3iN and HICL - is infrastructure investing worth a look?

Infrastructure is rather a sexy word at the moment. The banks are bust, the economy looks precarious, bonds are yielding almost nothing; where can you get a return? Infrastructure seems to be the right place. High quality income streams, high yields, little exposure to economic contraction - all the right things to help investors weather a recession.

Actually investing in infrastructure, though, hasn't always been as easy as it looked. Buying construction companies is one way in, but they only make money at the start of the contract - whereas what investors are really after is the long term cash cow. In France , for instance, toll motorways were part funded by the stock market; in the UK, BAA provided investors with a chance to buy into the cash flow of the main London and Scottish airports, till the company was taken over.

The Private Finance Initiative (PFI) and other PPP (Public-Private Partnership) schemes have created fascinating vehicles for the private sector to invest in infrastructure. They have great long term cash flow, but they're tricky to get into as a secondary investor. The limited liquidity and often high gearing of the underlying investments, together with their long-term nature, makes many of them unsuitable for the stock market.

However,  there are a number of funds that give investors exposure to the infrastructure sector. I've looked at two - the 3i Infrastructure Fund (£3iN ) and the HSBC Infrastructure Company Ltd ( Hsbc Infrastructure ). They may sound similar, and they are both offshore companies (hey! You don't pay stamp duty on them!) - 3iN is Jersey based, HICL is Guernsey registered - but they're actually quite distinctive in their investment policies and portfolios.

3iN was spun off from 3i, the venture capital fund manager, and 3i still advises it on its investments. It seems to have a rather patchy portfolio - an investment in Anglian Water, an investment in I2 (a fund investing in the PFI secondary market), an investment in 3i's India Infrastructure Fund, 10% of Novera, and a bunch of other assets including the Norfolk & Norwich Hospital, and a German waste to energy plant.

The major risk to this fund is any breakdown in the relationship with 3i. Currently, it has a right of first refusal over 3i investment ideas in Europe and North America, but this expires in 2012. It can also be required to transfer the Alpha Schools and Anglian Water investments back to 3i if the partnership is dissolved. I also note that it does not have control over the investment funds in which it has stakes, so shareholders are taking a risk not just on 3iN management, but on the management of the funds it's invested in.

On the other hand there are fairly strict rules about the constitution of the portfolio. 3iN's not allowed to invest more than 15% of its capital (at the time of the investment) in listed companies or investment trusts, so its gearing to the stock market is not high. It's also not allowed to invest more than 20% of its funds in any single investment.

The shares are currently trading on a 5.3% yield and at a 7% discount to the asset value. (A bit tight perhaps, but better than most REITS which are now trading at a premium.)

The interims to September 2009 showed earnings up 11.8%, which looks good - but the return on shareholders' funds was only 1.8%, against a target of a 12% return. Part of the problem may be the fact that there's currently £330m of cash on the balance sheet to invest, and the fund didn't manage to make any new investments in the period [ref] Interim Statement, p4: http://www.3i-infrastructure.com/news_halfyearly_results09.php [/ref] , perhaps not surprising given the economic climate. There's also been a hit from exchange rate volatility, impacting the reporting of the Indian fund - which is sad, as the exposure to India is one of things I really like about this fund.

On the whole, this fund looks like a decently run venture, with some interesting investments and steady income stream. The yield is good, but not so good it's suspicious. Whether the share price is likely to improve in the near term, though, I rather doubt; I suspect this one suits the income or buy-and-hold investor more.

While 3iN is still looking for new projects, HICL only looks for old ones - its underlying investments are all mature, and it's typically buying stakes in PFI and PPP assets once they are already operational, so it doesn't have stakes in construction phase projects [ref] Daily Telegraph, Questor Column, 4 June 2009; http://www.telegraph.co.uk/finance/markets/questor/5445911/QUESTOR-HSBC-Infrastructure-is-a-solid-dividend-play.html . [/ref] . It has also avoided investing in assets such as toll roads, ports, and bridges, which are economically sensitive; though it may now consider these, it's still ruling out what it calls 'non core' infrastructure such as care homes and motorways. Mainly based in the UK till now, with 29 projects in the portfolio, it's currently looking abroad, and it's also broadening its investment remit somewhat. (It might now consider investing in airports, for instance, and utilities.) Renewable energy is also being considered - it's got two operational solar PV projects in Spain being looked at.

I wonder whether the broadening of the investment remit is a response to the difficulty that 3iN has obviously experienced - too much money chasing too few good projects. There's obviously something of a risk to entering new investment fields. Will HICL's management prove to have as good an eye for decent infrastructure investments in other countries and in new infrastructure areas as they have had for UK PFIs?

HICL's trading on a 5.7% yield, and a 5% premium to NAV. I find the premium a bit worrying - these aren't typically the kind of assets that are going to see much upwards move in valuations, I'd have thought.

But I do like the assertion in the interim statement that “There are no operational matters to report on any of the projects” - delightful tedium! [ref] Interim statement, p 8: http://www.hicl.hsbc.com/hicl/inv-relations/press_release.html [/ref] I wish more companies could say the same.

Looking at the interims in a bit more detail, PBT was slightly down (from £10.9m to £9.8m on a revenue basis) and another slight worry, the distribution was above the level of earnings, though management points out that cash received is actually the relevant criterion and at £25m it more than covered the distribution. The company targets progressive distribution and certainly for the last three years shareholders have seen dividends grow reliably. It's also worth noting that the fund appears to have strong defensive principles in place; all projects have their own funding in place, and don't need any refinancing [ref] Interim statement, p9 [/ref] , there are no 'demand based' projects, and all project company debt is hedged to interest rate risk [ref] Interims presentation, p 10: http://www.hicl.hsbc.com/hicl/attachments/inv-relations/hicl-pub/int_ppt_12nov09.pdf [/ref] .

The biggest investments are the Dutch High Speed rail link and the Home Office - both below 20% of the portfolio - and Colchester Garrison is also quite a chunky investment. Most of the projects have a 20-30 year life, with only 5% of them having below 10 years [ref] Interim Presentation, p14 [/ref] , so in terms of long term income streams, this is as good as you can get.

I like both of these stocks, though I have reservations about paying a premium to NAV for HICL. But is there a political risk to investing in this sector?

I suspect not - or not a particularly high risk, anyway. Governments are unlikely to seek to overturn existing contracts - that would be difficult to do without legal challenge, in any case. There may be fewer PFI projects available in future, partly owing to reduced public spending meaning that projects are cancelled, but existing ones should continue to generate returns. I suspect consultants like Capita and Serco are more likely to see their terms of business savaged by newly  frugal governments, rather than the infrastructure companies getting hurt.

The one area where it's possible to envisage government action hurting shareholders is tax. Both these companies are structured as offshore funds, and there has been some concern over that [ref] The Guardian: http://www.guardian.co.uk/politics/2008/mar/04/economy.tax [/ref] . It is possible that a future government might try to change this, which would probably lead to smaller profits for both these funds. Still, the Guardian started poking this issue in March 2008, and so far none of the political parties really seem to have picked it up as an issue.