The best infrastructure funds to hedge your income against inflation
Enthusiasm for the renewable energy sector has cast a shadow over the original infrastructure funds with a much broader mandate. These diversified funds continue to thrive, generating growing dividends and asset values through investments in cyclical companies and facilities. These have little to no income risk, strong cash flows, inflation protection, and hopefully the potential to slightly increase returns through active management.
The original three – HICL infrastructure (LSE: HICL), 3i Infrastructure (LSE: 3 inches) and International Public Partnerships (LSE: INPP) – were launched in 2006-2007. They were joined by Investments in GCP infrastructure (LSE: GCP) in 2010, BBGI Global Infrastructure (LSE: BBGI) in 2011 and Pantheon infrastructure (LSE: PT) Last year. The top four have grown significantly through share issues to fund acquisitions and now have assets of £3bn, £2.5bn, £2.8bn and £1bn sterling, while the fifth is now 64% invested and has assets of £400m.
Reflecting its higher historical returns (which come with higher economic risk), 3IN yields 3% and trades at a 22% premium to net asset value (NAV), while the numbers for HICL are 4 .2% and 15%, for INPP 4.5% and 12%, for BBGI 4.2% and 20%, and for GCP 6.2% and 0%. PINT is trading at a 9% premium but has not yet paid a dividend. These premiums reflect the conservative valuation of the underlying assets, but also allow funds to issue new shares at a price above the book value (but not necessarily the true value of their assets).
While dividend growth has been steady, the net asset value and share price performance has varied significantly, reflected in a share price of 350p for 3IN, 177p for HICL, 166p for INPP, 177p for BBGI and 113p for GCP, at the time of writing. Given that all initial public offerings were priced at £1, this implies that 3IN had the highest returns, followed by BBGI, then HICL, INPP and GCP.
Debts and equity
Funds have their differences. The capital structure of a typical investment is a mixture of equity, debt and secured bank loans. While most infrastructure funds invest in the equity portion, GCP focuses its investments in debt. This should be less risky than equity – although, if a project runs into financial difficulties, in practice banks will take over to cover their loans. Debt owners have priority over equity, but they often sink together.
Owners of the equity share, however, enjoy additional returns through good management and can exercise control to improve performance if things are not going well. Since few projects encountered difficulties, the disadvantages of the GCP strategy outweighed the advantages, leading it to seek a link to inflation (now 52% of its portfolio) and moderate exposure to the rise. By sector, 62% of the portfolio is invested in renewable energies, 23% in public-private partnership (PPP) projects and 14% in supported habitat (ie housing).
At this point, yields above 6% and stocks trading at asset value are undeniably attractive, both in absolute terms and relative to fixed rate alternatives – especially since GCP has, unlike a typical bond, been able to increase both its net asset value and dividend over the years. Therefore, stocks are a buy, says analyst Iain Scouller of investment bank Stifel.
HICL focuses on “core” infrastructure, meaning “essential real assets that generate resilient cash flows from a protected market position”. Although it has diversified from its original mission of UK PPP projects into investing overseas and in other areas (such as water), it is more revenue risk averse than others. Only 22% of the portfolio is made up of on-demand assets such as roads and rail (including 5% in the HS1 rail project).
Regulated assets account for 12% – mainly Affinity Water, which provides water but not sewerage services in source counties. Regulation is increasingly fierce, but Affinity has remained on the regulator’s good books through investment and good service. This leaves 66% of the portfolio in PPP projects such as hospitals, schools and government buildings in the UK and overseas. Europe now represents 18% of assets, including 9% in North America.
The appeal of PPP
Under PPP, the private sector finances and builds projects for the public sector and then manages them for a set number of years before ownership reverts to the public sector. Infrastructure companies buy the completed project from contractors using a mix of equity, bonds and bank loans, outsource management while maintaining overall control and accountability.
Since revenues are linked to inflation, this provides HICL and other operators with a predictable long-term revenue stream with the ability to add value through cost savings, improvements and investments. This results in moderate, predictable and low-risk returns. Since its IPO, HICL has generated a total shareholder return of 9% per year and increased its dividend by 35%, helped by high-priced asset sales, new investments and a steady record of value added.
