Description

Summary: trading at a c20% discount to reported NAV, HICL offers an implied c9% IRR in real terms with strong inflation linkage. This is a decent return with upside potential via closing the NAV discount. Such infra investment trusts had a natural shareholder base of UK retail investors who think in terms of absolute post-tax dividend yield. Retail has been reallocating to bonds, creating selling pressure. The sector is now trading below private market values. Infra private equity is a large and growing pool of capital which thinks in terms of “inflation plus” hurdles and 7-10 year mandates. The managers and boards of trusts are increasingly incentivized to close the NAV discounts via buybacks/asset sales. Without this, they cannot grow. And if they don’t, infra PE will take them private. Plenty of precedents exist illustrating the spread between public and private valuations for UK listed infra. As interest rates stabilize, I expect the current NAV discount situation to resolve itself on a 2 year view.

I am pitching the most attractive and one of the most liquid UK infra trusts. However, smaller funds/individuals could also purchase a basket of such trusts, to increase the chance of owning a take-private candidate.

The UK has a long history of investment trusts, the FTSE100 constituent Foreign & Colonial was launched in 1868. Perhaps the most internationally recognized trusts today are bull market darling Scottish Mortgage (currently managed by Baillie Gifford) or Ackman’s perennially discounted Pershing Square Holdings, which invest in large public equities. However the permanent capital structure of trusts is also suited to illiquid assets. Today there are c400 listed trusts in the UK, covering a host of asset classes from VC, real estate, private credit to music royalties. Historically the sector has moved in boom-bust waves. Bull markets see new trust launches and equity issuance. Bear markets see buybacks, liquidations and take-privates. Today the sector is trading at the wider end of its historical discount range. Stripping out trusts invested in liquid equities (which usually trade on a small discount to reflect the management fee), trusts invested in alternative assets are trading at a wide discount to reported NAVs (slightly dated chart below). The infra trusts specifically are trading at a c20% discount. The market is saying it does not believe the carrying NAVs calculated by the managers of these trusts (akin to Private Equity “marking its own homework”).

HICL – as a simple example

The last two decades of low interest rates saw a flurry of trusts issued to invest in private infrastructure assets. One of the first and largest of such trusts is HICL, managed by the infra PE house InfraRed Capital (itself spun out of HSBC back in the day). HICL was originally launched to invest in UK PPP assets. Today they own a globally diversified portfolio of c100 core infra assets. They have been successful over time at reinvesting a portion of cashflows to grow and extend the portfolio in real terms. See appendix for excerpts from latest HICL portfolio overview presentation.

https://www.hicl.com/wp-content/uploads/2023/05/HICL-2023-Annual-Results-Presentation.pdf

Given the nature of investment trusts, HICL must publish a regular NAV. This requires them to assume a discount rate. Since 2006 IPO they have used between 7-9%. As at 31-Mar-2023, the latest NAV was 164.9p. This was calculated using a 7.2% nominal discount rate. They also assume a long-term inflation of 2%.  Inflation linkage for the portfolio is c0.8x, so a 1% increase in the LT inflation assumption would increase the NAV c0.8%.  So the implied real discount rate used is c5.6%.

Of course as fundamental investors we do not really care what discount rate management assumes. Every investor will have his own hurdle rate and the market provides us a quote every day. The shares currently trade at c132p for a c20% discount to latest NAV. We can use their sensitivity table (see appendix) to calculate that the market implied discount rate at 132p share is c10.6% nominal (164.9 – 132 = 32.9 / 9.6 = 3.4% + 7.2% = 10.6%) and c9% real.

I personally find 9% real an attractive rate for core infra with 0.8x largely contracted inflation linkage. We are not in deep value territory but this is likely a LDD nominal return with low risk and inflation protection.

Dividend target for YE Mar-24 is 8.25p for 6.3% yield.

HICL raised some equity in July-22 back when they were trading at NAV. This year they have disposed of a small asset at a modest NAV premium, and issued some PP debt. This covers their remaining investment commitments. Post the transactions the portfolio will have roughly 10% gearing. They released a trading statement 1-Aug in which they stated, [bracketed comments mine] “the prospect of higher UK interest rates has continued to weigh on the Company's share price, which has consistently traded at a discount to NAV over the period. In the Board's view, the Company's current share rating does not fully reflect the positive impact of higher than assumed inflation on HICL's cashflows... The Investment Manager continues to observe a material disconnect between public and private markets in the valuations applied to inflation-correlated core infrastructure assets.  Transaction data points in private markets, albeit in lower volumes, support the view that valuations are generally remaining stable [i.e. at NAV] as inflation correlation provides a hedge against higher discount rates. This is further validated by the valuations seen across the Company's NWP sale, a recent UK PPP sale by a separate InfraRed-managed fund, and HICL's live disposal activity. [i.e. they are in active discussions]”

In my opinion these guys are one of the best operators in the space, and have a track record since 2006. I would expect they will sort out their discount at some point. 9% real is too high for core infra. The HICL board and management have been buying shares PA in the market.

