April 16, 2024

He is led by an invisible hand to promote an end which was no part of his intention

Adam Smith

BIP’s financial structure incentivizes its manager, Brookfield Asset Management, to pursue fee maximization practices.  On first view, drivers of fees - a higher unit price and higher distributions to limited partners - may seem to align the interests of the managers and owners.  However, the unintended consequence of BIP’s success is that financial policies have become toxic for limited partners.  Units have been transformed into a variation of a pyramid scheme, where the profits of the underlying investments alone cannot pay the bloated fee structure and expected investor returns.  Comparing BIP with a sister entity that was launched in 2023 by Brookfield illuminates BIP’s fatal flaws clearly.  

DISCLAIMER

This report represents the opinions of Keith Dalrymple and Dalrymple Finance on Brookfield Infrastructure Partners.  It is an opinion piece and should not be taken as investment advice of any kind.  This is not an offer to sell or a solicitation of an offer to buy any security, nor shall any security be offered or sold to any person, in any jurisdiction in which such offer would be unlawful under the securities laws of such jurisdiction.  

BIP’s webpage provides the names of sell-side analysts and firms that provide research coverage.  The firms and analysts listed are in the business of providing investment advice to individual and institutional investors.  We strongly encourage those seeking investment advice to consult one or more of the sell-side research firms listed.  

The report is based on publicly available information and due diligence Dalrymple Finance believes to be accurate and reliable.  However, it is presented “as is” without warranty of any kind, whether express or implied.  Dalrymple Finance makes no representation, express or implied, as to the accuracy, timeliness, or completeness of any such information or with regard to the results to be obtained from its use.  This report contains a large measure of analysis and opinion.  It is subject to change without notice.  

Following the publication of this report we intend on continuing to transact in the securities mentioned.  We may be long, short or have no position at any time.  That position may change at any time.  

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Negative Space

The seeds of BIP’s collapse are embedded in its success as an investment vehicle.  The unintended consequences of its fee maximizing incentive structure is that BIP has been transformed into a variation of a pyramid scheme.  

Years of overpayment of distributions has driven units to trade at a multiple of NAV.  Both contribute to the bloated expense structure.  20% cash expenses, but only 12-15% expected returns means that erosion is inevitable.  

Equilibrium will not come easily.  There are three options.  BIP can continue as it has done by funding eroding equity by selling units at above NAV; management must generate returns on equity of greater than 22.5% to prevent NAV erosion, or the expense structure must be rationalized.  

Relying on selling equity above NAV is a risky approach, in my view.  It relies on finding new investors willing to pay $2 for $1 worth of businesses.  I don’t think it is not a sustainable long-term strategy.  Likewise, I don’t think BIP can generate the returns necessary to prevent equity erosion with the current expense structure.  Therefore, management and incentive fees must be cut, which cannot happen without a lower unit multiple and distribution cuts, implying significant investor losses.  

Management deftly avoids discussion of limited partner equity or net asset value.  In some kind of suspension of disbelief, investors have not questioned management on value creation, instead focusing attention on management’s chosen metrics.  However, equity matters. Without equity, there is no return.  Without equity there is no partnership.

2023 has provided additional context in which to examine BIP.  BIP unitholders seeded a related-party entity, Brookfield Infrastructure Income Fund (BIIF), with investments in return for shares.  BIIF is an untraded fund that trades at NAV with NAV-based management and income-based incentive fees.  

Comparing the two entities has grim implications for BIP unitholders.  BIIF has a substantially similar portfolio, yet trades at a greater than 50% discount and pays a fraction of the fees.  Both vehicles own investments purported to generate 12-15% annual returns.  Doubtless, investors in both vehicles expect the returns.  Yet, returns cannot be equal when BIP unitholders purchase the portfolio for over 2x the cost and pay ~2.5x the base management fees.  

BIP’s high expense structure means that net returns must be significantly lower than BIIF’s, begging the question of how BIP can continue to exist with its current financial structure? 

