The EU referendum and subsequent devaluation of sterling, the election of Donald Trump and impending Eurozone elections have all contributed to a lack of confidence in the debt and equity markets. With political uncertainty around Brexit negotiations, bond yields have increased and many investors are concerned about inflation in anticipation of increased government borrowing to fund fiscal stimulus. In this unpredictable environment, infrastructure investment has the potential to provide a safe haven for investors.
Since 2006, the UK-listed infrastructure sector has grown in prominence through its track record of producing stable income during a financial crisis and the subsequent period of low interest rates. The current climate has highlighted once again the attractiveness of these income characteristics for cautious investors.
Today there are more than a dozen infrastructure investment companies listed on the main market of the London Stock Exchange, with a combined market capitalisation of over £12bn. Their shares are traded like any other listed equity and their closed-ended structure is suited to investing in unlisted and illiquid underlying assets.
While the precise strategies and the risk/reward proposition of the companies vary, the sector has a common objective of producing a reliable stream of dividends for investors, sourced from a diversified portfolio of underlying infrastructure investments.
Investment vehicles
Infrastructure investment companies tend to take equity, and sometimes debt, exposure to underlying assets that are often monopolistic in nature with high barriers to entry for competition. These assets generate relatively stable and predictable revenues and can be broadly sorted into four categories:
• Public-Private Partnerships (PPPs): A project company undertaking a PPP contract delivering social infrastructure such as a hospital building or school facilities typically receives payments from a government department or local authority counterparty in return for ensuring the asset is available for use by the public sector. These availability payments are contracted for a period of 20-30 years and are not correlated to either the economic cycle or the level of usage of the asset.
• Other contracted assets: Some infrastructure assets receive revenues through contracts with other corporates, such as wind farms and other renewable energy projects that have entered into power purchase agreements.
• Regulated assets: A company that is a monopoly owner of essential infrastructure, such as a water utility or an electricity network, is often subject to price controls set by a regulator. The regulator periodically determines an allowed return for investors and revenues are set accordingly. The revenues have low correlation to the economic cycle and little-or-no usage risk.
• Demand-based assets: The revenues of a demand-based asset depend on usage volumes, for example the level of traffic on a toll road. These assets are more economically sensitive, and therefore perceived as riskier, than either PPPs or regulated assets. However, their revenues are usually predictable based on their track record and limited competing choices for users.
The long-term operating and financing costs of infrastructure assets are also capable of being forecast with a degree of confidence. In PPP concessions, the costs of operating and maintaining assets are subcontracted for an identified price; and the operating budgets for regulated assets are typically re-set as part of the regulatory review process. Infrastructure assets are also often financed with long-term debt where interest rate costs are fixed or hedged.
In this context, investor cashflows from infrastructure assets are perceived as reliable and stable. If held for the long term, the total returns from underlying infrastructure assets also tend to be correlated with inflation due to explicit provision for indexation of revenues in contracts or the regulatory framework. This in turn feeds into portfolio returns for the investment companies, providing a degree of protection for investors concerned that high inflation may erode the value of income and capital.
Exposure
Generally, investors in infrastructure assets are exposed to a limited set of residual risks, although the precise risk profile depends on the underlying assets. Examples of key risks to the performance of these assets include:
• Political/regulatory risk: Where a contract exists (for example, a PPP), returns depend on the public sector honouring the terms of the agreement. In the case of regulated assets, returns are influenced by the outcome of periodic regulatory determinations. Although regulatory and political risk differs by country, in most developed markets these are perceived to be relatively low.
• Demand risk: As already noted revenues and thus returns for some assets vary with underlying usage.
• Counterparty risk: Poor performance of a key contractor or cost overruns may adversely impact returns, although this is often mitigated by passing an element of the financial impact on to the contractor.
• Foreign exchange: The value of and income from assets denominated in currencies other than Sterling may vary but the impact of this can be mitigated through hedging contracts.
• Stage of development: An investment in a project in its construction phrase, often referred to as a ‘greenfield’ investment, has the additional risk of construction completing on time and to budget. Normally this risk is passed to a suitable construction company through a fixed-price, date-certain contract.
The impact of these risks is also substantially mitigated through the diversification which is offered by some of the larger infrastructure investment companies. However, there are some systemic risks that cannot be mitigated and could impact returns to investors, one example being an increase in corporation tax rates.
Investors should also note that the capacity of infrastructure investment companies to add further attractive assets to their existing portfolios can be impacted by political decisions, (for example, decisions around whether to encourage further private sector investment in essential infrastructure).
The risks and the stability of any particular investment company’s dividends will vary with the mix and risk profile of the underlying infrastructure assets held in its portfolio; and, as with any investment, investors need to be comfortable that the returns offered are commensurate with the risks. However, for those seeking steady income during a time of uncertainty, an allocation to infrastructure is certainly worthy of consideration.
Harry Seekings is a director at InfraRed Capital Partners, which acts as the investment adviser to HICL Infrastructure Company
Key facts
• In the current unpredictable investment environment, infrastructure investment has the potential to provide a safe haven for investors.
• Infrastructure investment companies tend to take equity, and sometimes debt, exposure to underlying assets that are often monopolistic in nature.
• Investors in infrastructure assets are exposed to a limited set of residual risks.
