prudence says no to infrastructure

http://www.intelligentinvestor.com.au/

Infrastructure funds are not as safe as they’re cracked up to be, one of our intrepid subscribers has discovered.
Imagine the scene. Prudence Warywallet has just got home from visiting the grandkids and she sits down for her afternoon tea. All of a sudden, the phone rings.


‘Hello Mrs W, it’s Bert from BusyTrade Brokers. I know you’ve been looking for some safe income-producing investments, and I’ve got just the thing for you—infrastructure funds.’



‘Infrastructure funds you say?’ replies Prudence. ‘Sounds interesting. You’re sure they’re safe and reliable?’



‘Sure I’m sure, Mrs W. The ASX says so on its website: “Revenues from [infrastructure] assets are not considered volatile, and infrastructure is generally regarded as a stable asset class.”’



‘OK, Bert, thanks,’ says Prudence. ‘I’ll look into it.’



This catches Bert off-guard. He was rather expecting a response like: ‘OK, Bert, thanks. You can put me down for $20,000.’ But he clearly didn’t know who he was dealing with. Prudence Warywallet isn’t a typical broking client. She keeps a close eye on her investments, has been a long-time subscriber of The Intelligent Investor, and she particularly enjoys doing her own research. This will be an interesting project. Bert says he’ll call back in a few days, and Prudence sets to work.



Alarm bells



She starts by putting the word infrastructure into the Investor’s College search function. The headlines of the first three articles this brings up set some alarm bells ringing: Easy ways to lose your shirt in 2006, In search of Australia’s Enron and Watch out for low-PER value traps. That doesn’t sound much like safe and reliable, she thinks.



The last of those articles, from issue 188/Nov 05, explains that the profits declared by infrastructure funds are often composed, in large part, of revaluations of their investments, rather than from cash actually coming in through tolls and so forth. So Prudence digs out the figures for net profit and operating cash flow over the past three years for a handful of infrastructure funds. Her figures are shown in table 1 on page 2, and there certainly does seem to be a big gap between profits and cash flow.



A search for some of the funds mentioned in that Investor’s College article reveals an infrastructure sector review, in issue 135/Sep 03, that goes into some detail about asset revaluations. Essentially, the assets get revalued upwards when a higher value of cash is expected to be received in the future. Using a toll road as an example, that may be because traffic is expected to increase, because tolls are expected to rise, or because lower long-term interest rates have increased the value of future cash inflows. Falling long-term interest rates have been a feature of the past few years and this has driven valuations of infrastructure assets higher.



Wide of the mark



But over many years’ investing, Prudence has learnt not to give much credit to distant forecasts, and she always likes to have a margin of safety. She reasons that if assets can be revalued upwards, then they can be revalued downwards too. One way or another, with the ‘revenues’ from these assets being so heavily influenced by revaluations, the suggestion from the ASX that they are ‘not considered volatile’, seems somewhat wide of the mark.






Prudence’s next step is to look up a two-part Investor’s College series on equity accounting that she dimly remembers from 2004. Part two, in issue 146/Mar 04, explains that, generally speaking, majority-owned investments are consolidated into the parent company’s accounts, while minority-owned investments are simply entered on the balance sheet as ‘investments’. This can give a company’s balance sheet a false sense of security, because the investments just mount up on the balance sheet, while any debt they carry is not shown.



Looking at the recent interim report from Macquarie Infrastructure Group (MIG), for example, Prudence finds that it has net debt of $2.6bn. But MIG’s proportionate share of the debt held by its investments comes to a whopping $5.6bn, to give a total of about $8.2bn. You can see Prudence’s working in table 2 below. The debt held by MIG’s investments is ‘non-recourse’ debt, which means that, in the event of a problem, the bankers can’t come crying to MIG. But it’s there nonetheless, and it magnifies any changes in the value of MIG’s investments. And with the $8.2bn debt amounting to only a little less than the $9.0bn market value of MIG’s equity, that’s a lot of magnifying.



Two more recent infrastructure sector reviews reveal further problems. Congestion in infrastructure, in issue 151/May 04, explained how the popularity of these assets had pushed up their price, and Empire building in infrastructure, in issue 180/Jul 05, discussed problems with the fees paid by many of these funds to their managers.



Fees in the firing line



This fee structure typically involves a base fee of 1–1.5% of market capitalisation, plus a performance fee that’s calculated as a proportion of a stock’s outperformance over a relevant benchmark index. The fees have been in the firing line lately, and Macquarie Bank (as a major manager of these funds) has evidently been rattled enough to produce a defence. The structure, claims Macquarie, is the most ‘clear and transparent way of aligning the interests of the investor with the interests of the manager’.



Prudence is not so sure. It seems to her that Macquarie’s incentives are to increase the fund’s market capitalisation, whether by performance or by issuing more securities. When new securities are issued, they dilute the current interests of securityholders, but the money is used to buy assets at the new, more competitive prices.






So Prudence runs a quick check on the fees paid by her sample of funds, and the results are shown in table 1. She’s astonished to see that MIG has paid 54% of its operating cash flow to Macquarie Bank in the past three years. The reason for this huge figure is that MIG’s underlying assets have seen significant increases in value. Australian Infrastructure Fund, by contrast, has not performed as well over the years, so it’s been missing out on the performance fees. It seems to Prudence that when she does well, the bankers take a huge slice of her profits and when she does badly, they still take a generous cut. It’s safe to say that Prudence Warywallet takes a dim view of such arrangements.



When Bert calls back, Prudence is hoping he’ll help her get to the root of some of these issues. Unfortunately, she’s left disappointed.



‘Hello Mrs W,’ says Bert. ‘I was just wondering how you got on with the infrastructure funds. Pretty good, aren’t they.’



‘Well, I’m not so sure actually, Bert. Much of their profit appears to come from asset revaluations and they have considerable off-balance sheet debt. I also have some concerns about the increasing popularity of the sector and the bidding up of asset prices. Finally, the fee structure seems to encourage managers to build empires rather than value, and they take a large cut if I win, and a medium-sized cut even if I lose. I’m not sure they’re for me.’



‘Er, OK, Mrs W … fair enough. Sorry … got to go.’ Click, brrrr …