While management declared 2023 “another marquee year” with respectable FFO growth, data from the 20-F shows actual cash flow from operations at many key assets have declined in the last two-years.  Though continuous acquisitions and scant disclosure obscure the erosion, but evidence remains.  

I estimate the annual FFO overstates LP cash flow by at least 20%, inflated by accounting gimmickry and by including cash flows from companies that are not in the financial position to pay distributions.  BIP cannot pay distributions based on IPL cash flows when IPL cannot pay distributions to BIP.

Japanese art aficionados know that “ma” or negative space is just as intentional and important as the object depicted in a painting.  Brookfield investors should be aware that the “ma” of BIP financials – what management does not talk about, does not disclose and ceases to disclose is at least and often more important than the metrics in focus.  

I continue to be short BIP.  

1. The Inevitable Outcome of a Pyramid Scheme is Collapse

BIP is a publicly traded pyramid scheme.  The long-term overpayment of distributions has helped drive a 2.3x NAV valuation, which contributes to the bloated and unsustainable fee structure.  Fees consumed 7.9% of NAV in 2023.  The underlying investments cannot generate the level of returns necessary to pay the excessive fee burden and promised distributions to unitholders.  Positive long-term returns from current unit prices can only be generated by recruiting buyers at ever higher valuations.  

The math of maintaining or growing NAV is irreconcilable with realistic return expectations.  Here’s how it works.

The table below shows changes in unitholder net asset value in the context of BIP’s 2023 cash expense structure.  It also shows the required rate of return needed to maintain a flat NAV.  

In 2023, unitholder net asset value declined by -0.95%.  The gross return on net assets is a plug figure obtained by using the reported ending net assets and the partnership’s expense structure.  In the year, BIP generated gross returns of 21.5%.  

The column on the right shows the required rate of return to prevent NAV erosion with the current expense structure.  The minimum required return on net assets is 22.5%.  

Utility and utility-like investments that generate a consistent 22.5% annual return do not exist, in my opinion.

Long-term return for utilities are between 8% and 10%, according to Morningstar and Pitchbook.  Management states that it can generate 12-15% average annual returns – 50% higher than industry averages at the midpoint of 13.5%.

If we assume management generates the 13.5% expected rate of return minus 7.9% of management fees leaves an expected net return to investors of a meagre 5.6%.   

If we assume management achieves the return goals, the outlook for unitholder NAV is grim. 

The expense structure assumes the unit market multiple remains the same, and both distributions and incentive distributions paid to BAM grow at 7%, which is the midpoint of management’s guidance.  With this cash expense structure, if management achieves the midpoint of stated return expectations of 13.5% and the current cash expense structure, unitholder NAV declines at an accelerating rate over time, beginning to collapse in year-3. 

Connecting fees to unit price and LP distributions has resulted in a toxic financial structure that consumes equity and imparts immense risks on BIP unitholders.  It is evident if one assumes a year of negative returns, as shown below.

If BIP’s investments ever experience a relatively modest down-year of -10%, unitholder NAV will plunge over 30%.  

I assume investors at current levels have bought into management’s “Grow-tility” narrative of safe stable yield and growth.  There is an implied free lunch in the conservative safety plus growth set-up, but the free lunch goes to management, which can currently sell equity worth $1 for $2.55.  In my view, are holding a ticking financial time bomb. 

Management is stuck between a rock and a hard place.  On the one hand, they must know that the expense structure is untenable and it implies the inevitable destruction of unitholder NAV.  On the other hand, avoiding all discussion of NAV, obscuring the financial model with smoke and mirrors financial presentations, and inveigling investors with narrative of safe high-yield and growth has worked well thus far, allowing them to fund the model by selling equity above NAV.  The problem is that it is a faith-based model.  Investors must believe that the unit price can increase irrespective of a stagnant or declining NAV, and somehow shoulder the enormous fee burden resulting from that increase.  That is not a tenable strategy, in my view.   

Outside the free lunch, there are only two ways this can return to equilibrium.

