While PFI has been a political hot potato over recent years, it has also established itself as a hot area for private investors, who can access PFI returns through a number of specialist closed-end funds as well as indirectly through construction companies holding operational PFI assets. It's easy to see why investors have been drawn to this area. PFI funds on average yield a healthy 5 per cent, income is government backed and inflation linked, and shares in funds exposed to PFI were resilient through the credit crunch. What's more, two recent government announcements underpin the investment case.
"Those people who have invested in infrastructure will not have done badly over the period and will continue to do so. They are good investments, they are not quite gilts, but they are not far from it," says Nick Prior, head of government and infrastructure at accounting firm Deloitte. However, given the perception of these investments as quasi index-linked gilts, should holders be taking fright from the recent weakening of the bond market following its extraordinary run?
The name is bond, quasi bond
The price of PFI assets is linked to gilt prices through the discounted cash flow models used to value such investments. However, the sector has on the whole taken a long-term view during the recent period of falling yields and kept discount rates fairly constant. This means valuations should not need to be adjusted unless there is a very sharp rise in gilt yields. Perhaps a bigger question is what will happen to sentiment if the bond market continues to weaken and possibly goes into meltdown, as some commentators have suggested.
The implication of rising bond yields for any investment that is primarily seen as a yield play must be negative. However, Iain Scouller, a fund analyst at broker Oriel Securities, points out that the yield on
So while infrastructure fans need to keep a keen eye on the bond market, it may be premature to panic. What's more, investors in the sector can take comfort from recent evolutions in the PFI market.
PFI: the story so far
The use of PFI to fund new capital projects while keeping all the nasty debt associated with them off the Treasury's books was initially manna from heaven for politicians. The scheme got under way in the Major years, then boomed under Labour PFI. However, a backlash began to build in earnest following the credit crunch.
Central banks slashed base rates and flooded markets with liquidity, allowing PFI consortiums to refinance at record lows and equity investors involved in the construction phase of projects made a killing. However, the opposite was true for government departments who were tied into inflation-linked contracts while budgets were being cut under austerity.
The result was a media feeding frenzy and in 2011 an investigation was carried out into a PFI contract at the Queen's hospital Romford, a project losing tens of millions a year. The report spoke of improving efficiencies and better contract management but fundamentally this was tinkering - and, crucially for investors, their payments and therefore returns were secure.
This report has now been followed by the unveiling of the new PFI model in the chancellor's Autumn Statement. The clue in its name - 'PF2' - is that it is very much like its predecessor. It has been dubbed "son of PFI". Mr Prior thinks that the PFI sector is now in a better place. The structure of PF2 has been adjusted to make up for some of the shortcomings of the original PFI and create a more active market for operational projects which may benefit PFI asset prices.
PFI as a sector was given a further boost earlier this year when the Office for National Statistics announced it would not be making any changes to the methodology for calculating retail prices inflation (RPI). This clarified the basis under which income increases would be calculated, and the decision to stay with the higher RPI version will underpin returns.
Those expecting the increased clarity to unleash a wave of new PFI projects and investment look set to be disappointed, though. The problem is that government departments are having their budgets cut and, even with the capital cost moved to the private sector, they are unable to commit to contracted payments over 20-25 years on new projects.
Ways to play the PFI game
This isn't necessarily a bad thing for investors. With fewer new projects, there is the prospect of prices rising as more money moves into the sector. It was announced this week that Allianz Global Investors will be looking to raise over £1bn for an infrastructure fund focusing on the UK. Some of the best access is through investment trusts such as
The attractions haven't been overlooked, though. Henry Freeman, Infrastructure analyst at Investec, has recently turned more neutral on trust prices as they trade on an average 6 per cent premium to net asset value (NAV). But putting these prices in perspective, they aren't runaway. Taking HICL as an example, it is only 9.4 per cent ahead of its 2009 price, and that doesn't look too expensive for what is arguably an inflation-linked gilt.
Another way to play the PFI story is through the shares of individual construction companies that build and then own PFI projects. Joe Brent at Liberum Capital thinks there is an opportunity in UK constructors who have hidden value through their PFI holdings. Mr Brent thinks that valuations will grow as yields are compressed and they therefore provide a 'piggy bank' that can be raided. Mr Brent estimates that
Finally those of a more passive bent can gain access to infrastructure through a range of infrastructure ETFs such as db x-trackers S&P Global Infrastructure (XGID), or access the racier infrastructure needs of the developing world through iShares S&P Emerging Markets Infrastructure (IEMI).
IC VIEW: The concerns that political pressure could destroy PFIs returns have proved unfounded and the new PF2 model and RPI announcements greatly improve the outlook for the sector. For those investors looking to diversify investments and who want inflation-linked returns backed by government, there is definitely value in PFI.
We like constructors
The Investors Chronicle also featured two infrastructure investment funds in our Top 100 Funds: First State Global Listed Infrastructure is a solid globally diversified defensive play on infrastructure and proved itself during the worst of the financial crisis, while 3i Infrastructure (3IN) is an investment company that invests in infrastructure businesses and assets. It is building a diversified portfolio of infrastructure investments across the globe, with a focus on Europe and India. The appeal for investors is high-yield inflation protection.
While we continue to like the key features of infrastructure investment, such as consistent and predictable returns and inflation-linked income, we are more cautious on the pricing of existing infrastructure projects in the secondary market, partly because the asset class has become more popular and therefore demand for existing operating infrastructure projects has increased. PF2, the successor to the Private Finance Initiative (PFI) may also reduce the attractiveness for private investors in new public-private partnerships (PPP) as break clauses may be included in new contracts so that the government doesn't end up locked into expensive contracts. The amount of equity in projects is also expected to increase (albeit part provided by government) reducing the returns profile of PFI projects due to the lower levels of gearing, although listed infrastructure funds may themselves use leverage at the fund level to achieve higher returns, dependent on the cost of debt. While we do not think retrocessional changes to existing contracts will be made, new projects may therefore not be as attractive to those funds focused on operating contracts.
Our preferred infrastructure play is 3i Infrastructure (3IN), which has a greater focus on core infrastructure rather than PPP/PFI projects. At the end of a PPP/PFI contract period, the project asset returns to government or public sector control and ownership - whereas 3IN owns core infrastructure companies such as AWG (Anglian Water); Elenia (Finnish power and heating distribution); Eversholt (UK rolling stock) among others. Each of these companies has the ability to grow both organically and through acquisition, as well as to create operational efficiencies, thereby increasing profit margins. This gives 3IN a greater ability to deliver NAV growth in addition to the attractive income provided through the dividend. We estimate a live NAV for 3IN of 120.75p per share to which the shares trade at a 2.7 per cent premium, compared with an average premium of 7.6 per cent for the PPP/PFI-focused listed infrastructure funds. 3IN targets a 5 per cent dividend yield based on NAV.
Investors looking particularly for PPP/PFI exposure may want to look at International Public Participations (INPP). INPP is the most globally diversified by project of the PPP/PFI-focused infrastructure funds on the London market. As such, it is not at the mercy of policy changes by any one single government. INPP also offers diversification away from solely operating contracts as it has an allocation to construction projects. INPP trades on a 5.4 per cent premium to our live NAV estimate and yields 4.7 per cent.