3i Infrastructure has cash to splash

Shares in 3i Infrastructure, an investment company, offer the chance to pocket a nice dividend yield with the opportunity for capital growth on top. The fund invests in infrastructure assets, such as water utilities and private finance initiatives in education and healthcare. When fully invested, it aims to generate an eye-watering 12 per cent yield from its investments, with most of the underlying income passed on to shareholders.

At the moment it’s far from fully invested and has £311m of low-yielding cash – 37 per cent of its assets – sitting on its balance sheet. Despite these dormant pennies, stockbroker Oriel Securities still expects 3i Infrastructure to distribute a 5.5p dividend for 2009-10 – enough to generate a 4.9 per cent dividend yield. In addition, the broker reckons that net asset value is likely to have risen 3 per cent in the year, giving a total return of 8 per cent. Not bad to be going on with.

But where to invest? This question has plagued management for most of the past year as the fund spent little on new projects. This is set to change, however. More assets are expected to become available as pressure on government finances leads to privatisations, and those banks wanting to shrink their cumbersome balance sheets offload infrastructure investments. One such example is the sale of HSBC’s train leasing arm, expected to be valued at £2bn, and rumoured to be the subject of a bid from a consortium of Star Capital, Morgan Stanley’s infrastructure fund, and 3i.

The fund's investments are performing well and are key a reason we favour 3i over its closest peers, HSBC Infrastructure and International Public Partnerships (IPP). In its latest statement, the fund's management said underlying profitability is expected to increase year-on-year. Compared with both HSBC Infrastructure and IPP, 3i can invest in a wider spread of assets and is better diversified geographically. Furthermore, 15 per cent of the portfolio is invested in the 3i India Infrastructure fund, which gives it exposure to a fast-growing economy.

But this diversification comes with drawbacks as Oriel estimates that the fund lost £8m in the first half of the year due to sterling's weakness, though some should have been clawed back by the year end. At the half year stage, 85 per cent of the fund's exposure to the Euro was hedged, but its exposure to the Indian rupee was not hedged at all.

The so-called risk-free rate in each country – usually the interest rate on government debt – might also dampen capital gains. Infrastructure funds calculate their net asset value according to the expected future cashflows from their projects. To calculate these cashflows you need a discount rate to find out their value in today's money. This discount rate is made up of the risk-free rate plus a premium for the riskiness of the project. So if the UK's long-term interst rates rise, then the value of the fund's UK investments will fall. Still, as we say, the 3i fund has a comparatively low exposure to the UK.