1. Management must generate returns equal to or greater than 22.5% annually to avoid NAV erosion.

2. Unit devaluation and cuts in LP distributions and incentive distributions must combine such that the total cash expense ratio is less than or equal to management’s expected returns of 13.5% annually. 

BIP’s investments will almost certainly generate average annual returns of 22.5%.  That means the financial model is dependent on selling units above NAV to generate equity to avoid a collapse in equity, which I do not view as a sustainable strategy.  Eventually and inevitably, in my view, expenses must be right-sized, which has catastrophic return implications for current holders.  

2. Brookfield Infrastructure Income Fund Exposes BIP’s Fatal Flaws

Late in 2022, BIP unitholders sold a portfolio of investments in a related-party transaction to a seed a new investment vehicle started by BAM.  Brookfield Infrastructure Income Fund (BIIF) is a non-traded investment company that trades at NAV.  Its portfolio contains many of the same assets held by BIP.  However, The two vehicles have very different financial profiles.  BIIF trades at more than a 50% discount to BIP and pays BAM a fraction of the management fees.  

IFRS Book Value is NAV 

When my initial report was published, I received some pushback on the concept of BIP book value being NAV.  Some investors maintain that BIP’s IFRS values do not represent carrying values, therefore book value is not NAV.  This is patently false.  

Management doesn’t talk about NAV, but that should be no surprise – doing so would essentially be telling investors that they overpaid and own units at vastly inflated prices.  However, the fact is clearly evident elsewhere.

Management has spoken/boasted of selling assets at or above carrying values numerous times, including BN’s 4Q23 earnings release:

Brookfield Corporation Carrying Values

Source:  BN company press release.

IFRS value as carrying value is also evident in a related-party transaction used to seed BIIF which was effected at the end of 2022, disclosed below.

BIP’s Related-party Asset Sale

Source: BIP 2022 20-F.

BIP sold assets to Brookfield Infrastructure Income Fund (BIIF), a non-trade investment company.  The assets were transferred at fair value; BIP received shares in the entity as payment.  

It is also evident in position carrying values.  As shown in the accompanying table, IPL is carried at the same fair value at both BIP and BIIF.

BIIF raises some uncomfortable questions for BIP unitholders.  Comparing BIP with BIIF leads to the inevitable conclusion that BIP unitholders own an asset with toxic financial policies where returns cannot approximate those expected.

We can compare BIP and BIIF on several levels.  First and foremost, investors should keep in mind when comparing financial metrics that the two entities contain very similar portfolios, though as shown in the exhibits at the Appendix, they are presented in a very different manner.  This is important, because the difference in the way in which the portfolio and returns are presented is a key driver of the BIP trading price anomaly that drives the outrageous fees.  

While the portfolios are substantially similar, the price investors pay for the portfolio and fees are quite different.  The exhibit below details the basics of the fee structures for each vehicle. 

In contrast to BIIF, neither BIP’s management fee nor its incentive distribution are linked to profit or cash flow generated by the assets.  Fees are driven by capital market and securities metrics. 

BIIF is a non-traded investment vehicle and trades at NAV, whereas buyers of BIP pay the market-price, which over time has become decoupled from the NAV as investors have been encouraged to view distributions as the sole measure of value.  This difference has profound financial implications for BIP unitholders, as shown below.

The exhibit takes the value of IPL as reported by BIIF and adjusts it for its proportion of liabilities to obtain the net value.  I then show how much a shareholder is paying for the asset at both investment vehicles and how much they are paying in base management fees on the asset. 

BIP unitholders pay a higher price for the portfolio and a multiple of fees relative to BIIF.  

The difference in expense structures has profound implications for expected returns.  Brookfield expects their infrastructure investments to generate 12-15%, or an average of 13.5%, annual returns over the long-term.  Putting management’s expected returns together with actual expense ratios yields the average expected net return to investors.  

Management return expectations and BIIF’s 2.66% expense ratio results in a net expected return of 10.84% to shareholders.  BIP’s 8.39% current expense ratio reduces expected returns to a mere 5.11%.  BIP’s return assumes no change in the trading multiple.  

