By Dragana Timotijevic, Mercer's Head of Alternatives Research.

Infrastructure assets are generally highly geared because of the relatively high certainty of their cash flows (high barriers to entry, monopoly position, etc). However, this elevated level of gearing exposes them to adverse interest rate movements and increases in the cost of debt. In this paper we examine the affect of the recent issues in the sub-prime market and related response of the credit and equity markets on infrastructure investments.

Gearing and financing of infrastructure assets

Below are the key points with respect to gearing and financing of infrastructure companies/assets.

• Gearing is higher for unlisted than listed infrastructure. One of the advantages of unlisted infrastructure is an owner’s control of the capital structure. Hence, gearing levels in privately held infrastructure range from 50% at the lower end, for higher risk infrastructure such as airports, to 90% for social infrastructure (schools, hospitals, etc) for which the revenue stream is typically backed by government or semi-government payments. On average, gearing for listed infrastructure companies is around 40%. However, it varies significantly across companies and across regions. For example, gearing for some of the Australian listed funds is quite high (above 50%) while the European infrastructure companies have a low level of gearing (around 30%).

• Infrastructure businesses use typically long term, fixed rate debt financing. The duration of debt term varies from entity to entity ranging from five to 20 years. There is a lot of variation with regards to the form and the features the debt structure may take; the relative visibility of capital expenditures and the cash flows coupled with increased debt innovations over the past few years offers a lot of room for “debt sculpting” (for example “escalating interest rate swaps”) especially in privately financed deals. Some of these structures are quite complex and opaque. Typically, however, the cost of debt is priced off long term bond yields (five or 10 years) plus the appropriate margin (again depending on the asset) and there is very little use of short-term debt.

•  Debt of infrastructure companies/assets is typically of investment grade quality. This is due to the nature of the assets and its characteristics, i.e., cash flow certainty.  However, not all companies are rated as some of them use little debt or use bank debt only. Also an increasing portion of infrastructure financing is done through private debt.

• Regulated utilities (such as water) are shielded from the impact of higher interest rates. The prevailing cost of equity and debt at the time of regulatory resets (usually every five years) is allowed by regulators in determining the Regulatory Asset Value (RAV). Hence, the increased cost of debt and equity is passed to consumers through increased tariffs.

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Recent performance

As expected, listed infrastructure stocks have been caught up in the recent downturn in the credit and equity markets in which investors were indiscriminately selling down stocks in all sectors. The chart below compares the performance of the broad UBS Global Infrastructure and Utilities Index to the performance of the global equity market (as measured by the MSCI World index) and US 10 year bond yields.

The chart shows that the UBS index started declining before the broader market, largely in response to higher bond yields in May. Bond yields, however, have since declined, but the severity of the sub-prime problem hit the broader equity market during July leading to a sharp decline in both infrastructure and broader equity stocks.

Unlisted infrastructure investments are unlikely to have been affected much during the recent period. These assets are valued on a quarterly basis using 10 year bonds and the appropriate risk premium in the discount rates. Bond yields globally have declined in July after rising through June. Hence, bar an increase in long term interest rates or/and specific asset/fund issues the volatility of returns of unlisted infrastructure assets is generally quite stable.

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Debt profiles

In order to gauge the impact of tighter credit going forward we have asked the managers of listed infrastructure funds to provide the debt profile of their portfolios together with the hedging policy. Based on the information supplied by managers we have found that across the portfolios the outstanding debt duration is more than seven years and that at least 70% of this debt is fixed. For example the hedging profiles of the two widely held infrastructure stocks, MIG and Cintra Concessionaires, global toll road operators are as follows: more than 90% of MIG’s debt and 85% of Cintra’s debt is fixed for the next two years; 80% and 65% of debt for each company respectively is fixed for seven years or more.

The graph below demonstrates the maturity profile for Cintra’s EUR9.3b debt as at 31 December 2006. The average maturity of its debt is 13.4 years. Cintra must refinance EUR1.1b in the next 12 months but could refinance (depending on the relative attractiveness of the terms) as much as EUR2.3b.

source: RARE

The recently published UBS investment research report on the companies in the Australian Infrastructure and Utilities Index found similar results. For 25 companies in the Index, 70% of debt has interest rates fixed for 5+ years; the average term to expiry for Infrastructure debt is 6.9 years and for utilities debt 4.6 years.

The statistics above indicate there is a very low near-term refinancing risk and little impact of recent rate movements on cash-flows of infrastructure companies. Any refinancing of future debt issues will be subject to the prevailing rates of the day. Given that a large majority of the companies in managers’ portfolios are investment grade quality  and that the managers tend to select the companies with sustainable gearing structures higher credit spreads may have a relatively small negative impact on businesses’ cash flows.

Conclusion

Overall, in the near-term infrastructure investments are unlikely to be negatively impacted by the widening in credits spreads. This is due to the relatively low level of gearing (in the listed sector), long-debt profiles and the high level of hedging that exists in the current debt structures of infrastructure companies.

However, the investment environment has changed. Over the past year-and-a-half both listed and unlisted infrastructure has been affected by the strong M&A activity which pushed up the valuations (largely for the benefit of listed companies that were taken over by unlisted infrastructure funds). With the recent repricing of risk, the cost of doing business has increased and valuations have come down to more reasonable levels. These will make some marginal investments less attractive.

The worldwide trend towards increased infrastructure spending and rising securitisation of regulated infrastructure assets has not been significantly impacted by the recent sub-prime driven events. Bonds, cash rates and inflation remain below the rates used in the managers’ valuation processes and the global growth and industry dynamics indicate continuing patronage growth.

If the world economy slows, returns on regulated utilities should largely be unaffected as the increased cost of equity and debt for many sectors will be recouped in tariffs. Unregulated gas and electricity businesses with take or pay contracts will also continue to do well. Tollroad companies, however, will probably experience slower traffic growth while airports which are the most cyclical asset, will be the worst off.

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© 2008, Mercer Human Resource Consulting Pty Ltd

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