April 2019

Tulips Disguised as Toll RoadsJames A. Lydotes, CFA | Managing Director, Senior Portfolio Manager

William J. Adams | Managing Director, Global Investment Strategist

Brock A. Campbell, CFA | Director, Senior Research Analyst

2PAST PERFORMANCE IS NOT NECESSARILY INDICATIVE OF FUTURE RESULTS.

Publicly listed and direct infrastructure funds have each garnered a great deal of focus over the last decade for very sound reasons. The asset class offers investors the ability to buy into businesses that offer:

Stable underlying cash flows

Regulatory predictability

Asset ownership or rent collection features

Especially in periods of market volatility, investors take solace in the defensive nature of these businesses. The infrastructure business model invests cash upfront to build out a physical asset, and then harvests stable cash flows over the life of the asset, much of which is returned to investors in the form of dividends. Income is a core feature of the types of assets found within infrastructure. While the underlying asset types backing up either direct or publicly listed infrastructure are very similar, technical issues have created what we believe to be a bubble in direct infrastructure funds.

There is very little business variability with infrastructure assets, which is, predictably, a large part of their allure. It is much easier to predict how much water the UK will use over the next 12 months than it is to estimate how many iPhones will sell over that same period. Given the predictability of these businesses, they are often valued by the present value of future cash flows. The discount rate is a critical input in valuing a business using a discounted cash flow (DCF) methodology, and thus the valuations of these assets are very sensitive to changes in the discount rate.

Fully regulated US utilities are a good example of this. These assets are often referred to as “bond proxies,” and rightly so—US bond yields serve as the discount rate in valuing these companies, and as yields rise, the present value of cash flows declines. This relationship has historically been very tight, and fundamentally makes sense.

Whether these assets are publicly listed on an exchange or held within a direct infrastructure fund, their fundamental value should adjust (in either direction) as the discount rate changes. Over the last ten years, we have experienced considerable interest rate volatility. As an example, during the taper tantrum of 2013, the US 10-year Treasury yield went from a low of 1.62% to a peak of 3.0% over a short six-month period. Unsurprisingly, as the discount rate rose, the present value of listed utility cash flows declined, and these equities went down in value to reflect this.

In a DCF framework, as the discount rate goes up, the present value of future cash flows should decline. This is a logical relationship and has been the case historically in public equity markets. Perplexingly, over this same time period, when global interest rates continued to move higher, the value of direct infrastructure funds did not go down as we would expect, but instead went up. If we agree on the DCF basis for valuing these assets—how could this be?

Preqin Index: Direct Infrastructure

Source: Preqin. Rebased to 100, quarterly as of December 31, 2017.

50

100

150

200

250

2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017

Inde

x Re

turn

3PAST PERFORMANCE IS NOT NECESSARILY INDICATIVE OF FUTURE RESULTS.

Why the Differential?

In two words, fund flows. Investors’ appetite for direct infrastructure has shown no signs of slowing, and with values continuing to move higher every quarter, why would it?

One good measurement of investor enthusiasm for direct infrastructure is how much intended capital direct managers actually raised. As recently as 2015, direct infrastructure managers took in roughly 90% of their intended capital raise, a strong showing. Last year, they were able to raise 101% of their goal. On a year-to-date basis through August 2018, these same managers took in 122% of their intended capital raise. Simply, for every $100 these managers looked to secure, investors gave them $122. These managers now hold 22% in excess cash with only a finite list of areas in which to invest. Too much money chasing too few assets pushes prices higher, which can lead to asset price bubbles, but don’t take our word for it…

Average Proportion of Target Size Achieved by Unlisted Infrastructure Funds Closed

Source: Preqin. *As of August 2018.

What are Managers Worried About?

Direct managers recognize the root issue and appear to be worried. Preqin recently surveyed managers on the key challenges facing the sector in 2018.

Key Challenges Facing Unlisted Infrastructure Fund Managers in 2018

Source: Preqin. Based on proportion of respondents.

101% 96% 91%99% 101%

122%

2013 2014 2015 2016 2017 2018 YTD*

Year of Final Close

19%

19%

20%

20%

20%

23%

33%

36%

59%

Fulfilling Investor Demand

Volatility/Uncertainty in Global Markets

Fundraising

Interest Rates

Performance

Fee Pressure

Deal Flow

Regulation

Valuations

4PAST PERFORMANCE IS NOT NECESSARILY INDICATIVE OF FUTURE RESULTS.

Valuation is by far the single greatest concern for direct managers tasked with putting these dollars to work. They realize these assets are richly valued, but they’ve just been given over 20% more money than they intended to raise. With too much money and elevated valuations, one would think it prudent for direct managers to suspend putting this capital to work; however, this does not appear to be the case.

According to Preqin, when asked their intent to deploy capital over the next 12 months, over 40% of the managers surveyed indicated they would put “significantly more” capital to work over the next 12 months than the previous 12 months. Only 2% of managers indicated they would be putting less to work over that same period. With investors continuing to pour ever more capital into the asset class, it seems that managers have no alternative but to continue deploying capital.

