July 2010

Discussion Paper: Infrastructure Value

Page 2This document is not advice. No responsibility will be accepted by Value Adviser Associates for any loss or damage suffered arising from the use of this discussion paper. © Value Adviser Associates Pty Ltd 2010

Unlisted infrastructure post-GFC

Capital markets continue to exhibit significant volatility and mis-pricing. This discussion paper presents our thoughts

and provocations on the long-term value of investing in unlisted infrastructure.

This discussion paper is structured as follows (click on topic to jump straight to page):

2. Summary of our view (1)

3. Summary of our view (2)

4. What is fair value?

5. What drives value?

6. Capital market dislocation continues

7. Infrastructure and portfolio construction (1)

8. Infrastructure and portfolio construction (2)

9. Unlisted v listed infrastructure

10. Domestic v international infrastructure

11. Management of unlisted infrastructure

Page 3This document is not advice. No responsibility will be accepted by Value Adviser Associates for any loss or damage suffered arising from the use of this discussion paper. © Value Adviser Associates Pty Ltd 2010

Summary of our view

• For most investors, perceived long-term value is dependant on properly understanding four key attributes of every asset – equity beta, asset beta, gearing and expected cash flows. Our view is that few investors have understood the desired beta and gearing attributes of unlisted infrastructure investing as a part of their portfolio allocation and construction decisions. Significant education is required in this area.

• Value creating opportunities exist for investors and managers who can do the following better than existing managers:

– Create service and governance models which address the relatively high-cost nature of direct investing. There is evidence that ‘good governance’ reduces the deadweight losses of agency costs

– Identify listed infrastructure opportunities for addition to the infrastructure portfolio because of current low prices

– Properly articulate the risk and return profile of individual assets and the impact on the overall portfolio

– Reduce cost of capital and cashflow risks arising from debt stress by careful funding such as spreading roll-over across time, attempting to lock up funding for as close to asset life as possible

– Price and measure the risks and returns of international exposures

• Fair value can be defined a number of ways, and each will have its basis and merit. There may be short term departures or mispricing caused by fundamentals or changing risk factors. Transaction prices do not automatically determine fair value which in a dislocated market depends on the facts and circumstances and may require the use of significant judgment

• There are two high-level factors that drive value; cashflows and cost of capital. Prices move for a number of reasons; change in economic conditions, mispricing and the way a company is managed

Continued

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Page 4This document is not advice. No responsibility will be accepted by Value Adviser Associates for any loss or damage suffered arising from the use of this discussion paper. © Value Adviser Associates Pty Ltd 2010

Summary of our view

• The equities market continues to present volatility which is significantly higher than the long-term average. This translates to a higher short-term MRP (this is a systematic issue and not specific to infrastructure)

• Debt markets have not reverted to the 120 - 125bps BBB spread evidenced over the long-term, remaining around 300 - 400bps above swap. Unlisted infrastructure is frequently more highly-geared than listed equivalents which is not well understood by the investor community

• Listed

– Many infrastructure assets have been listed or acquired by listed infrastructure investors during a rising market (which attracted retail investor funds), but in a static or declining market these funds rarely remains attracted to the sector. The combination of renewed debt stress and the weight of retail investor funds consequently presents privatisation opportunities in the listed infrastructure sector at prices which appear to be lower than ‘fair value’

• Unlisted

– Within the unlisted infrastructure sector, social infrastructure presented significant value opportunities through the GFC and, if new PPP’s are announced, may present short-term value creation opportunities (due largely to debt access constraints). Other unlisted infrastructure sectors remain fairly priced (subject to the quality of cashflow forecasting and valuation processes – particularly with respect to short-term MRP)

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Page 5This document is not advice. No responsibility will be accepted by Value Adviser Associates for any loss or damage suffered arising from the use of this discussion paper. © Value Adviser Associates Pty Ltd 2010

What is fair value?

• Is there some underlying value that the market price moves away from now and again? If so, what is fair value?

