Capital Call

David Stevenson is an experienced investment commentator and writer, with a passion for media and technology. David writes for a number of leading publications including The Financial Times, where he is a columnist, the Investors Chronicle, Money Management and trade newspaper Investment Week, where he’s the contrarian columnist.

June 4, 2021

The US may have pioneered the development of the REIT and MLP investment structure, but it is the UK that has very much been in the forefront of the infrastructure investing boom. Over the last twenty years dozens of infrastructure funds have emerged raising huge sums of money. Currently the London market boasts at least 26 listed funds with assets of over £20 billion (£25 billion if we include medial property funds) with many of the most exciting new launches in the digital space – namely the Cordiant and D9 digital infrastructure funds which between them have raised over £650m to date.

The rapid growth of the UK infrastructure market provides some useful clues as to how digital infra funds might grow in the future on both sides of the Atlantic. Established outfits such as HICL and INPP (both worth around £3 billion each) in the public private partnership space and TRIG (£2.6 bn) in the renewables space speak to a number of drivers for investment interest. The sweet spot seems to be producing an income in the 4.5 to seven percent range with a promise of progressive dividend increases, alongside one to three percent per annum capital appreciation on an annual basis. Investors have also chased up valuations to premium ratings largely off the back of low levels of share price volatility and dividend payouts more than covered by underlying cash flows.

But this huge success with attracting investor interest has also pointed to some warning signs that might be worth heeding for the fast-growing digital infrastructure sector. Take political risk or more pertinently in the traditional infra space, policy risk. In the run up to the last UK election investors started to worry that the main opposition party (Labour) would renationalise the public private assets, possibly even confiscating projects with returns regarded as too generous to private investors. That is not a realistic risk in the digital space but what is very much a concern is security and geopolitical risk. Digital infrastructure platforms are at the centre of our new internet enabled economy, one which is full of malign actors and geopolitical players keen to create confusion and chaos. One can easily imagine a scenario where a malign state actor causes damage to fibre connections or takes out key data centres in a show of spite. This could in turn prompt drastic changes in government policy, possibly to build greater resilience into digital networks at great cost to the operators.

Another arguably related area of concern centres on ESG investing. At the moment most ESG policies are being developed through voluntary industry initiatives. Cordiant for instance here in the UK has been focused on acquiring assets located in regions with abundant, low cost renewable power from hydroelectric sources (hydroelectricity offers the benefit of permanent generating capacity, something solar energy, for example, does not). Regions of focus for the fund include Scandinavia, Québec, and the Pacific Northwest of the US and Canada. This is all eminently sensible but the spectre of government intervention is already looming in the background. European Union rules (eagerly embraced in post Brexit Britain) are now explicitly targeting transparent and comprehensive embedded emissions benchmarking and reporting that will become progressively more onerous over time. Given the Biden administrations professed desire to catch up with the Europeans, what’s the betting that US regulations won’t also become increasingly onerous for data centres?

But it’s not just policy concerns that have troubled investors in recent years – they have also been spooked by embedded volatility in industry revenue structures. Take the example of the renewable infrastructure funds who promised investors a steady return on investments in wind and solar power. The implicit promise was almost a modern version of read my lips – “No or very low volatility”. Except that wholesale power prices proved to be hugely more volatile than expected, at one point crashing and then, in recent weeks, shooting back up again. The impact on balance sheets was much more restrained but investors took fright, nevertheless. There’s no direct analog in the digital market as market dynamics are very different but woe become the fund that promises steady pricing or growth rates but which then delivers volatile outcomes. If you sell investors a steady, no vol investment outcome, make sure you deliver on the promise.

One area where volatility might creep in is through the back door of valuation models underpinning balance sheets, which can change abruptly because of changed economic variables. All the big infra players use fair value methodology calculated in line with private equity guidelines. This system calls for unquoted investments to be valued using a number of approaches which fall under three headings; income approach (discounted cashflow); market approach (multiples); and the replacement cost approach (net assets).

Most players in the digital space such as Equinix, Vantage Towers and Cellnex are generally valued using multiples, typically of EBITDA. But some existing infrastructure players involved in digital assets use DCF models instead. 3i Infrastructure for instance previously owned the Wireless Infrastructure Group and recently acquired DNS:NET (which owns the largest independent fibre-to-the-cabinet network in Berlin as well as three data centres). This hugely popular fund values its investment using a discounted cash flow methodology. What concerns many investors is that valuation models are susceptible to changing economic conditions which in turn impact the underlying DCF inputs. This has led some analysts such as those at one investment bank (JP Morgan Cazenove) to champion what’s called a Steady State valuation approach. This attempts to adjust the discount rate for a range of factors to get a better handle on how much return an investor should expect if they buy at the current share price.

One final source of anxiety is execution risk, especially around outsourcing of new project builds. Investors have become acutely aware that most funds do outsource key execution projects to third party contractors, many of whom are susceptible to intense pricing pressure. What happens when those third parties fall over?

Despite all these concerns and challenges, the infrastructure space has boomed in the UK and continues to attract huge levels of interest with digital projects very much at the front of the pack. And it’s worth emphasising why investors have snapped up those Cordiant and D9 shares with vast new placing programmes for both funds imminent. In simple terms, their business model is different, with value derived from long-term contracts boasting annual escalators, with excess cashflow reinvested to create further value through growth capital expenditure which in turn drives NAV growth. By contrast, most existing public private infra funds are based on concession based assets which typically provide real returns through access to portfolios of fixed, (often) inflation-linked cashflows in the form of unitary payments.

As analysts at Investec recently noted in a detailed note on Cordiant, digital assets may in fact prove the superior asset class. In particular, the banks fund analysts draw attention to “the power of reinvesting excess cashflows into new and complimentary assets [that] can have a profound effect on EBITDA growth and NAV progression over the long term. American Towers grew its EBITDA at a CAGR of 12.7 percent between 2007 and 2020!”. Given current chunky valuations for many digital assets plus the tailwind of low bond yields, the challenge is to keep delivering on that steady compounding without excessive market volatility – if the lesson of UK infrastructure is anything to go by, allowing volatility to creep into returns could throw a real spanner in the works.