Risky Business

To examine the real risk of overpaying for a stable infrastructure asset by direct managers, let’s take a recent private transaction as a more extreme example.

In September of 2018, Canada-based AltaGas announced the sale of 35% of its Northwest British Columbia Hydro Electric Facilities for an implied price of 27x EV/EBITDA (in 2017 EBITDA terms) to a consortium of private infrastructure investors. What does this imply for a go-forward, pre-tax yield? A scant 3.7%, which offers very little risk premium above the US 10-year Treasury yield.

What are some of the risks associated with such a price since these are stable cash flow assets?

Unexpected maintenance capex

Regulatory changes that could weaken the contracted revenue levels

Continued upward pressure on interest rates

For context, the S&P Global Infrastructure Index traded at 11.1x EV/EBIDTA as of November 30, 2018, implying a 9% forward pre-tax yield on assets with very similar characteristics, which clearly discounts a variety of risk factors that could impact the present value of future cash flows associated with underlying infrastructure holdings.

The risk of more deals cemented at elevated levels has increased substantially due to the capital raise activities noted above. With the same finite set of brownfield assets trading hands numerous times across many managers, the exit multiples on these assets continue to rise. This process can continue over the near term, and we expect that it will until flows into the asset class start to slow.

Two notable examples of this phenomenon are the 407 Express Toll Route in Canada and Thames Water in the UK. In the case of 407 Express Toll Route, portions of the asset have changed hands eight times since being privatized nearly twenty years ago. Similarly, Thames Water, the UK’s largest water and wastewater services company, has seen portions of their group transacted seventeen times since September of 2001.

Will there be Contagion into Publicly Listed Infrastructure?

Predictability defines infrastructure assets. If you can effectively forecast the underlying fundamentals, the only remaining argument for a manager is the price you pay for the cash flows generated by the business. With listed infrastructure equities, these prices are struck every second of every trading day. This “mark-to-market” mechanism occurs in equity markets, and there is nothing opaque around the value of these businesses. If you want to know how expensive your listed infrastructure fund is today, look at its price/cash flow valuation. All the information is at your fingertips.

5PAST PERFORMANCE IS NOT NECESSARILY INDICATIVE OF FUTURE RESULTS.

We believe we are undeniably in the early stages of an infrastructure boom. The regulatory landscape is evolving quickly, as are the relative value opportunities. We continue to believe in the structural opportunities across a wide cross section of infrastructure assets in the coming decades due to the cross currents of investor appetite for defensive, cash-generative businesses, and the societal need for continued investment in infrastructure. If you pick the right manager, the quality of these assets are the same across both direct and publicly listed infrastructure. What is not the same is the price you are paying for what you are buying. In the end, the price you pay is the single most important consideration.

‘Price is what you pay; value is what you get.’ Whether we’re talking about socks or stocks, I like buying quality merchandise when it is marked down.”

Warren Buffett

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James A. Lydotes, CFAManaging Director, Senior Portfolio Manager

Jim is a senior portfolio manager for the Global Infrastructure Dividend Focus Equity and Global Healthcare REIT strategies. In addition to his role as lead portfolio manager, he is also senior research analyst on the Global Equity team, primarily focused on the International Equity and International Small- Cap Equity strategies. Jim is responsible for research coverage of the non-US health care, utilities, information technology and communication services sectors. Additionally, he is responsible for assisting in the development and enhancement of the team’s quantitative stock selection models.

Prior to joining the firm, Jim served as a fixed income business analyst at Wellington Management Company. Jim has been in the investment industry since 1998.

Jim earned a BA in economics from Syracuse University. He holds the CFA® designation and is a member of the CFA Institute, the CFA Society of Boston and the Boston Committee on Foreign Relations.

William J. AdamsManaging Director, Global Investment Strategist

Bill is a global investment strategist for the firm’s active equity, Small Cap Value, Non-US and Emerging Markets investment disciplines, responsible for communicating the teams’ strategies to clients, prospective clients and consultants. He is a critical interface between client-facing staff and investment teams and guides the messaging and positioning of these investment strategies.

Before joining the firm, Bill was an associate at Deutsche Bank, where he was responsible for European equity research sales. Previously, he was a senior account officer at Putnam Investments, where he managed 401(k) relationships, and a senior account administrator at State Street Research and Management Co. Bill has been in the investment industry since 1995.

Bill earned a BA in political science from Boston College and an MBA in finance from the University of Maryland.

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Brock A. Campbell, CFADirector, Senior Research Analyst

Brock is a senior research analyst on the Global Research team as well as a portfolio manager for the Global Infrastructure Dividend Focus Equity strategy. He is responsible for covering Utilities and Industrials. Previously at the firm, Brock was a research associate supporting senior analysts covering the Energy, Utilities and Materials sectors. He has also served as a portfolio assistant.

Brock has been in the investment industry since 2005.

Brock obtained a BA in political science and economics from Wheaton College. He holds the CFA® designation and is a member of the CFA Institute.

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