Infrastructure 'millionaire factories' face a spiral of decline

The funds that bought up British infrastructure - once seen as a guaranteed source of profits - are seeing investors bail out, writes Helen Power

30/08/2008

Aussie-bashing has been the sport of the month since Team GB thrashed their Antipodean rivals with 19 gold medals at the Olympics compared to Australia's 14.

But anti-Aussie sentiment has also been rife in the world of finance after the pioneering infrastructure operators from down under, Macquarie and Babcock & Brown, announced a series of catastrophic financial results this summer.

Once the darlings of the stock market - Macquarie was known as 'the millionaires factory' - the pair have come crashing down since the credit crunch took hold.

Macquarie has seen 38 per cent wiped off its share price this year and Babcock an incredible 92 per cent as investors have fallen out of love not only with their business models, but also with infrastructure assets in general.

Yet research group Private Equity Intelligence says investors continue to plough money into the asset class with 2008 set to be a record year for fundraisings. So can the infrastructure fund really be dead?

The classic listed fund model was pioneered by Macquarie - whose European fund owns National Grid Wireless in the UK - and is often referred to as the Macquarie model. As with Babcock, the Macquarie parent company sits at the centre and charges asset management fees to its separately listed funds as a private equity house would charge fees to investors.

Nice work if you can get it in a booming global economy when asset prices are going only one way and there are plenty of fee-generating deals to do. Since the credit crunch, however, the cost of debt has risen exponentially - in turn increasing costs for the listed funds - and the dealflow has dried up. In combination this wiped out the parent company's profits.

The funds, which are both now moving to deleverage, have also been criticised for taking on far too much debt.

"What a significant number of the Australian funds have been doing is to borrow at the listed fund level on the basis of future dealflows - its leverage on leverage," said a banker at a rival UK infrastructure fund.

Babcock, which has a UK-listed fund and a range of property in PFI assets in Britain, has undertaken a strategic review of the future of its business and has hired Deutsche Bank and Goldman Sachs to advise it. Last week the fund said it was going to cut headcount by 25 per cent and close its private equity arm to concentrate solely on its infrastructure assets.

The move is part of a bid to make substantial reductions in its cost base, but Babcock is also expected to sell assets - particularly in Australia where Babcock & Brown Power is very heavily indebted - to pay off its debts. The Babcock parent company has A$9.6bn (£4.5bn) of debt, with billions more at listed fund level.

A spokesperson for Babcock said: "The changes made to the business, particularly our focus on being an alternative investment originator and asset manager in infrastructure, will allow Babcock & Brown to operate in the current market environment, to build on its leading position in its key markets and position itself for ongoing earnings growth in future years."

Analysts believe Macquarie is in far better shape than its rival, but there is no doubt it has been hit by investor nervousness. Some of its publicly listed funds have stopped doing deals, with one dedicated to airports conceding last week that it won't participate in some of the investment opportunities it has been offered.

Macquarie Airports is also selling stakes in its European assets, including Brussels and Copenhagen airports, worth A$1.5bn to fund a A$1bn share buyback.

However, the Australian fund remains bullish and some of the indidivual listed funds have been buying back their own shares because they consider them undervalued.

The company has said it will consider asset sales on a case by case basis where they create value for investors, but also points to A$22bn spent on new investments this year as proof investors still think the funds are a good bet.

There have been a number of high-profile collapses of infrastructure assets in Australia and others, such as the Sydney orbital road, continue to be loss-making. But Emma Ormond of Oriel Securities who advises infrastructure funds believes the picture is skewed because Australian assets are a special case.

"The Australian market is pretty unique and there will be some distressed deals there," she said. "There may well be contractors who need to generate investment profits at times when underlying trading performance is less solid and therefore who need to sell things in order to do so."

But she argued that the success of infrastructure funds in the past decade has been about more than just cheap debt.

"All of the infrastructure funds have made returns from a combination of financial engineering - which might include refinancing - but also from portfolio management and the scale benefits that delivers," she said.