– Are there short term aberrations or departures (or is this mispricing), and if so, what causes them?

– Are the causes a departure from the fundamentals or are they due to higher and lower risk factors?

• It is not appropriate to automatically conclude that a transaction price is determinative of fair value. Determining fair value in a dislocated market depends on the facts and circumstances and may require the use of significant judgment about whether individual transactions are forced liquidations or distressed sales.

• The accounting standards proffer a number of plausible definitions of fair value. They discuss a range of information and valuation techniques that a company might use to estimate fair value when relevant observable inputs are not available (e.g. the use of a company’s own assumptions about future cash flows and appropriately risk-adjusted discount rates is acceptable when relevant observable inputs are not available). In some cases a company may determine that observable inputs require significant adjustment based on unobservable data (e.g. where the volume and level of trading activity in the asset have declined significantly, the available prices vary significantly over time or among market participants, or the prices are not current)

• In the circumstances of a deep, liquid market, observable transaction prices are objective and unavoidably persuasive of fair value. However, when markets are in states of irrational excitement or gloom, market prices can depart substantially from any reasonable assessment of future economic value. It would seem too easy to argue for the adoption of one high or low priced trade in a thin market to justify inflated or deflated asset values.

• Further, from a legal perspective, courts have held that whether a price offered for an asset is fair depends on a variety of factors, including: assets, market value, earnings, dividends, the nature of the company and its future prospects and any other elements that affect its intrinsic or inherent value

• So, determining fair value involves a valuer considering the circumstances of the particular case and, where those circumstances reveal one or more factors which may affect the fairness of a valuation arising from a particular valuation method, determining whether that method should be modified or abandoned in favour of another method (or combination of methods) which is more likely to result in a fair valuation

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Page 6This document is not advice. No responsibility will be accepted by Value Adviser Associates for any loss or damage suffered arising from the use of this discussion paper. © Value Adviser Associates Pty Ltd 2010

What drives value?

• The underlying economic view of value is a DCF-based notion. There are high-level factors that drive value:– Cashflows (timing and quantum including the likelihood of incurring costs of distress)– Cost of Capital

• It is unlikely that all investors will share a common view about the distribution of possible cash flows (even if they share a common view about cost of capital). Differences between price and value could arise due to a lack of convergence on views as to one or both of these variables, but this implies there is a ‘true’ underlying value. We are not sure that this is the case ex ante

• Inevitably, markets (and transactions) will highlight the divergence of views as to management’s ability to deliver on stated outcomes. There is also frequent divergence in views as to mid- to long-term forecasts of cashflow outcomes in the listed arena as it is rare for listed companies to present mid- or long-term outlooks to the market due to disclosure liability issues

• Prices are observed to change over time. Prices move for a number of reasons:– Change in economic conditions at both the macro and sector levels– Mispricing– Fundamental way a company is managed

• ‘Market value’ will change over time for all sorts of reasons related to revised forecasts of performance, risk and attitudes to risk, for example, changes in consumer demand, probability of incurring distress costs or greater availability of information. Thus:– Creating value from acquisitions is about factors such as buying in distressed conditions and better

information sources and cash flow forecasts than the seller– Creating value from managing is about issues such as better governance including incentives– Creating value from better information flow to the market is about ensuring market has information about the

business, key drivers etc– Creating value from disposal is about the reverse of creating value from acquisition

• Consequently ‘long term fair” value, like beauty, lies in the eye (or forecasts) of the beholder

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Page 7This document is not advice. No responsibility will be accepted by Value Adviser Associates for any loss or damage suffered arising from the use of this discussion paper. © Value Adviser Associates Pty Ltd 2010

Capital market dislocation continues

• Market price can differ from long term fair value

• Listed equity market volatility peaked at 40% in early 2009, reverted to longer-term trend levels in late 2009 / early 2010 and then spiked in March-May 2010 during the correction (see chart opposite - top)

