UK-listed infrastructure investment trusts have been one of the most successful equity market innovations of recent years, offering exposure to state-backed social infrastructure to a wide range of investors and providing stable income and capital growth.
HICL, INPP, BBGI and John Laing Infrastructure (JLIF) have seen strong assets growth, with a combined market capitalisation of approximately £7bn.
While we see the assets owned within these vehicles as attractive, and the trusts as well managed, we believe they are over-valued at their current significant premiums. HICL is trading at a premium of 15 per cent above NAV, INPP at 11 per cent, BBGI at 13 per cent and JLIF at 12 per cent.
Firstly, it’s increasingly apparent that underlying returns are relatively unattractive compared with direct infrastructure equity holdings. There’s a very clear style drift as the funds move away from their legacy availability-based social infrastructure investments towards economic infrastructure and regulated utility assets, and there are also risks such as underlying currency fluctuations and rising risk-free interest rates.
HICL’s most recent reported results are a good illustration. Over the year to 31 March 2017 NAV/share grew from 142.2p to 149.0p, excluding dividends paid of 7.6p/share. However, the 6.8p/share growth in NAV included 2.1p as a result of share issuance at a premium and 2.8p as a consequence of an aggregate reduction in the discount rate applied to future cashflows.
Therefore, underlying growth in the value of the portfolio over the year was 1.9p/share; or 1.3 per cent. The dividend paid totalled 7.6p, an attractive yield of 4.5 per cent based on the current share price, but in terms of capital growth over the year HICL delivered a negative real return, once the gains from lowering its aggregate discount rate and issuing new stock at a premium are excluded.
Our second reason not to hold the infrastructure investment trusts right now is the change in the assets in which the funds are investing. The managers of infrastructure investment trusts are incentivised to grow their asset base, but there’s a scarcity of PPP/PFI assets in both the primary and secondary markets. Managers are turning to regulated utility assets as an alternative source of growth, with two major transactions in recent months.
In December 2016, INPP was a member of the consortium which successfully bid for a 61 per cent stake in National Grid’s UK gas distribution network Cadent. INPP’s share of the acquisition cost £274m, its largest single investment at 15 per cent of the portfolio.
In May 2017, HICL announced that it was investing £269m in the acquisition vehicle for Affinity Water, a UK regulated water utility, representing around 10 per cent of its portfolio. INPP paid a 53 per cent premium to Regulated Asset Value (RAV) for its investment in Cadent; on an adjusted basis Citi Research estimate the premium was 44 per cent. HICL paid a headline 53 per cent premium to RAV for its investment in Affinity Water; on an adjusted basis RBC estimate it was approximately 40 per cent. These represent very full prices in comparison to the UK pure-play quoted water utilities, which currently trade on premiums to 2018 RAV of 23 per cent (Severn Trent) and 17 per cent (United Utilities).
Thirdly, we believe that there is a degree of investor complacency around the potential downside risks to NAV relating to rising risk free rates. In its latest trading statement INPP itself recognises this risk, stating that “government bond yields in the majority of jurisdictions in which the Company invests have increased. On a net basis and other things being equal, the net increase in government bond yields could be expected to have a negative effect on the Company’s NAV”. INPP also flags the potential negative risks to the NAV from recent currency fluctuations.
We believe that the infrastructure investment trusts are an efficient and well-managed way for investors to access infrastructure assets. However, we’re concerned that the persistent premium valuations to NAV fail to reflect the modest underlying returns, the change of investment strategy to more risky economic infrastructure, the full prices paid on new investments and the risks to NAV inherent in a valuation model which factors in exposure to rising sovereign debt yields. We will not consider investing in these investment trusts while they trade at such lofty premiums to their NAVs.
Jim Wright is manager of the Miton Global Infrastructure Income fund