Infrastructure trusts are offering ‘compelling value’ alongside inflation protection and could prompt a wave of takeovers by private buyers and pension funds.

Stubbornly high inflation in the UK, which stalled at 8.7% in June, has caused concern for investors wary of seeing their money eroded by rising costs. This has made infrastructure trusts particularly attractive given many of them have government-backed contractual inflation protection on a large portion of their revenues.

Despite these attractions, infrastructure-related investment companies still trade on wide, double-digit discounts, with the Numis Infrastructure PPP (public-private partnership) Core sector on an average 20.2% discount, and the Infrastructure Renewables sector trading at 17.1%.

JP Morgan Cazenove investment companies analyst Christopher Brown said infrastructure funds were offering ‘incredible value’ as high inflation will ‘increase contractual cashflows albeit with a lag’.

This value is likely to prompt further consolidation among investment companies, a sector already awash with strategic reviews, mergers and managed wind-downs.

Numis investment company analyst Ewan Lovett-Turner said infrastructure is the most interesting area for consolidation thanks to ‘wide discounts’ that could ‘attract interest from private or pension fund buyers’.

He noted the 2018 takeover of John Laing Infrastructure by Dalmore Equitix for £1.4bn at a 20% premium to net asset value (NAV).

‘We acknowledge that some pension funds have experienced their own issues recently and all investors are trying to grapple with the implications of a higher interest rate environment,’ said Lovett-Turner.

‘However, we believe the listed infrastructure investment companies have the potential to attract private market attention given the quality of cash flows, particularly renewable energy projects that are valued at below-replacement cost.’

He flagged trusts investing in energy storage, renewable energy and core infrastructure, such as logistics and utilities, as the ‘easiest targets’ for buyers.

‘It is a healthy feature of the investment companies sector that underperforming funds or those that are sub-scale and trading on persistent discounts become subject to corporate action,’ he said.

Real asset woes

The sector might be ripe for takeover but that doesn’t mean the path of real asset investment is smooth.

Brown said a ‘sharp spike in real yields could be a problem’ due to the fact discount rates comprise both a ‘real element and an inflation expectation’. Discount rates are different from trust discounts, and are the level of compensation that you would need for taking on the risk of the investment. A high discount rate means there is a high level of risk.

There is also a risk depending on the type of asset the infrastructure trust is holding. There has been a widespread shift away from regulated assets towards demand-based assets.

Brown said that although ‘the cashflows for these were recalibrated following Covid’, some funds ‘have not been able to diversify before the equity-raising door slammed shut’.

He flagged infrastructure behemoths International Public Partnerships (INPP ) and HICL Infrastructure (HICL ) as having potential asset concerns. INPP is a major investor in the Tideway project, which aims to reduce untreated sewage being discharged into the River Thames, with the investment making up 13.5% of the £3bn portfolio.

HICL is invested in Affinity Water, which supplies water but not waste services in the home counties and makes up 7% of the £2.5bn portfolio.

Brown said infrastructure trusts are also being hampered by a ‘lack of yield growth’ and payout restrictions.

‘In the case of HICL, there is likely no dividend growth for a couple of years as two assets are not distributing… though retaining cash at the underlying special purpose vehicle level would lead to a higher valuation than were it to be paid up, so value is not lost,’ he said.

Investors are currently wary of falling prices and the ‘Achilles heel’ of widening discounts.

‘Having seen discounts widen, investors seem to be panicking that they could widen further,’ said Brown.

‘In mitigation, this could happen, but we think it is likely that private funds will take a look and bid for the companies, or most likely the assets nearer to NAV.’