate as the level of compensation that managers would need for taking on the risk of the investment. Lots of risk means a high discount rate; if the cashflows are very predictable the discount rate should be lower.” He gives the example of the 3i Infrastructure portfolio, which currently has a discount rate of 10.9%. “That means that if everything goes according to plan (based on management assumptions) the portfolio will grow by 10.9% over the next year.” Although the focus is on yield, economic infrastructure trusts in particular may produce some capital growth too. Gilligan explains that investors in these trusts can work out their expected total return as the discount rate minus fees, adjusted for the premium/discount to NAV. “Going back to 3i Infrastructure, it has a discount rate of 10.9% and fees (OCR) of 1.4%, so if it’s trading at par investors can expect a 9.5% annual return. That return will be less if it’s trading on a premium and more if it’s on a discount. 3i Infrastructure is yielding 3.5% (as at 3 November), so in this case you should expect some decent capital return over and above the yield.” The infrastructure sector has not escaped recent market volatility, as gilt yields climbed dramatically on the back of the former chancellor’s mini-Budget. Rising interest rates mean rising discount rates, which in turn lead to future NAV writedowns.
“In a rising rate environment, as loans mature these funds can reinvest at higher yields, which can lead to higher dividend coverage and potentially higher payouts.”
Share prices have fallen as a consequence, and most trusts now trade on a discount to net asset value – raising the question of where the best opportunities may now lie for bargain hunters. Ratnasingam thinks yield-focused funds offering a typical 6-7% total annual return may no longer be enough to attract investors. “We believe value-add funds that offer higher returns through improving operational performance of assets, organic growth and strategic M&A are best poised for the current market cycle,” he adds. He picks out the trusts with exposure to battery storage, digital infrastructure and economic infrastructure in this context, and also favours debt funds. “In a rising rate environment, as loans mature these funds can reinvest at higher yields, which can lead to higher dividend coverage and potentially higher payouts,” he explains. In contrast, Gilligan backs the social infrastructure plays: “They have much greater certainty over their long-term cashflows than the economic infrastructure plays and now trade on more attractive yields.” He also likes 3i Infrastructure: “We think the high discount rate is good compensation for the risk investors are taking.”