• Debt costs have followed a similar trend and today are around 300 - 400bps over swap for BBB instruments (see chart opposite - bottom)

• During the GFC, fund liquidity, unexpected forex contract close-outs and the denominator effect caused investors to rapidly liquidate listed assets in order to satisfy short-term cashflow needs and portfolio rebalancing

• Funds Under Management [“FUM”] inflows to alternative assets (PE, hedge funds, direct property and infrastructure) fell dramatically

• However, with the rise in equities markets over the last twelve months, FUM is again available for investment in alternative assets

Implied Volatility of 12-month Options on ASX200 Index

0%

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45%

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Implied Volatility

Pre Crash Average

Australian 7-year Corporate Bonds Spreads over 10-year Government Bonds

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2001 2002 2003 2004 2005 2006 2007 2008 2009 2010

Deb

t Sp

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AAA

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Page 8This document is not advice. No responsibility will be accepted by Value Adviser Associates for any loss or damage suffered arising from the use of this discussion paper. © Value Adviser Associates Pty Ltd 2010

Infrastructure and portfolio construction

• The word “infrastructure” is widely used but here it encapsulates the range of essential facilities and services that are fundamental to every economy. Economic infrastructure includes the facilities that provide transport, energy, water and communications. Social infrastructure encompasses the provision of justice, health, housing, defence and education services

• There is a wide range of views in the appropriate allocation to alternatives. Some funds have, over the last several years, had an allocation of 40% to alternatives or private market assets. During the capital market dislocation, the private market assets increased to as much as 65% of some portfolios

• Unlisted infrastructure has typically been allocated 5-10% of FUM

• It appears from our work that little thought is given to the total infrastructure exposure (i.e. both listed and unlisted), with some funds investing on an index-weighting basis in listed infrastructure and then separately in unlisted infrastructure. Curiously, there is only one other sector which gets this treatment (i.e. property), where investors will invest in REITs and direct unlisted property (PE can be debated as it covers many sectors of the listed market)

• Some smaller funds have invested in unlisted infrastructure with limited consideration of diversification issues. Listed investments may be limited to a 50bps exposure but individual unlisted investments can sometimes represent 2 or 3% of total FUM

• We observe smaller funds investing in low asset beta but high equity beta structures in an effort to gain exposure to returns that are higher than the overall equities market. It has been suggested that some of these investments have been structured to enable a “2 and 20” management fee

• Many unlisted infrastructure investments present equity beta materially in excess of the market as a whole, notwithstanding that few infrastructure sectors approach the market beta of 1. That is, asset betas typically lie in the range of 0.2 to 1.0, but high levels of debt can push the corresponding equity betas above 1.0

Continued

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Page 9This document is not advice. No responsibility will be accepted by Value Adviser Associates for any loss or damage suffered arising from the use of this discussion paper. © Value Adviser Associates Pty Ltd 2010

Infrastructure and portfolio construction

• In some quarters there is limited understanding of the covariance and volatility of infrastructure and its impact on overall portfolio construction. The chart below highlights the wide spread of asset and equity beta of infrastructure. (Note that the typical gearing of unlisted infrastructure is higher than listed equivalents)

Beta_Equity vs Beta_Asset for Various Investments and Asset Classes

PPP

Regulated Utility

Tollroad

Port

Timberland

90% 80% 70% 60% 50% 40% 30%20%

10%

0%

MARKETAirport

0.20

0.40

0.60

0.80

1.00

1.20

0.20 0.30 0.40 0.50 0.60 0.70 0.80 0.90 1.00Beta_Asset

Beta_Equity

← G

earin

g le

vel (D

/V)

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Page 10This document is not advice. No responsibility will be accepted by Value Adviser Associates for any loss or damage suffered arising from the use of this discussion paper. © Value Adviser Associates Pty Ltd 2010

Unlisted v listed infrastructure

• Every observed price – whether in a listed or unlisted market – reflects the unique view of the purchaser and vendor as to the future cashflows and returns from the asset. An agreement between buyer and seller to transact does not necessarily mean they agree on value

