The COVID19 crisis and ensuing credit crunch will hit different assets in different ways. The intention of this article is to provide a quick ready reckoner on what we see being the key risks for each of the traditional infrastructure sectors. In our view, there are two shocks in play:
· A revenue/volume shock – as COVID19 shutdowns (and the associated economic downturn) hit volumes/revenues. The most classic example of this would be the hit to passenger volumes from the virtual shutdown of the airline industry.
· A credit shock as lending conditions for all assets (not just infrastructure) tighten resulting higher credit margins and lower leverage levels.
The following sections briefly outline our views for each sector.
Patronage assets – that is, airports, toll roads, ports, etc. For these assets the risk is the short-term collapse in volumes. While this will be painful – particularly where the reduction is particularly severe (eg airports) – it is likely to be temporary. In fact, the hallmark of a quality infrastructure asset (and proof of its underlying monopoly) is its capacity to bounce back and return to the previous trend. The following charts illustrate this behaviour for ports (taking Longbeach CA as example) and airports (taking the Hong Kong Sydney city pair).
Cargo volumes rebounded after each period of economic slowdown and passenger numbers recovered after the SARs outbreak in 2003.
Regulated assets – that is, electricity and gas transmission and distribution networks. These assets should enjoy good revenue stability through a crisis. Their key risk is on the credit shock side.
A typical regulated asset often has substantial capex programs that need to be debt funded (i.e. it is not uncommon for half of operating cash flow to need to be invested in regulatory capex). In good times, this capex is easily debt funded. However, in the face of the current credit shock, utilities face the risk of a double whammy. That is the combined effects of a forced deleveraging on their existing debt level as well as challenges in financing their ongoing capex.
In theory, under building block based regulatory regimes, utilities should benefit from a higher allowable rate of return when credit spreads widen. However, the reality is that the regulatory WACC will only respond to sharp increase in risk premia with a lag. Furthermore, most utilities have higher actual gearing than that assumed by regulators. This means the rise in WACC is unlikely to fully compensate for the higher cost of debt.
As a final risk factor on this front, the experience in the GFC in the UK was one of political/regulatory interference to stop higher risk premia feeding through the regulatory framework to higher regulated revenues. This left regulated utilities squeezed between fixed revenues and a higher cost of capital.
PPPs. For most PPPs the revenue side should be fine. The key risk is refinance risk. Post GFC most new PPPS have been financed with five year mini perm structures, with the project left exposed to credit margins post year five. That is a debt structure where the debt of a 30 year PPP is financed through a sequence of six consecutive five year debt facilities.
For these projects, equity returns will be squeezed between higher refinance costs compared with fixed revenues.
It is Important to recognise this dynamic will be quite slow moving. The impact will be felt at the next refinance date – which could be up to five years away. Credit markets may recover by then. If they don’t, PPP projects are very highly levered, and so even a modest increase in refinance costs will necessitate a substantial equity injection to de-lever.
In the near-term, valuers will adopt more conservative refinance assumptions and this will hit valuations. In a world of lower base rates, the credit margin is a much bigger share of the overall cost of debt and so sensitivity to credit margins has increased as base rates have fallen. (for example, see newsletter article Not All DSCRs are Created Equal from Q2 2017 which explores this issue in depth).
It is also important to note that equity stakes in PPPs are being valued at extremely aggressive discount rates (6-8% equity IRR). While base rates are likely to stay low, in a distressed environment these equity IRRs could gap higher. As with all very long duration assets, changes in discount rates can have a big impact on equity valuations.
Energy assets. Electricity prices are likely to fall in the short term on the back of lower demand and lower oil/gas prices (and gas prices are a key driver of bidding behaviour by generators). The impact on energy assets will depend on the level of electricity price exposure (i.e. how much PPA contracting is in place) as well as debt exposure (and, hence, refinance risk and cost of debt exposure). It is likely that highly contracted projects will have higher debt, and hence this will be the key return driver. That is, a fully contracted will behave more like a PPP, while a more merchant project would perform more like a patronage asset.
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