In the alternatives mix, it doesn’t come with the glint of gold, or the shiny façade of a new property development. But if you like inflation-linked asset classes, often backed by a government balance sheet and with a yield significantly above government bonds, they tick a lot of boxes.
In part, this is why companies in the infrastructure investment company sector have historically traded on such a rich premium to net asset value.
Yet time and again, history reminds us that there’s no such thing as a free lunch.
Given the scope of sectors such as the infrastructure investment company sector, investing in projects the length and breadth of the globe, from transport and schools through to the health service, it is not surprising to see it become something of a political football.
The collapse of Carillion at the start of this year underscored further that while the infrastructure investment company sector may be about predictable income streams, it is far from risk-free.Infrastructure has always been about much more than those stable income yields, and always had potential to make it into those political speeches. And whether it’s political posturing or plain hyperbole, this is perhaps rightly so.
In hindsight, then, in the UK it is no wonder that shadow chancellor John McDonnell’s 2017 Labour conference speech targeted the sector, even if his threats that a Labour government would bring “wasteful” private finance initiatives contracts back into the public sector were unfortunate, to say the least.
His comments hit share prices in the infrastructure investment company sector hard, leaving question marks regarding the sector’s vulnerability to political meddling.
The collapse of Carillion at the start of this year underscored further that while the infrastructure investment company sector may be about predictable income streams, it is far from risk-free. Fast forward to October’s 2018 Budget, it was no surprise to see chancellor Philip Hammond mention infrastructure in his speech.
Yet Mr Hammond’s announcement on PFI in the Budget was, in fact, an absolute non-announcement. In other words, if you look at ‘new’ PFI flow in recent years, this has largely tailed off, so really, he did not announce stopping very much at all. But given that risks posed by infrastructure – and more specifically for the purposes of this article, the infrastructure investment company sector – are now more widely known, let’s take a look at some of those risks in more detail.
Revenue risk
Comments on PFI are relevant to a particular group of (public) infrastructure assets, with relatively stable cash flows. However, this is not the case for all infrastructure assets.
Moving up the infrastructure risk scale involves moving from assets such as hospitals and schools to airports and ferries. The latter are clearly much more exposed to economic cycles.
Here, rather than revenues being contractually defined and government-backed, they move to being determined by demand, which increases their correlation with economic growth.
Companies in the sector span this risk scale to varying degrees. However, with the goal of reducing correlation with other economically exposed assets, we prefer those towards the lower end of the risk scale.
Labour political risk and nationalisation
Mr Hammond’s comment in his Budget speech on the cost of breaking existing PFI contracts was a reminder of the minefield in implementing the policy suggested by Mr McDonnell. We believe it would be very hard and unlikely for a Labour government to be able to follow through in full on those promises.
For the listed infrastructure investment companies we own, the pain of a Carillion break-up and the subsequent costs borne by the private sector and the shareholders of companies in the infrastructure investment company sector – ourselves included, was a reminder that risk transfer did exist.
In other words, it was a reminder that backing government infrastructure projects is not necessarily a win/win for the private sector and there needs to be a risk/reward pay-off.
Were Mr McDonnell to have had his way immediately following the speech, the costs for dealing with the break-up of Carillion would have been a cost for the public purse.
Supply chain
The Carillion debacle is a reminder of the potential impact of disruption from other contractors that collapse into administration.
Other contractors similar to Carillion have issued profit warnings in the past year, but the indication is it is not systemic.
Looking underneath the hood of infrastructure companies and their exposure to various contractors can indicate how diversified they are in this regard.
Rising interest rates
Rising interest rates potentially impact infrastructure companies through two main sources: one is the impact on the cost of financing, given the debt embedded in these companies, and the other is through the demand side for infrastructure investment companies, which could wane as interest rates rise and the need for income funds subsequently recedes.
The counter to this is that higher rates are already partially priced into the discount rates used to value the assets. The longer-term discount rates used over the past 10 years is in the 7 to 8.5 per cent range, so despite the much lower base rates, discount rates are pretty much sitting there already.
Rising interest rates are a potential risk, but not one the sector cannot weather.
So what about the future? The government had already changed PFI into PF2 in 2012, but only six new projects have so far been signed under this regime, arguably because it has proved too complex.
A number of the infrastructure investment companies have been broadening their remit overseas, with some of them even diversifying into social infrastructure projects suchas social housing.
However, the government still needs to find around £600bn to fund future infrastructure projects, and approximately £300bn of that will need to come from the private sector. So we can anticipate a trilogy in the Public Private Partnership Initiative, although it might need a rebrand – PP3 has a slightly unfortunate ring given the political background.
Whatever the rebrand, we remain happy holders of a number of companies in the infrastructure investment company sector.
The combination of political risk and Carillion risk at the beginning of the year gave Seven Investment Management an opportunity to add and the subsequent performance of the sector has vindicated this move.
Matthew Yeates is investment manager at Seven Investment Management