Investors in both vehicles likely have the same return expectations, but that cannot be.  BIP unitholders need to digest the fact that the majority of expected investment returns are consumed by fees.  

Unitholder expected net return of 5.11% is less than 50% of BIIF’s and a mere 59 basis points above the risk-free rate, U.S. 10-year treasury of 4.518% (as of 4/12/24).  

Here we have two Brookfield-managed investment vehicles with substantially similar portfolios.  Investors can buy one vehicle for $1 with an expected annual return of ~11% or could buy the other for $2.55 with an expected return of 5.11%, with the embedded risk of a ~60% decline as price reverts to NAV.  

3. Continuous M&A Activity Hides Eroding Cash flows

BIP’s “cash flow” as defined by management’s FFO metric, increased 9.6% in 2023.  Although down from the 20.4% growth in 2022, still quite respectable.  Analysis of the sources of cash flow, however, shows that growth is driven by adding assets.  Most traceable assets have experienced cash flow erosion.

The table below shows the cash flow on a “same store” basis for investments that BIP that have been reporting for 3-years or have not changed materially.  I eliminated newer investments and those, such as the Indian Telecom Towers, which had a material acquisition.  Unfortunately, analysis is limited, in part, because management eliminated the disclosures that with the data necessary to perform this analysis with equity accounted investments. 

10 of 13 assets have declining cash flows over the 2-year period.  Aggregate growth as reported over the period was only $65M and that only because Canadian diversified midstream, Inter Pipeline (IPL) was acquired in 3Q21.  The proper way to view the change is cash flows is on a full-year basis at the business level.  I adjust IPL’s 2021 cash flows to include the full-year, though BIP did not own it the entire year.  Doing so increases the 2021 proforma cash flows by $165M, which makes the 2-year change ($100M) or -4%.  Viewed on a true comparative basis, BIP’s consolidated business have seen an erosion of cash flows over the last 2-years.

The chart below compares the different measures of cash flow – BIP’s reported FFO, the “same store” cash flow from operations, and “same store” including a full allocation of IPL’s 2021 cash flows. 

FFO shows a 32% increase in “cash flow” over the period.  In contrast, adjusting the same-store numbers on trackable assets for a full allocation of IPL cash flows shows a -4% decline. 

As far as I can measure, cash flows at most of BIP’s consolidated investments have declined on a same-store basis over the last 2-years, despite growth CapEx investments.  Investors would do well to keep this performance in mind the next time management talks about BIP’s “inflation protected cash flows”.  Inflation protected does not mean they go up.  

The 30% differential between the 31% reported 2-year FFO growth and 2% on a trackable business basis, is likely M&A.  It is not mysterious why BIP engages in serial acquisitions.  Buying creates the illusion of growth and masks cash flow declines.  

4. Does BIP Have a Conservative Payout Ratio?  

BIP reported comfortable FFO-based payout ratio of 66% in 2023, down from 68% in the prior year.  The AFFO payout ratio, that is the payout after maintenance CapEx, declined marginally to 82% from 83% the prior year.  

As I detailed in my initial report, FFO is a proportional metric that includes BIP’s proportion of FFO from both consolidated and equity accounted investments.  The aggregate figures are used to measure payout irrespective of how much cash BIP actually collects in distributions from its investments.  

BIP’s definition of FFO inflates cash flow available for distribution.  It includes cash it does does not receive for a variety of reasons, including the lack of free cash and accounting gimmicks.  

To illustrate the impact on 2023, I make two clear and simple adjustments to BIP’s numbers.  One is for IPL, which cannot pay distributions due to excess leverage.  (Some of the investment is debt, which are recorded as distributions.  This cash is included in my estimates.) The second is BUUK, which has a revenue recognition policy that dramatically inflates FFO.  

In the table below, I show BIP’s payout on an as reported and as adjusted for the two items above.  Further below, I detail the financial performance of each company and discuss how and why I made the adjustments.

With just two adjustments, BIP’s conservative payout profile crumbles.  FFO increases to 81% from 66% and the AFFO payout increases to 108% from 82%.  

