Infrastructure trusts: cheap opportunity or political target?

Last month, the collapse of government contractor Carillion (CLLN), which provided facilities management for projects infrastructure trusts invest in, has also dented their share prices.

And the National Audit Office released a report a few days after Carillion’s collapse that raised questions about the benefits and cost of PFI. As a result, infrastructure investment trusts are trading on lower premiums to net asset value (NAV), and in the case of HICL Infrastructure (HICL) a discount.

HICL and John Laing Infrastructure Fund (JLIF) have the largest exposure to UK PPP projects and Carillion. As of 5 February, HICL was trading at a discount to NAV of 1.4 per cent, according to Winterflood Securities. But as recently as August 2016 the trust was on a 30 per cent premium to NAV. John Laing Infrastructure was trading on a 1.2 per cent premium to NAV as of5 February 2018, in contrast to a premium of 23 per cent in August 2016.

International Public Partnerships (INPP), which invests in public and social infrastructure assets, and also invested in some projects where Carillion provided services, was trading at a 7.1 per cent premium to NAV as of 5 February, compared with17 per cent in June 2016.

Political worries and bond yield threat

A fall in an investment trust’s premium to NAV can in some instances present a buying opportunity, and the trusts that had exposure to Carillion do not expect they will have to cut their dividends due to the costs incurred. However, there are concerns about what would happen if other PFI project contractors went into administration.

David Liddell, chief executive of online investment service IpsoFacto Investor, says: “We have been seeing a lot of trouble with outsourcers lately. After Carillion, Capita (CPI) [which saw its share price fall almost 50 per cent on 31 January] has had well-publicised issues. The trouble with these things is that we may only be seeing the tip of the iceberg.”

He therefore suggests that investors attracted by the lower than usual ratings of infrastructure investment trusts should hold back for a while before committing new capital.

There is also rising political risk. “Investors have not been accustomed to such drama from the infrastructure sector and it has served to intensify the political pressure on the PFI model,” says Kieran Drake, research analyst at Winterflood Securities. “The recent share price declines are arguably more a reflection of the new political climate, in which Jeremy Corbyn as prime minister is a real possibility.”

As well as bringing existing PFI contracts back in house, some Labour MPs have proposed a windfall tax on PFI contracts. Iain Scouller, managing director of investment funds research at broker Stifel, says this could negatively impact infrastructure trusts’ NAVs and dividend-paying ability.

“In the past we felt these trusts were attractive as a source of yield and inflation protection because the underlying contracts have some inflation linkage,” adds Jason Hollands, managing director of Tilney Group. “But we’ve got a government teetering on the edge and an opposition party high in the polls that has an aggressive position on PFI, so I wouldn’t go into these trusts at the moment. There’s too much uncertainty and risk to put money into them.”

It is also important that infrastructure trusts continue to refresh their portfolio of assets as the income they receive from a PFI contract typically lasts 25 years. After the contract ends the income stream stops. And even before the recent criticism of PFI, the number of PPP contracts was dwindling.

Meanwhile, if demand for infrastructure assets were to fall, this could lead to more infrastructure trusts trading on discounts to NAV. This in turn could negatively affect trusts’ ability to raise money to invest in new projects by issuing equity, as their boards would be reluctant to do this while trading at a discount. In the worst-case scenario, investors would effectively be left holding a wasting asset.

“The cash flows from existing portfolios [would] more resemble annuities with NAVs dwindling to zero over the long term as concession lives end,” explains Mr Drake. “Given the illiquid nature of the underlying investments and the relatively small [amount of] cash available after the payment of dividends there is only limited scope for share buybacks to control discounts. We therefore have concerns about ratings within the sector and see scope for discounts to widen if selling pressure continues.”

Inflation protection is one of the main benefits of holding an infrastructure trust, but future inflation in the UK could be less of a concern than it has been over the past 18 months. Mr Hollands says this is because the rise in inflation over that period was driven by the fall in sterling that followed the surprise vote to leave the European Union. This made importing goods more expensive. But this temporary effect has started to fade and recently sterling has risen strongly against the US dollar. So he expects that consumer prices index (CPI) inflation, which is currently 3 per cent, will fall closer to the Bank of England’s target of 2 per cent during this year.

