Over the past 15 years, the infrastructure sector has boomed. It provided capital first for public-sector projects in the UK such as schools, roads and hospitals, then for such projects overseas, and subsequently for private-sector projects that came with low-risk and long-term cash flows.
In the early days, the politicians welcomed a structure that resulted in projects being completed on time and on budget at an overall cost far less than the public sector had been able to manage. But in time, they became resentful at being made a fool of by the scale of profits produced by private finance initiatives (PFIs). PFIs were restructured as public-private partnerships (PPPs) and then stopped. The result of a return to public-sector procurement has been the disaster of HS2.
The sector expanded with the first renewable-energy funds launched in 2013. Funds, once listed, were quick to take advantage of share prices trading above net asset value (NAV) to raise additional capital for investment. Investors received generous dividends, well above the yield on long-dated gilts, and these increased broadly in line with inflation. This ensured rising capital values, though managers sought to keep these “conservative” so that new equity could be raised at a premium.
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The total capital invested in the 34 listed infrastructure funds is now £24bn, half of which is accounted for by renewable energy. This sum includes capital appreciation but excludes funds that have been taken over and other returns of capital. In addition, more than £50bn has been raised by 113 UK-based unlisted funds, according to Preqin, a data and insight provider for the sector. This includes £18bn for Hinkley Point C nuclear power station in Somerset.
Why infrastructure funds have slumped
This year, though, it has all gone wrong. Share prices have dropped below NAV. Equity issuance, both for new and existing funds, has dried up and dividend yields, sometimes more than 10%, have failed to attract investors. Shares generally trade at discounts to NAV above 20%, only two are at discounts below 10% and none at premiums. Since no funds want to increase borrowings, there is virtually no new investment and plenty of assets for sale.
The slump in share prices is widely blamed on soaring gilt yields, but this is highly questionable. Christopher Brown of broker JPMorgan Cazenove reckons that an appropriate benchmark for infrastructure funds is the yield on 15-year index-linked gilts, plus a risk premium of 2.5%. This benchmark has risen from a negative yield in late 2021 to a current one of nearly 3%.
But nobody believed that ultra-low bond yields were sustainable. So “steady-state returns” (the long-term annual return that shareholders should expect) were always higher, representing a cushion against higher gilt yields.
This cushion or “spread” was about 5% until 2020 for conventional funds, and until early 2022 for renewable funds. It then, as expected, started to fall as gilt yields rose. This year, though, the spread has risen from 3% back to 5% for conventional funds and from 4% in mid-2022 to 7.5% for renewable funds.
Factors other than rising bond yields are clearly at work. Perhaps there is a lack of confidence in valuations, which, for private-equity funds, are the subjective judgement of professional valuers who may be susceptible to groupthink. But, infrastructure funds have always had an incentive to keep valuations low to facilitate equity issuance. Besides, there have been a string of asset sales in the infrastructure sector at or above asset value.
For example, 3i Infrastructure recently sold a significant investment at a 31% premium to its valuation but was disappointed that it made no difference to its discount. If the trust was trying to send a message that valuations were modest, it didn’t work. Likewise, HICL has sold eight investments from across its portfolio at or above carrying values, generating proceeds of £310m, but the confirmation of its valuations and the reduction of debt hasn’t lowered its discount. The reality is that infrastructure funds trade off their inflation-linked dividend yields, not their NAV, and dividend yields are not subjective.
Renewable energy trusts have suffered additionally from the fall in energy prices and from a backlash against the net-zero agenda being rammed down people’s throats. But the consequent collapse in investment promises to support prices as demand continues to grow, while income is bolstered by long-term contracts and renewable-energy subsidies. There is no likelihood that these subsidies will be removed.
“High and rising dividends will attract investors again”
Are infrastructure funds too small given that overseas investors are happy to buy into larger companies but not smaller ones? This would suggest a merger of funds but some are already large (five have assets of over £3bn) and that hasn’t helped. Besides, shareholders would be unlikely to support a share merger with no cash exit. More importantly, sterling-denominated yield funds operating mostly in the UK have no obvious appeal to international investors.
Fees and management costs have been a major factor in putting off wealth managers and there is a pressing need to make cost disclosures more comprehensible, rational and useful. The problem is that a “one-size fits all” figure for management costs, as insisted on by regulators, is misleading and doesn’t enhance competition between funds. A trust that manages physical assets is bound to have higher costs than one that just invests in liquid, listed shares.
A more detailed breakdown to make cost comparisons more meaningful might help, but this would add complexity and take time to gain regulatory approval. The government promised to abolish the KIID (key investor information document) some years ago – required by the EU and universally regarded as useless – but nothing has yet happened.
In addition, costs – as defined by the KIID – are significantly overstated as they include, for instance, debt costs, but they are still faithfully reported by intermediaries and brokers. Yet arguing that investors should pay more attention to the figure calculated by the fund than independently according to a regulator’s formula is tough. For example, Scottish Mortgage has, over 15 years, halved its cost ratio from 0.7% to 0.35%, yet a figure of 2% is quoted by some platforms.
Trading at a sizeable discount to NAV gives some trusts the opportunity to enhance NAV by buying back shares. However, it is rarely effective in narrowing the discounts, will raise the cost ratio as the trust shrinks, and may just encourage more sellers. Besides, few trusts have spare uncommitted cash (many have debt) for buybacks without selling assets.
Trusts need to focus on the long haul
Trusts may have to accept that they are in for the long haul and have little choice but to stick to what they are doing and wait for the tide to turn. There are grounds for optimism. A continued stream of high and rising dividends will, sooner or later, attract investors again, and the political, public and media hostility to private-sector investment in infrastructure, evident for the past 20 years, is lessening.
With bond yields having risen sharply in nominal and in real terms, government borrowing is becoming very expensive and the disaster of HS2 proves, once again, that public-sector procurement inflates costs and delays completion. When this or the next government faces up to the precarious state of public finances and the many failings of public-sector projects, perhaps they will revive PFI or PPP.
Returns will have to be attractive to draw in private-sector capital, but before any new capital can be raised, share prices will need to return to premiums. That, in turn, will attract unlisted capital as well. The upshot? Those who invest in the sector at the current irrationally depressed prices rather than wait for the storm to pass should earn the best returns.
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Max has an Economics degree from the University of Cambridge and is a chartered accountant. He worked at Investec Asset Management for 12 years, managing multi-asset funds investing in internally and externally managed funds, including investment trusts. This included a fund of investment trusts which grew to £120m+. Max has managed ten investment trusts (winning many awards) and sat on the boards of three trusts – two directorships are still active.
After 39 years in financial services, including 30 as a professional fund manager, Max took semi-retirement in 2017. Max has been a MoneyWeek columnist since 2016 writing about investment funds and more generally on markets online, plus occasional opinion pieces. He also writes for the Investment Trust Handbook each year and has contributed to The Daily Telegraph and other publications. See here for details of current investments held by Max.
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