In 2023, adjusting for the inflationary impact at two investments reduced FFO and AFFO by -19.4% and -24.2%, respectively.  

FFO Adjustments – the Technicalities

The tables below detail how I arrived at the adjustments. IPL’s financial statements show the company made no distributions in 2023.  However, part of Brookfield’s position is structured as interest bearing debt. I assume BIP received its proportion of the cash interest payments.  

BIP management includes customer contributions for construction as revenues at BUUK. As such, it generates ~100% margin FFO despite the fact that it is a CapEx contribution, not free cash that can be used for distributions.  In my view, it is a deeply deceptive and inflationary practice.  I remove the CapEx contributions from FFO.  

I attempted to engage BIP in a discussion regarding BUUK’s revenue recognition practice and its impact on BIP’s financials.  Repeated email queries were unanswered.  

IPL simply cannot afford to upstream BIP’s proportion of FFO.  

In the table below, I show estimates of BIP’s proportion of FFO from IPL compared with the actual payout; and BIP’s accounting calculation of BUUK’s FFO and compared to the real, economic value of FFO.  

My calculations show that BIP recorded ~$314M in FFO from IPL, which would underpin $207M of distributions, but the partnership only received $68M in cash.  In BUUK’s case, 70.3% of FFO is the financial equivalent to vaporware.  I believe these inflationary, financial games of deceptive metrics used to justify an unsupported distribution payout inveigle investors into buying the implied free lunch of safe yield and growth, resulting in a unit price that exceeds any measure of intrinsic value.   

This is, in part, how BIP as an investment fund was transformed into a pyramid scheme.  

5. Company Performance and Valuation: What Management Will Never Tell Investors

In effort to counter management’s “marquee year”  narrative with a dose of reality, I’m providing a short review of BUUK and IPL’s 2023 performance. BUUK and IPL were 36.5% and 13.75 of net assets, respectively, for a total of 45.2% of NAV.  

BUUK Infrastructure: Still Inflating Cash Flows

In my original BIP report, I detailed how BUUK’s cash flow is inflated with a highly unusual revenue recognition method.  BUUK’s P&L has two key revenue lines: distribution, which is pipeline revenue, and connections, which is how the company classifies CapEx contributions made by customers.  In reality, the CapEx contributions are an offset for the costs BUUK incurs in constructing the electricity/gas connections.  

The table below shows revenue for the last 2-years. 

Overall revenue grew by 10%, but zero-margin connections revenue was the larger driver with 17% growth.  I estimated EBITDA and FFO using both as reported or accounting numbers, and adjusted numbers I call economic.  I estimated cost of sales, OpEx and the financial expenses.  

The table below shows valuation and leverage metrics on an accounting and economic basis.  

Connections revenue cannot support distributions; it is a CapEx contribution.  Removing it brings FFO down -70% to $85M from the reported $285M.  The removal of connections revenue drives valuation and leverage to sky-high levels.  The EV/EBITDA goes from a market 13.05x to 28.91x, a valuation that to my knowledge has never been seen in third-party transactions.  Leverage shifts from a very high 8.2x to an extreme 18.21x.  

I said it in my original report and I will say it again:  BUUK is a zero. 

Inter Pipeline (IPL): Years of Underperformance

IPL is BIP’s largest consolidated equity position and the largest consolidated contributor to proportional cash flow from operations, and likely FFO as well.  2023 was another year of disappointing results for IPL.  Heartland, the company’s petrochemical complex, has been more difficult to bring operational than anticipated.  Underperformance at Heartland has led to missed estimates and very high leverage.  

The table below shows rolling historical EBITDA estimates for Heartland vs actuals.

When Brookfield was negotiating the purchase of IPL in 2021, Heartland was scheduled to produce a total of $708M in EBITDA for 2022 and 2023.  As the table shows, the guidance evaporated.  The original 2022 estimate of $283M turned into an actual of ($55.2M).  In 1Q23, IPL withdrew the C$400-450Mguidance for the year, and actual EBITDA was $41.2M.  The combined two-year delta from original guidance was ($722M).  

