A modern economy can only function efficiently if its infrastructure is up to the task. Essential assets like good quality roads, bridges, railways and hospitals play a vital role in all of our everyday lives, but these facilities are expensive to construct and maintain and command premium prices.
Historically most of the critical infrastructure in the UK was directly funded by the public sector, but this all changed in 1992 with the introduction of the Private Finance Initiative (PFI). This controversial policy brought in by the Tories and then heavily extended under Tony Blair changed the way that large-scale investment in this area is financed.
PFI was designed to encourage private investors to design, build, fund and operate critical public infrastructure projects such as new schools, hospitals, social housing, defence contracts, prisons and road improvements. There are now hundreds of these schemes in operation around the country.
The way it works is that the private sector delivers the infrastructure and the public sector then contracts to use it for a minimum period of 25 to 30 years with the money being used to repay the investors.
In theory, PFI provides an efficient means of attracting capital to pay for the essential assets that we all depend on, but it is not cheap. The cost of debt is in many cases much higher than government debt and the service charges tend to be expensive and costly to change, which is good news for the people providing these facilities but not so good for the taxpayers who end up footing the bill.
How to benefit from the impressive returns
Infrastructure assets typically provide attractive, stable, long-term returns that tend to increase in line with inflation. The easiest way to benefit is to buy one of the associated investment trusts.
BBGI (LON:BBGI) is a good example of the sort of exposure you can expect from the sector. The £658 million fund has invested in 39 mostly fully operational projects including the M80 Motorway in Scotland, the Mersey Care Mental Health Hospital in Liverpool, seven fire stations in Stoke on Trent and Staffordshire, and the Golden Ears Bridge in Canada.
These sorts of assets would normally be expected to appreciate in value over time. The fact that they have good quality public sector tenants means that there is very little risk of default and they are often committed to paying high rent and service charges with regular inflation-linked increases.
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Hospitals, motorways, fire stations and the like are illiquid assets that cannot be sold quickly or cheaply, but that is not normally a problem for an investment trust. This is because shareholders can buy or sell the investment trust’s shares whenever they want on the London Stock Exchange without there being any cash flow implications for the underlying portfolio.
According to data from the analysts at Winterflood, the listed infrastructure funds have generated an average share price return of 63% over the last five years and are yielding an average of 5.1%. The strong performance and high income have attracted a lot of investor interest and pushed the shares up to an average 8.6% premium to net asset value (NAV).
Red flag
Some people believe that the costs of the PFI contracts are excessive and place an unfair burden on the public finances at a time when they are already overstretched. This prompted the surprise announcement by the Shadow Chancellor, John McDonnell, at the Labour Party Conference in September that a Labour government would not enter into any new PFI contracts and would bring existing contracts “back in-house”.
Since then there has been quite a lot of back tracking with Labour saying that they would review existing PFI contracts and that not all of them would necessarily be brought back in-house. It has been suggested that the contracts would be exchanged for government debt, although it is not clear how the process would work.
Jeremy Corbyn’s leftist Labour Party has also announced that it would nationalise the rail, energy and water companies, which would have implications for other elements of the infrastructure sector if it ever came to fruition.
Some of the infrastructure investment trusts have a higher exposure to UK PFI investments and regulated assets (such as water companies) than others. Those with potentially the most to lose are John Laing Infrastructure (LON:JLIF), BBGI (LON:BBGI), HICL Infrastructure (LON:HICL) and International Public Partnerships (LON:INPP) with all four seeing their share prices fall 2% to 3% during the Labour Party Conference.
Much ado about nothing
Even if there is a left wing Labour Government there is no guarantee that anything will come from the proposals. The analysts at Canaccord Genuity are unconvinced by the practicalities of nationalising PFI contracts given the complexities involved and the significant compensation that would be required to terminate these arrangements.
PFI contracts typically document a right for the project companies to receive compensation if they are voluntarily terminated by the public sector and normally this compensation is based on market value. It is also likely that any decision to nationalise PFI contracts would be followed by numerous legal challenges.
Another potential threat is the recent increase in interest rates by the Bank of England with the prospect of further increases to follow. These would be expected to have a negative impact on the value of infrastructure assets, hence the reason for the recent weakness in the share prices of the funds.
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The value of an infrastructure asset is calculated using a discounted cash flow model that takes into account all of the future income and expenditure and then works out the present value of these amounts based on the current level of interest rates.