In contrast, “a lot of good news is factoring in,” says Scouller. The shares are trading at a high premium and “stock issuance is likely at some point.”
BBGI invests exclusively in PPPs (“availability-based investments”) but 67% of the portfolio is overseas, including Canada (36%), Australia (11%), Europe (9%) and the United States. United (11%). This makes it a beneficiary of a weaker pound, reduces political risk and increases investment opportunities. Transportation makes up more than half of the portfolio, but it’s not toll roads, so there’s no revenue risk. Unlike other funds, it is self-directed, so the ongoing charges are well below 1%.
These strengths, a good track record of adding asset management value (1.4% last year) and a consistent annualized shareholder return of 10.4% are reflected in BBGI’s premium rating.
The annualized return for the shareholders of the International Public Partnerships since the introduction is only 8.5%, held back in part by an ongoing charge of 1.18%. It recently raised £325m in new equity, so there’s no chance of additional new issues driving the price down. With trading reported to be strong, the Thames Tideway ‘super sewer’ project progressing well (9% of the portfolio) and inflation assumptions of just 2.75% for this year and next, a good increase in value liquidation is probable.
INPP is considered to have one of the most diverse portfolios, although 75% is in the UK. Pure PPPs with no revenue risk represent 31%, PPPs with some revenue risk 10%, regulated assets 47%, railway rolling stock 10% and digital infrastructure 2%. Assets include power transmission, gas distribution, wastewater, military housing and schools. The discount rate – the implied future return on investment – is 7%, but INPP has a good track record of adding value, making long-term returns sustainable for shareholders.
Take more income risk
3i Infrastructure – which is 30% owned by private equity firm 3i – takes on more revenue risk than others with low PPP exposure. Economic infrastructure represents more than 60% of the portfolio, while “basic” (regulated) infrastructure represents approximately 25% and PPPs just over 10%. This translates to a target total return of 8% to 10% per year although, in practice, 3IN has achieved over 13% annualized since its IPO.
There are far fewer explicit links to inflation than in other funds, but “real assets like infrastructure that provide essential services have real pricing power, which makes them very attractive in the environment current,” notes Chris Brown of investment bank JP Morgan Cazenove. Some 44% of the portfolio is described as focused on “energy transition”, 25% on “digitalisation” and 16% on “globalisation”. Only 36% are in the UK.
The largest investment, representing 17% of the portfolio, is ESVAGT, which owns and operates support vessels for offshore wind farms and emergency response, while 10% is in Infinis, a renewable energy producer based in the United Kingdom, 9% in GCX, which owns 66,000 km of submarine cables and 9% in TCR, which operates ground equipment for airports.
3IN is happy to make profits on successful investments and reinvest the profits. Last year it sold much of Oystercatcher, its oil bunkering business, as well as several European PPP projects, and invested in GCX and more recently doubled its stake in TCR to 96%. It can be seen as operating midway between low-risk infrastructure funds and high-risk private equity funds, although its return – paid out of operating income – has kept the stock’s rating close. the former rather than the latter.
The last arrived
Rather than competing with established funds, Pantheon Infrastructure has focused on communications and data centers, but there are also investments in renewable energy and power transmission and distribution. Its emphasis is on co-investment rather than control, and its return on investment target of 8% to 10% suggests a risk profile closer to 3IN than others. This is just the beginning, but the reputation of the investment manager Pantheon, the investments made so far and the track record to date suggest that it is also a fund worth supporting.
All funds performed well in difficult markets and can be expected to weather the economic turmoil. TCR may have been impacted by the airport closures, but the effect on 3IN was minor and other investments benefited from the closures. Relations with regulators have been well managed and political threats, such as windfall taxes, have diminished.
With earnings explicitly or implicitly linked to inflation, and funds, especially those with PPPs, often benefiting from higher interest rates, they are all well positioned under current market conditions. The only caveat is that rising bond yields are undermining the relative attractiveness of their yields. While real returns are strongly negative, inflation protection more than compensates. However, when real bond yields turn positive again – which does not seem imminent – the sector will row against the tide.