With bond yields hovering close to zero today, investors need to be clear about the cost of capital they plug into their valuation models, Nick Langley, managing director, co-founder and senior portfolio manager at RARE Infrastructure says.
This cost of capital decision is most pronounced as investors consider the terminal value of an asset, Langley (main picture) says, noting also that fast-moving economic and political factors are leading to constant reassessment of scenarios and sensitivities for cashflows.
The interplay between inflation, valuation, and the concessional agreements that underpin assets where governments are involved are of particular interest in the current and prevailing environment, he explains.
“Yes, inflation is key, and most infrastructure companies have a link to inflation in their cash flow, so they get to increase their prices by inflation each year, as a result the valuations are positively correlated to inflation,” Langley describes.
But inflation is just one of the assumptions built into the models’ infrastructure owners – both of listed infrastructure companies and unlisted assets – will be keenly watching in a world where bond rates are pinned to the floor by central banks trying to stimulate sputtering economies.
“If you assume inflation is going to be higher in the future, then actually the valuations in this space should increase,” Langley says. “But these assumptions play into cash flows and also into discount rates. So higher inflation should also lead to higher discount rates because your risk-free rate is going to be increasing as well.”
Listen to the full interview with Langley on Investment Magazine’s Market Narratives, which touches on redefining of the infrastructure universe, valuation risks and the impact of the macro-economic cycle.
Then there’s the stakeholder engagement aspect investors in these companies and assets need to factor in, Langley continues.
“For owners of unlisted infrastructure it’s also how you think about longer-term cash flows and discount rates in the context of the evolution of public policy, regulation, cyclical and structural factors,” he says.
For instance, in the UK water sector where regulators have become a lot more proactive setting and policing operational targets in recent years, excess returns of poorly run companies are a lot lower than efficiently run companies where returns in the past would have been a lot more evenly dispersed, Langley highlights.
Where the forces of the unique macroeconomic environment collide with regulated assets bound by concessional agreements, that’s where some “pretty thorny” issues could arise and may need to be factored in investors’ thinking.
“Will regulators allow these companies to earn high returns against a negative real bond yield?” Langley poses.
“If you are running negative real yields for five years and you’re thinking about the customers of a utility that is trying to increase its rates at inflation, you’d have to expect the regulator to say they’re earning too much. The question becomes how do you model for that scenario,” Langley says.
Real-time cash flow modelling
The 30 or 40 years’ worth of cash flow modelling RARE runs for listed infrastructure companies is not unlike the modelling owners of unlisted infrastructure assets will run, but it’s the constant updating of those scenarios that’s likely to set the listed modelling apart, Langley says.
“Once you get out beyond a few years, you’re in a bit of a crystal ball situation. And so you need to break the cash flows down into different components
“You’ve got to look at how regulation is going to evolve over that time, and what implications it will have for your cash flows, what are the potential cyclical and the larger secular themes that may come through. That may be a result of public policy or it may be technological advances over time, autonomous electric vehicles, for example,” he says.
Quarter to quarter and year to year assessment and reassessment of scenarios and sensitivities for cashflows make listed infrastructure a valuable accompaniment to unlisted assets within an infrastructure portfolio.
“Valuers in the unlisted world look back on what’s going on in the listed stocks and adjust cost of capital and EBITDA multiples and growth as they assess values of unlisted assets,” Langley says.
While investors should expect more volatility in the short term in the listed market, there shouldn’t be a trade-off investing in listed over unlisted infrastructure in the longer term according to Diana Zinurova, director of manager research, Australia, Willis Towers Watson.
“’Over the longer-term’ is an important factor because a lot of investors look in the shorter term and you will see similarities in equity sectors in terms of volatility of returns,” Zinurova says.
“For global listed infrastructure you should still expect consistent high dividends, long-duration assets with stable cashflows often regulated or backed by monopolistic market positions as you would expect in unlisted as well as lower correlation with equities and other equity sectors over that longer-term horizon,” she says.
Both Langley and Zinurova point out that the specific definition of the infrastructure category will play a role in determining volatility and returns profiles. So called ‘core’ infrastructure will have slightly different return characteristics to investments in companies and assets where categories are stretched towards real estate or data centres. Meanwhile, ESG considerations are shaping return profiles of infrastructure companies and assets too.
Wireless tower companies remain in the infrastructure camp because of their long-dated contracts even though they share the characteristics of a real estate investment, but data centres often stretch the categorisation because the contracts that govern the revenue generation are often not long enough in duration, Langley explains.
Sub-categorisations and morphing of the asset class aside, investors in global listed infrastructure would expect an average yield over the last ten years of around three and a half per cent with average earnings growth consistent averaging 3 to 5 per cent for the last 15 years, Zinurova points out.
Make it tactical
Trading off volatility of earnings and returns between listed and unlisted infrastructure is purely a timeframe consideration, both Langley and Zinurouva agree.
“Through the cycle, you’d expect infrastructure to have more stable earnings and less volatility, that’s what you want from your infrastructure portfolio overall, she says.
For institutional investors willing and able to take some volatility in the near term, daily tradability can open up more options for tactical allocations through the listed market, Langley points out.
“[With listed exposure] you’ve got the ability to increase or decrease your allocation and you’ve got the ability to warehouse money in listed while you’re waiting for it to get called down into unlisted opportunities. Then on the flip side, when it comes back from those unlisted funds returning capital, you can pop it into the listed market for a period of time,” he says.
“We have had discussions with a number of our institutional investors about running completion portfolios or overlay portfolios, so essentially using the listed market to complement what they’re doing on the unlisted side… it might be ‘I don’t have enough GDP exposure in my unlisted portfolio, can you get me [some more exposure to] toll roads and airports?’. Or the flip side, ‘I want to get some more utility exposure in the US’, or ‘I want to get some renewable exposure in Europe’, that type of thing,” he says.
In Australia in particular where there is a heightened focus on liquidity following the government’s early superannuation withdrawal policy, more funds are thinking about their exposure to liquidity in traditionally illiquid asset classes.
CIOs of super funds thinking more deeply about liquidity importantly need to ensure they’re not compromising the return profiles of their respective asset classes in the process, Zinurouva says.
“Just as there is increased pressure on the superannuation industry in terms of liquidity, there is also this pressure relating to financial returns and outcomes to members,” she says.