Higher rates reduce the value of income that accrues in the future, and the further in the future it is the bigger the discount. This makes long-term infrastructure assets vulnerable to rising interest rates unless they can offset the effect by increased demand for their assets (such as toll roads or bridges) or via inflation-linked increases in their income.
Since the Labour Party Conference the sector has seen average share price falls of around 7% and a narrowing of the premiums to NAV, which could be seen as a buying opportunity if you think their proposals will come to nothing and that the interest rate rises will be offset by higher inflation or more economic activity.
Funds to consider
The Winterflood investment trust team recommend the £2.7 billion HICL Infrastructure Company (LON:HICL), which has made some significant changes to its portfolio in the last few months.
HICL invests in fully operational projects that deliver steady returns and has made some big alterations to its holdings. The most notable of these was the recent purchase of a 36.6% stake in Affinity Water, the largest water-only company in England, which has 1.5 million customers in the south east of the country.
To pay for its recent acquisitions the company raised £260 million of new capital in March and a further £267.7 million in June. It has since announced an investment in the High Speed Rail project with a net funding requirement of £140 million, which suggests that there could be another capital raise before the end of the year.
Other major holdings include: the new Home Office HQ in Westminster, the Pinderfields and Pontefract Hospital in Yorkshire, the M1-A1 Link Road, and the Dutch High Speed Rail Link that connects Schiphol Airport to the Belgium border.
HICL is also on the buy list at Canaccord Genuity on account of its ‘superior long-term risk-adjusted returns, an ability to preserve capital and low correlation with other asset classes’. These attractions are further compounded by the strong income characteristics of the portfolio.
The fund has delivered a solid share price return of 60% over the last five years and is yielding an attractive 5.1% with quarterly dividends. Its current premium of 4% is about a third of the level it has averaged over the last 12 months, which could make it a good time to buy, although the extent of the recent changes warrant a certain degree of caution.
Numis have a core buy recommendation on International Public Partnerships (LON:INPP) (see fund of the month below) and 3i Infrastructure (LON:3IN).
3i Infrastructure differs from the rest of the sector as it aims to invest in asset-owning businesses rather than acquiring concessions to run a particular asset for a limited period of time. There has been a lot more competition for these attractive investments in recent years, especially from Sovereign Wealth and pension funds, which has reduced the target returns for new projects.
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The manager has rotated out of many of its regulated assets in favour of Private Equity style investments that generate revenues under a mixture of short- and medium-term contracts. It now has just two regulated assets left: Elenia, the Finnish electricity distribution business; and the Anglian Water Group. If they are sold the proceeds could be used to pay down debt with some of the money potentially being used to provide a capital return to shareholders.
3i aims to generate a shareholder return of 8% to 10% per annum over the medium term, but the recent performance has been significantly stronger with a five-year increase in the share price of 98%. The shares are yielding just under 4% and are trading on a 12% premium to NAV.
The analysts at Canaccord Genuity have a buy recommendation on BBGI (LON:BBGI), which has more of an international portfolio with significant exposure to infrastructure assets in the UK, Canada and Australia. It has the lowest ongoing charges in the sector (0.95%) on account of it being self-managed and has generated a share price gain of 59% in the last five years. The shares are yielding 4.7% and are trading on an 11% premium to NAV.
FUND OF THE MONTH
International Public Partnerships (LON:INPP) invests in public and social infrastructure assets to provide sustainable long-term returns via a mixture of dividends and capital appreciation. Three-quarters of the portfolio is located in the UK with the largest holdings including the Thames Tideway Tunnel, a new £4.2 billion investment in the London sewer network; Cadent, which has a 4.4% interest in National Grid’s gas distribution network; and the Diabolo Rail Link that connects Brussels Airport to the rest of the country’s rail network.
Numis believe that the managers have built up an excellent portfolio that is capable of generating high quality cash flows with low variability over the long term. For every 1% increase in inflation these are likely to increase by 0.75%, which is the highest linkage in the sector and should help to ensure continued strong performance.
INPP shares are up 60% over the last five years and are trading on a 12% premium to NAV, although they have more scope for capital growth than many of the other infrastructure funds. The investment trust is yielding 4.30% with the dividends paid twice a year.
Fund Facts
Name: International Public Partnerships (LON:INPP)
Type: Investment Trust
Sector: Infrastructure
Total Assets: £1,910 million
Launch Date: 2006
Current Yield: 4.30%
Gearing: 0%
Ongoing Charges: 1.24%
Website: www.internationalpublicpartnerships.com