It might just be the season (bah humbug), but it is starting to feel awfully late in this economic/market cycle. The current cycle has been unusually long – stretching from March 2009. However, over the past few months cracks have started to appear. These include:
Equity market weakness (in particular, cycle high fliers – the FANGs – seem to have lost their lustre);
Retracement of the US 10 year government bond back to below 3%,
Higher volatility – the VIX has moved sharply higher; and
Widening credit spreads – with both investment grade and below investment grade spreads widening by 10-20% over the past quarter or so.
While this may prove a false dawn (or perhaps the phrase should be false dusk) on a period of unusually strong asset price performance of the past 10 years (and I should declare that I have expected an end to the current cycle well before now), it is worth thinking ahead about what a turn in the cycle could mean for infrastructure assets.
In my view, there are two key points investors should keep in mind:
Unlisted asset valuations will lag – and probably by more than you expect; and
Exposure to leverage/credit spreads will probably be a more important driver of valuation changes than the level of risk free rates or economic growth or inflation.
Unlisted vs Listed Valuations
For many Australian investors, listed versus unlisted infrastructure are seen as significantly different asset classes. Listed infrastructure often forms part of the equities allocation – with no specific allocation. By contrast, unlisted infrastructure (usually equity) is seen as a distinct asset class bringing specific risk/return characteristics. This goes as far as many funds counting infrastructure equity allocations towards their “defensive assets” allocation (but this is a debate for another day).
Unlisted assets are difficult to value. Valuations are inherently subjective and are a significant resource/cost burden for superannuation funds and their infrastructure managers. My experience is that most funds update the valuation of their unlisted infrastructure assets annually (or have their underlying managers do so). In normal market conditions, this strikes a reasonable balance between member equity (are unit prices/crediting rates being calculated on up to date valuations?) and cost. However, an up shot of this is that valuations are, on average, circa six months old. Most of the time this doesn’t matter, but at the turn of the cycle, it does.
While the actual valuation lag might be six months, the effective valuation lag is longer. When a valuer undertakes an assessment of the market value of an asset, one key part of the process is to compare the valuation of the asset against transactions for comparable assets (often using key metrics like EV/EBITDA or EV/RAB). For an asset that has many listed comparables (for example, a valuer of Melbourne Airport could look at the value of Sydney airport) this gives a real time assessment of value. However, for assets that mainly have unlisted comparables, e.g. an Australian port, then assessments of value might need to focus on unlisted transaction examples. That is, by looking at M&A transactions involving similar assets (often on a global basis) over the last two to three years.
Inherently, this involves a significantly longer lag. That is - six months for the valuation itself, and then perhaps another 18 months for the average age of the transaction evidence on which the valuation is based.
To be clear, I am not suggesting that funds deliberately prop up valuations – far from it – it is just a feature of the process that when there is a big shift in markets it can take a significant period for new unlisted transactions to occur post the shift and, in doing so, provide a firm basis on which valuations can be updated.
It is for this reason, during the GFC, that while equity markets were already falling substantially in 2007‑08, the impact on unlisted infrastructure valuations only started to really come through in 2008-09 (and continued past the trough in listed markets).
A further complicating factor is the increased valuation disconnect between unlisted assets and their listed equivalents (for example, look at the EV/EBITDA or EV/RAB multiples of the last few years’ large port and utility privatisations). These transactions have underpinned a view that unlisted infrastructure trades at a premium to its listed equivalent. I am not going to get into the philosophical debate of whether this is right or wrong. Rather my point is that, if this pricing dynamic were to change, it would take a significant period for sufficient transactions to accumulate to prove it one way or the other.
Valuation Factor Drivers – Risk Free Rates/Credit Spreads/Growth/Inflation
Abstracting from the specifics of particular infrastructure assets, you can simplify the factors that drive cash flows (and, hence, value) down to four factors:
Economic growth – which drives patronage or throughput. Some assets are quite sensitive to this (eg ports/airports), while other assets have effectively zero exposure (eg. PPPs);
Inflation – this drives the growth of cash flows for most infrastructure assets (but not always – for example some PPPs have nominal cash flows);
Credit spreads (and availability). That is, what is the cost and availability of the debt side of the capital structure. Higher credit spreads and reduced debt availability both reduce the cash flows available to equity and, hence, equity valuations; and
Risk free interest rates. Infrastructure assets generate long-term cash flows. The value of these cash flows is inherently linked to long-term interest rates. The higher rates are, the lower are equity valuations, both directly (through reduced NPV of future equity cash flows) and indirectly (a higher risk free rate increases the cost of debt and, hence, reduces the cash flow available to equity).
All of these factors will be impacted by a turn in the economic/market cycle. A downturn would be expected to:
Reduce economic growth (although most infrastructure assets are actually relatively insensitive to growth – being monopolies/essential services);
Reduce inflation – though it is worth noting that inflation is a lagging indicator;
Reduce risk free interest rates; and
Increase credit spreads as banks/lenders become more risk averse and default rise.
Mark Twain once said ‘history doesn’t repeat but it often rhymes’, however, this time it may in fact be different.
In particular, during the previous crisis the blow of higher credit costs was softened by lower risk-free interest rates. The typical infrastructure equity investment has an interest rate duration of around 10 years. This means a 1% fall in discount rates – all else equal – would produce a 10% increase in value. This means that in the prior crisis – where bond rates have typically fallen by 1.5%-2% - there has been a 15%-20% discount rate effect that has mitigated the impact of weaker growth, lower inflation and higher credit spreads.
However, at today’s official cash rate of 1.5% and 10 year bond rates of 2.5%, a fall of 1.5%-2%, would require a view that Australia could replicate Japan and have zero cash rates and a sub 1% 10 year bond rate. As a small country with a long history of dependency on capital from foreigners (the last current account surplus was before I was born!) I find this prospect difficult to envision.
By contrast, credit spreads are low, albeit not down to their 2007 all time lows. This leaves plenty of room for spreads to rise in an environment of increased volatility, falling asset values and increased defaults.
It is this dynamic – as well as the natural self absorption of a credit investor – that makes me think that it might be credit, rather than risk free rates, that is the more important dynamic at the next turn of the cycle (whenever that is).
If this proves correct, then an implication is that some of the lowest risk assets – that is those with the most predictable revenues – might actually be the most dangerous. Low risk assets – such as PPPs – tend to have the highest level of leverage (a PPP is often financed with over 85% debt). High leverage equals high exposure to rising credit spreads.