• The buyer will probably think the asset is undervalued or they can add value that the seller cannot, and the seller may think the asset is overvalued (which is why they transact)

• These prices are also influenced by any vendor anxiety to sell quickly (and sometimes, the anxiety of the purchaser to buy quickly in a rapidly rising market)

• Some infrastructure sectors are not available in the listed market (e.g. social infrastructure, airports, ports)

• Similarly, there are some infrastructure sectors which can only be effectively accessed via the listed market (e.g. telecommunications [submarine cables, satellites, cell towers etc are typically held by the large telco’s or remain in government ownership])

• Some investors believe that the mark-to-market process for unlisted assets presents lower volatility in choppy markets. This may be fallacious and rely on valuers not being aware of the MRP impact on cost of capital of high market volatility:

– During the GFC, the short-term MRP peaked at 16% (domestic) and 12% (international). The long-term effect of this was to increase the MRP to 8% and 7% respectively

– On low-beta assets this causes a significant shift in value (absent any compensating change in cashflow outlook)

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Page 11This document is not advice. No responsibility will be accepted by Value Adviser Associates for any loss or damage suffered arising from the use of this discussion paper. © Value Adviser Associates Pty Ltd 2010

Domestic v international infrastructure

• There is some evidence that Australian investors have pursued absolute return outcomes by moving into international markets. This presents a number of risks which are not present in the domestic market: forex, country risk, lack of knowledge of in-country regulatory, political and capital market operational risks. Rarely are these factored into the investment decision, valuation or management resourcing

• There is a valid opportunity to acquire mispriced infrastructure in markets which have lower understanding of the risk/return and cash flow implications of the sector (e.g. USA). However, this brings with it the increased risk of regulatory model changes, lack of liquidity and the resourcing requirements of foreign investment ownership

• On the flipside and at the valuation level for example, few investors have considered the possible benefits of a diversified international portfolio in the context of MSCI-based betas and / or MRP being marginally lower than the domestic market in which pensions and superannuation payments are made

• If the risk issues are appropriately addressed, priced and measured, international investment may present considerable value opportunities

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Page 12This document is not advice. No responsibility will be accepted by Value Adviser Associates for any loss or damage suffered arising from the use of this discussion paper. © Value Adviser Associates Pty Ltd 2010

Management of unlisted infrastructure

• Unlisted infrastructure is seen as “expensive” due to perceived high management fees and governance structures

• Many funds with FUM in the range of $1-5bn have directly invested in unlisted infrastructure with no internal capability to manage these investments. This has been the appeal and province of the specialist sector manager. However, as some of these funds have grown in size, specialist management has been internalised (e.g. Australian Super, QSuper) and mandated specialist sector managers have been terminated

• The decision to insource is often driven by MER. However, as the pendulum swings from outsourcing to insourcing there is an uncomfortable risky period for the fund as the MER savings are accompanied by a lack of breadth and depth of experience in the internal team

• One of the outcomes of the GFC and the subsequent APRA and Cooper Review focus on superannuation investing is the fresh thinking being applied to the roles of investors and managers

• A fresh approach is required for those mid-size funds who are concerned with the level of management fees. We believe there is significant scope for co-sourcing. The benefits are clear for both parties – savings for the fund and client retention for the manager

• We also see an opportunity to combine listed and unlisted infrastructure within pooled vehicles. This would involve educating the market place to remove the somewhat inappropriate “listed -v-unlisted” distinction and for the manager to demonstrate that listed infrastructure investing may deserve more than the 25-50bps management fee of the typical listed equities manager

• Post-tax performance measurement is increasingly important for investors. This is an area where unlisted managers have been ahead of the game. Demonstrating to asset consultants and investors an ability to measure performance on a post-fees, post-tax basis and compare to listed equivalents will be increasingly important

• Value-creating opportunities exist for both investor and manager if these issues are appropriately addressed

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