And rising bond yields could dampen demand for infrastructure assets. “Bond markets have been weak in 2018so far,” says Mr Drake. “Historically, share prices in the UK-listed infrastructure sector have had some correlation with bond markets.”

Mr Liddell adds: “It’s been a no brainer to buy higher-yielding assets when gilts have been returning so little. But if a 10-year gilt would also pay me, say, 4 per cent, I would be most likely to buy that.”

PFI fears overdone

However, other analysts think the doom and gloom surrounding PFI and infrastructure trusts is excessive. “We still believe the sector offers investors exposure to high-quality inflation-linked cash flows, which are difficult to replicate,” say analysts at broker Numis. “The asset base of most businesses is conservatively valued, relative to pricing being achieved across the private infrastructure market. This should limit the potential for persistent discounts across the sector. Investors who have avoided the sector due to high premiums may well see current share price valuations as an opportunity to own.”

Stifel analysts suggest that if an infrastructure trust was to trade on a sizeable discount to NAV for a prolonged period, it would probably attract a takeover bid. This could potentially come from other infrastructure trusts with more highly rated shares or pension funds looking for ready-made portfolios of infrastructure projects.

Concerns about a potential windfall tax and the nationalisation of PFI projects if Labour wins power may also be overdone.

“A UK general election is some years off – 2021 or 2022 – and there is a reasonable likelihood that a Labour government or left-wing coalition does not get a majority,” says Mr Scouller. “Nationalisation is in reality probably at least five years away and may only involve failing projects and trophy assets. Many of the original PFI projects will be nearing the end of their lives in five years’ time and will naturally wither away.”

And even if PFI projects are nationalised investors would receive compensation close to portfolio valuations.

“Politicians like to sabre rattle at times to play to their audience, but [nationalising PFI contracts] would be a huge legal embroilment for years to come,” says Mr Liddell. “So while it is a risk, I wouldn’t be too concerned about it.”

And analysts at Winterflood point out that broad infrastructure investment trusts yield about 5 per cent on average, which is attractive in the current low interest rate environment. Having exposure to physical infrastructure assets also provides some diversification from the equities market, which could help mitigate downside in the event of market falls.

Numis analysts add: “Infrastructure ranks highly on many government agendas as the asset class remains a key economic driver of growth and delivers positive social benefits. The capital investment ambition of governments globally is significant and should continue to generate additional investment opportunities for the funds.”

New opportunities

Because of the scarcity of new UK PFI projects, many trusts have already reduced their exposure to these and started investing in international projects and regulated assets. For example, John Laing Infrastructure has invested in US service stations and International Public Partnerships has put money into gas distribution networks. Although these types of investments could change the duration and risk profile of the trusts, they could also increase their returns.

Meanwhile, HICL last year invested inits first regulated asset, utility company Affinity Water. This is now HICL’s largest investment, accounting for 9 per cent of its assets as at 30 September 2017. This follows the trust’s first investment in toll roads, which are demand-based assets, in 2016. In the 18 months since it invested in these, HICL has seen its inflation linkage rise from 60 per cent to 80 per cent as at30 September 2017, according to Numis analysts. They add that at its current discount to NAV, HICL looks good value and that they would feel comfortable buying it.

Although cautious on the infrastructure sector, Winterflood analysts have retained their buy recommendation on HICL.

“[It] provides well-managed infrastructure exposure, albeit heavily weighted towards PFI,” they say. “We view recent diversification into regulated assets, Affinity Water and demand-based economically-sensitive projects, such as toll roads and HS1, as positive in terms of reducing exposure to PFI, but they are also a move up the risk spectrum.”

HICL also takes an opportunistic approach to investing in corporate assets with long-term counter party arrangements such as rolling stock. It has around 115 investments that have a weighted average asset life of 30.6 years.

