Lower base rates - which infrastructure sector wins most?

While the previous article focused on the long-term impact of lower interest rates from an investors’ perspective – it is worth looking into the impact of lower base rates on infrastructure asset valuations. This is particularly timely given the 30 June valuation season is upon us – with many unlisted infrastructure assets revalued for year end.

In simple terms, all infrastructure assets will benefit from lower rates. 10 year bond rates have fallen by around 1% since 30 June 2018. This would be expected to flow through into a 1% lower equity discount rate in a typical DCF valuation and, given the long-duration nature of infrastructure cash flows, around a 10-15% uplift in value (assuming no change in cash flows).

However, across infrastructure, all is not necessarily equal. Infradebt divides the infrastructure asset class into four sub-sectors:

  • Contracted Assets – for example PPPs;

  • Patronage Assets – such as airports, toll roads and sea ports;

  • Regulated Assets – such as electricity transmission and distribution networks; and

  • Electricity Generation Assets – such as solar farms/wind farms.

Contracted assets such as PPPs are likely to be the biggest winners from lower base rates. For a PPP the project cash flows are effectively locked in by the concession agreement (assuming no operator defaults/abatements). This means the full benefit of lower discount rates is likely to feed through to valuations. The main exception to this is inflation – some PPPs have CPI linked payments – and inflation is likely to disappoint relative to the 2.5% adopted by many infrastructure investors.

Patronage assets also have the potential to do very well (and often can have higher duration – that is interest rate sensitivity -than contracted assets). The main risk to this is economic growth. Long‑term growth in patronage is often linked to economic growth (particularly for seaports). This raises a critical question – is the fall in base rates a harbinger of a forthcoming recession/economic downturn? If so, the lower DCF discount rates need to be matched by lower patronage/throughput levels and, hence, lower cash flows. In this context, there is a potential disconnect between the theoretical construct of year end valuations (where the discount rate effect is likely to be fully captured, but the lower growth rates not so much) and the real world.

Regulated assets get a much smaller benefit from lower base rates. For most regulated assets, the allowable revenues set by the regulator are calculated on the basis of a regulated rate of the return (the regulatory WACC). Lower base rates will lower this return and, hence, the future cash flows received by investors. If the valuer and the regulator used the exact same assumptions this would mean that lower base rates actually have no impact of asset values. However, in reality the regulator tends to use WACC assumptions with lower gearing, a higher cost of debt, and a higher equity risk premia than investors. This results in a modest valuation benefit from lower base rates. However, this effect is quite mild, and so probably wont be the key driver of returns this year – more relevant factors are likely to be how optimistic/realistic investors have been relative to regulatory decisions.

Electricity generation assets fall somewhere between contracted and patronage assets depending on the project and its contracting status. However, it is worth noting that electricity generation assets are typically valued on much lower EV/EBITDA ratios (7-15 times compared to the 20-30 times that seems ubiquitous for large core infrastructure assets in Australia). A lower valuation multiple implies a lower base rate sensitivity. For these assets lower base rates will boost valuations but electricity prices will be equally important revaluation drivers.

On this basis – across the sectors – we have declared contracted assets the winner from the recent collapse in base rates. As has been the case over most years this decade, we expect that many funds will reveal significant write-ups of their infrastructure portfolios in their 30 June results. We also expect them to also say ”Don’t expect this again next year”. Eventually they (and we) will be right!

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At Infradebt we are not tied to investment labels. At the end of the day, all investing is investing. We believe the most important thing is a laser like focus on risk vs reward trade-offs, and unders