Sources close to Babcock argue that the financial model of long-term stable cash flows which are particularly attractive to pensions will have its time again, particularly as most infrastructure assets have been bought using money borrowed over a very long period so won't be forced to re-finance in the middle of a credit crunch.

One said: "There's a real difference between the specialists like B&B and private equity firms who dabble in infrastructure - we can add much more value."

Another source added: "If you look at infrastructure funds that hold assets for a very long time and have cashflows for say a 25-year period, they generally don't need to be refinanced for 24 years so the economic situation is not going to make a great deal of difference to the business."

And Ormond believes the money is also still there for the really good deals.

"Bank facilities are being secured even in the middle of the credit crunch. You may have to pay an extra 30 basis points more for the money, but that is not a prohibition to new projects getting signed," she said.

Some in the industry also argue that it is really about the type of infrastructure funds invest in rather than levels of debt, with PPP and PFI assets the current favourite for those investing in the UK.

"If you look at our fund we are very focused on European PPP and PFI with a tried and tested rental stream. That is very different from people who are doing greenfield toll roads where they are taking a risk on traffic," said one banker.

"There's a real difference between social infrastructure where there is a solid rental stream and economic infrastructure such as airports and toll roads. Economic infrastructure has significant growth potential, but it is also where there is a refinancing risk at the moment," he explained.

In the UK, infrastructure funds are now mainly targeting PFI and PPP assets, rather than economic infrastructure.

"If you look at a country like the UK, not a lot of money has been spent on infrastructure, meaning considerable finance is required. If the government can't pay for things itself, you either sell the assets to the private sector or do a public private partnership," said a source close to Babcock.

However, some PFI experts warn the days when PFI and PPP were a licence to print money are coming to an end because of a change in the political climate.

One said: "The question is will PFI survive. Aside from the more general question of what the Left will try to do under Brown as the Government begins to move to the end of its term you've got the major factor that the Treasury has promised - under international pressure - to bring PFI spending back onto the balance sheet.

"Once you bring PFI back onto the balance sheet, it is far less attractive for the Government to do these deals."

Ormond, however believes there is plenty of mileage in PFI.

"On the primary side, we believe that the British Government remains fully committed to PPP. Bringing it onto the balance sheet won't really make a big difference - many projects already are - they will carry on with investment programmes through political necessity," she said.

The PFI expert, however, warned that a likely change in government from Labour to the Conservatives - who would ordinarily be expected to be more business friendly - might actually spell trouble for funds expecting to invest in new UK PFI projects.

"Its unclear where the Tories stand on PFI, particularly Andrew Lansley the shadow health minister. So bad has this programme been, so ridiculous some of the projects and so great some of the cost overruns and so outrageously has the public been ripped off, that the Tories might actually think about changing it," he said.

Ormond, however, disagreed. "The mood music in the UK is that there is very much a political consensus about PPP and PFI and although things have been tougher, there is a view that once we get through the summer the pace of dealflow will increase again," she said. Either way, funds like Babcock, HSBC's infrastructure arm and 3i's fund will be watching the next election with interest.

Richard Stus from Private Equity Intelligence believes the real divide is between the listed funds - like those run by Macquarie and Babcock - and unlisted funds which operate a fund-raising model more akin to private equity.

"Plenty of the big pension funds are still investing in infrastructure - Calpers for instance recently allocated 3 per cent of its fund to infrastructure and that's 3 per cent of $238bn," Stus said.

"The unlisted funds market - considering the economic climate - is performing well. From our research, the assets look like they will hold their value."

Sources close to Babcock argue that the company is an unfortunate victim of a temporary blip in public confidence.

"What we are seeing is a sentiment problem affecting the listed funds. If you look at unlisted funds there is still significant appetite," said one source.

"Babcock is in the process of de-leveraging already. The slump in the share price is related to people's confidence. This is a credit crunch-related issue and people are worried about levels of debt.

"But what's really scared people is the plummeting value of CDOs and so on, but the value of these assets doesn't change overnight."

If it's all just about investor sentiment, perhaps the answer is for Macquarie and Babcock not just to buy back the shares, but to take the entire funds off the market.