HICL aims to provide investors with long-term, stable income and to preserve its capital value, with potential for capital growth. It yields around 5.4 per cent and has increased its dividend in each of its last six financial years. HICL is targeting a dividend of 7.85p for its current financial year, 8.05p a share for its financial year ending31 March 2019 and 8.25p for the year ending 31 March 2020.

The trust’s NAV performance beats the FTSE All-Share index over three and five years, but lags it over one year. And due to its recent difficulties, its share price performance over one year is negative. The trust has an ongoing charge of 1.18 per cent.

The recent fall in John Laing Infrastructure’s premium could also present a buying opportunity, according to Stifel. In November, the trust announced that if all its UK projects were voluntarily terminated it would receive compensation equating to approximately 86 per cent of its UK portfolio value. Although this statement spooked the market and led to a sell-off in the trust’s shares, Stifel points out that any nationalisation of assets is still a hypothetical risk. In the meantime, the trust looks cheap on a premium to NAV of around 1 per cent and it has one of the highest yields in its sector at almost 6 per cent. The trust has also grown its dividend every year since its launch in 2010.

John Laing Infrastructure invests in the equity and subordinated debt of operational PPP projects, and overall its investments have a weighted average asset life of 19.3 years. It has 62 investments, about two-thirds of which are in the UK, with the remainder in continental Europe and North America. Its largest holding is the Barcelona Metro, which accounts for 12 per cent of its portfolio.

“The Catalonian call for independence has, after a difficult period, seen tensions ease,” comment analysts at Stifel. “However, were the political situation to escalate again, it would be appropriate if the risk premium on the asset got adjusted upwards.” The trust has an ongoing charge of 1.48 per cent, which is one of the highest in its sector.

Overseas exposure

If you want to limit your exposure to UK infrastructure because of the political risks, options include BBGI SICAV (BBGI). Only 42 per cent of its assets are in the UK and it has lower exposure to UK PFI than other infrastructure trusts. It also has no exposure to Carillion.

BBGI is an infrastructure investment company incorporated in Luxembourg and listed on the London Stock Exchange. It aims to provide exposure to a diversified portfolio of infrastructure PFI/PPP assets in the UK, continental Europe, Australia, Canada and the US. As of 30 June 2017, it had 43 assets, 27 per cent of which are in Canada and 18 per cent of which are in Australia.

Roads and bridges account for 42 per cent of its assets, as BBGI’s managers believe these are simpler to operate than infrastructure in sectors such as health, which accounts for 20 per cent of its portfolio. BBGI has a yield of around 4.7 per cent and one of the lowest ongoing charges in its sector at 0.95 per cent. But it is trading on a premium to NAV of 13.2 per cent, one of the highest in its sector.

Another fund with less of a UK focus is Lazard Global Listed Infrastructure Equity (IE00B5NXD345), which invests in the shares of companies with exposure to monopolistic projects, inflation-linked revenues and low demand volatility. This open-ended fund has about 60 per cent exposure to continental Europe, around 15 per cent to the US and 13 per cent to the UK. Its largest sector exposures are toll roads, diversified utilities and electricity utilities, which account for more than 50 per cent of its assets.

Examples of holdings in its concentrated 27-stock portfolio include Atlantia (IT:ATL), which operates 5,000km of toll motorways across the globe, as well as airports in Italy and France; French firm Vinci (DG:PAR), which designs, finances and builds infrastructure and manages concessions globally, and US rail freight firm Norfolk Southern (US:NSC).

Lazard Global Listed Infrastructure has beaten its benchmark, FTSE Developed Core Infrastructure 50/50 Index, over one, three and five years and yields about 3 per cent. It has an ongoing charge of 1.03 per cent.

However, because it invests in listed equities it is more likely to move in line with markets and provide less diversification.

But Mr Hollands says: “While this fund is not as high yielding as the listed infrastructure investment trusts and you are taking on more equities risk, we think it is an attractive way of getting exposure to global infrastructure.”

Infrastructure funds' performance

Source: Morningstar as at 6 February, *The AIC. Performance data as at 02/02/18.