Infra trusts as an asset class are on a discount

Note the “core” infra trusts like HICL have relatively stable cashflows in real terms. The “core plus” assets typically including some uncertainty on volume and margin. And the renewable energy assets include (typically partially hedged) energy price risk.

Most of the infra investment trusts were launched in the last two decades. They raised money from UK retail investors often placed with HNWs via discretionary wealth managers (Rathbones, St James Place etc) or with mass-market via the DIY platforms (Hargreaves Lansdowne etc). See table below for the largest owners of the UK trust sector as a whole (includes public equity trusts which have well documented headwinds of their own, driven by consolidation amongst wealth managers).

The infra trusts were primarily marketed on their 3-5% dividend yields which were attractive in a low rate environment. The popularization of such trusts, growing demand, and falling interest rates meant they rarely traded at discounts to NAVs. This enabled them to regularly raise more equity and buy more assets.

Retail investors can now earn absolute yields on gilts, in a tax advantaged format (no capital gains tax on gilts purchased below par). Few professional funds invest in the infra fund space as it involves stacking management fees, and many of the trusts are small and illiquid. I believe this has created an excess supply which has contributed to the current NAV discount/implied yield across the sector.  These names have become highly correlated with UK interest rate expectations over the last year or so. Whilst infra/utilities always have some correlation with bonds, it is important to remember how inflation linkage feeds into the return algo.

HICL passes through inflation at 0.8x. Given the assets contain some volume growth through time, this inflation linkage is not immediately reflected in the Year 1 dividend yield. So if all you care about is current yield (post personal income tax), it could superficially make sense to swap to gilts. But the higher inflation rebases the escalators higher, creating permanent NAV growth (+£690m expected cash inflows over the life of the assets since Sep-21). The UK infra trust sector has substantially underperformed general EU infra equities this year. Whilst these are not perfect comps, I believe this is partly caused by the different shareholder base of the trusts (vs mainstream equities).

Today the sector is trading at a c20% discount to NAV and therefore cannot raise fresh equity. For the last c18 months the managers have been advising shareholders to be patient. I believe that the longer the discount situation persists, the more pressure will be brought to bear for managements/Boards to “fix” the discount. There can also be a prisoners dilemma dynamic for smaller players – if one guy can get back to NAV, any lagging peers start to look like potentially accretive M&A targets.

We have started to see mergers and continuation votes triggered in the wider UK trust sector. For example Abrdn has merged several of its subscale equity trusts this year. https://moneyweek.com/Investments/trusts/investment-funds/abrdn-puts-its-house-in-order

In the renewables space we have also started to see activity. Some of the trusts have started repurchasing shares. The small (and therefore vulnerable) player AERS has launched several initiatives including buybacks, voluntary continuation votes and the management company has elected to receive fees in shares. Large player TRIG announced last week a disposal of 3 small assets at a price 26% above their carrying NAV. TRIG trades on an 18% discount (so implies a price 54% above where the shares currently trade). This is the first major disposal I have seen in the space. Let’s see whether it encourages others to follow. It is possible the space could snap back relatively quickly, if we start to see a few transactions validating NAVs.

To be clear I think a full take private of HICL is unlikely. But the entire sector trades somewhat in lockstep. HICL could either dispose of a few more assets to validate NAV. Or a small peer could receive an offer. This could collapse discounts across the sector. A 9% real entry IRR starts to look pretty healthy if HICL received the NAV credit for 0.8x inflation correlation within 2yrs:

Infra private equity is one of the fastest growing private asset classes with billions to deploy. There has been a steady bid for UK listed asset-backed companies in the last few years. It is widely accepted there is a spread between private and public valuations for infra.

If you speak to sector contacts they will tell you that private market values for core infra are well above 9% real IRR. Renewables are still changing hands at 6-7% nominal, albeit transaction volumes are depressed.

There are only two remaining listed core infra trusts – HICL and INPP. There were previously two others. JLIF was acquired in 2019 by an infra consortium for c2bn at a 20% premium to NAV. JL was acquired in 2021 by KKR Infra at a 35% premium to NAV.

A non-exhaustive list of UK/EU infra take privates in the last few years: JL, JLIF, ASPI, ASTM, Augean, Applegreen, John Menzies, Albioma, Dignity, Biffa, Viridor, Suez UK, Energy Assets plc, Calisen.

All the trusts use slightly different assumptions. I have calced a rough normalized comps table below (directional but not exact). The scope for managerial discretion is far higher for the renewables trusts as they make a power price assumption for the unhedged portion.

Can discuss the other names in the Q&A. UKW have excellent assets but the mgmt. team already cashed out the GP to Schroders which could complicate a transaction. TRIG is the renewables sister to HICL. INPP is decent but more expensive than HICL. GSEO are cowboys but have a pipeline of assets under construction so scope for dividend growth. AERS are shareholder friendly but small. JLEN/FSFL/NESF/BSIF are all decent for a basket. GCP includes some debt investments, and is currently considering a merger with two other vehicles.  

Overview of HICL

Catalyst

Asset disposals to validate NAV

Buybacks

Peer takeout

Sector rerating