Look to PFI for income, not growth

The final quarter of 2017 proved to be an interesting period for the listed social infrastructure sector. Last October, comments from Shadow Chancellor John McDonnell regarding PFI (Private Finance Initiative) infrastructure projects and the prospect of a future Labour government taking these back ‘in-house’, caused a short but sharp sell-off as markets digested this prospect.

The last weeks of 2017 saw a rally following a period of weakness and closed a broadly positive 2017, with solid gains enjoyed across the sector despite an increase in volatility. However as we enter 2018 the dual impact from the Carillion liquidation and publication of a National Audit Office (NAO) report on the use and impact of PFI threatens to dampen further gains.

The announcement of the Carillion liquidation created a few market jitters initially, as a number of companies engaged Carillion for the provision of facilities management services on various infrastructure projects. Companies have enacted contingency plans to ensure continuity of service and appoint replacement operators. Whilst we anticipate little operational disruption as a consequence and payments should continue to be received by project companies, the ability of project companies to distribute income may be inhibited due to a technical loan default being triggered on loan agreements within certain affected projects.

Although resulting in reduced dividend cover in the short term, this should be a temporary effect. Cash accumulated until replacement operators are in place should be able to be distributed once this is resolved. Ongoing uncertainty will likely draw some of the bubbling disquiet on the sector from certain political circles back to the surface and grab column inches over the coming weeks.

The NAO report itself does not highlight anything particularly revelatory, although coming on the back of the Carillion news will deliver a further negative shock to investor sentiment. It notes the well-known pros and cons of PFI investment, the principal pitfall being that PFI may not offer taxpayers the best value for money and that benefits attributed to private efficiency are overdone or indeed non-existent.

The benefit of risk transfer from the public to private sector should not be underestimated, particularly construction risk and cost control, something which the government has historically struggled with. Quantifying this risk poses a challenge and therefore one should not be too hasty in writing PFI off as folly in its entirety, although with hindsight the PFI approach clearly has imperfections. The majority of PFI deals were struck in a higher interest rate world, and the combination of lower rates and declining corporation tax means these deals appear particularly expensive to the taxpayer when set against today’s financial landscape. Therefore, certain recent criticisms may not be entirely fair.
 
Our view in light of the recent volatility - that price weakness should be considered a buying opportunity - is largely unchanged; indeed, we now find prices back at levels last seen in October 2017. However, persistent negative press will create headwinds for near term growth and it is unlikely that we will see significant premiums return to the sector whilst political risk lingers in the background.

Investors should be allocating to the sector for the attractive dividends on offer (4.5% - 6%) and not be expecting significant growth beyond this. A continuation of the double digit returns enjoyed over recent years is unlikely. It should be highlighted that the sector is not a pure play on PFI infrastructure. Companies have significantly diversified themselves away from this exposure in recent years into regulated utilities and economic infrastructure projects. We still feel the sector offers value and we retain positions within our alternative allocations.
 
Looking ahead to 2018, it feels increasingly likely that we can expect a long awaited wobble in equity markets. High valuations and seemingly unquenchable bullish thirst make equity markets particularly vulnerable to an external shock. Our central thesis would not be that bond yields will rise aggressively, particularly in the UK, but this cannot be ruled out entirely. Set against this market backdrop an allocation to alternative assets remains a sensible way to diversify  portfolios. Within this we believe that infrastructure still has a part to play and can deliver positive returns whilst providing welcome diversification.

Mark McKenzie
Head of Alternatives Research and Senior Portfolio Manager

 

Article first appeared in:

What Investment (in print on the 1st March 2018)

 

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Thomas Miller Investment is the trading name of the businesses in the Thomas Miller Investment Group. This note has been issued by Thomas Miller Investment Limited which is authorised and regulated by the Financial Conduct Authority.