Total FFO for IPL declined significantly in 2023.  Although the pipeline business is very stable, the company took on a lot of debt both to build Heartland and to help finance the Brookfield purchase.  The company has begun recognizing interest expenses that were capitalized prior to Heartland’s commissioning.  The result is a skyrocketing finance charges causing FFO to collapse in the face of stagnant EBITDA, as shown below. 

IPL’s financial statements indicate that the company did not pay distributions in 2023.  Part of Brookfield’s ownership is structured as interest paying debt.  Total cash interest paid on the related-party debt was C$163.7M.  

I assume that BIP received its proportionate share, which was C$92M.

BIP’s midstream MD&A disclosure technically mentions the issues at IPL, but frames them in a way that implies the overall impact was neutralized.  There is no way investors could know from the disclosure that FFO at BIP’s largest investment declined -23.2% in 2023.  

BIP’s Midstream Disclosure

Source: BIP 2023 20-F. 

In contrast to BIP’s blandly misleading disclosure, Fitch gets to the point directly:

IPL Performance:  Fitch Gives it Straight

Source:  Fitch note August 2023. 

A key point from Fitch: Underperformance will continue for what looks like another two years, at least.  The comment regarding dividends indicates that Brookfield will not be able to extract material dividends from IPL for the foreseeable future unless they are willing to take IPL from investment grade to junk. 

Despite IPL’s inability to upstream material distributions for the foreseeable future, it will remain BIP’s largest contributor to FFO, rendering management’s reported payout ration meaningless.

IPL may be underperforming financially, but the valuation has done well.  In 2023, the total value of the equity as reported by BIP increased 12% year over year to $5.8B from $5.2B.  

Fitch sites Williams as the closest comp.   

It looks like BIP’s DCF valuation modes haven’t been adjusted for the aggregate (C$7022M) in EBITDA misses and the continued underperformance for the next few years going forward. 

6. Management Fees Devour Equity, Financial Engineering Manufactures it

There were a lot of transactions in 2023 that significantly altered the financial statements.  Total consolidated assets increased from $73B to $101B over the year.  Corporate debt increased 34% to $4.9B, and total consolidated debt 52% to $15.6B.  In contrast to the balance sheet, limited partner net asset value moved little, declining modestly.  On an as reported basis, NAV/unit decreased -1.6% in 2023.  However, closer inspection show that the NAV stability was largely the product of financial engineering.

The table below shows the LP net asset value account.  I created line items for estimates of the contribution of key items on the as reported NAV and adjust the numbers to show changes in NAV ex-financial engineering.

LP net assets decreased by a modest ($51M) or -1.6% in 2023 on an as reported basis.  Distributions of over 13% of the beginning equity balance creates a difficult to fill hole on BIP’s equity statement.  The panel on the bottom detailing key contributors to NAV shows the source of net asset stability.  Operations in the form of net income only contributed 1.9% of net assets.  The vast majority of the contributions 10.7% came from discretionary fair value marks and selling shares above NAV.  In this case, it was BIPC’s 3Q23 issuance for an acquisition that was by far the most profitable transaction of the year for limited partners.  

Excluding financial engineering LP net assets decrease -11.65% to $4.7B from $5.4B.  As shown below, the decline is larger on a per unit basis due to the increase in units over the year. 

A key message in 2023 is that non-operational financial adjustments drive unitholder equity.  NAV/unit decreases -8.55% in the year even if we include fair value changes, making it clear  that BIP’s investments cannot support the expense structure.  

The single-most profitable part of BIP’s business model in 2023 was selling/issuing shares above NAV.  In fact, BIP’s entire business model hinges on selling units above NAV.  Without it, NAV/unit would collapse, because net income plus fair value gains cannot reliably generate returns to cover the 22% expense burden. 

APPENDIX

BIIF Private Investment Portfolio

Source: Brookfield Infrastructure Income Fund annual report. 

BIIF Private Investment Portfolio

Source: Brookfield Infrastructure Income Fund annual report.