Navigating inflation with infrastructure assets

A simple way to gauge what people are concerned about is to browse through search data on Google Trends. This is a free tool that lets you look at how much people are searching online for a given word or phrase, either in a specific country or across several.

Readers are unlikely to be surprised that searches for inflation related terms in the UK have increased markedly over the past 18 months. A notable example is the phrase ‘inflation investments’, which has seen several surges in search volume during that time.

What the intention behind those searches hints at is a frustrating problem we face when confronted with inflation. It is not difficult to understand that prices are rising but it is hard to identify investments that offer meaningful protection against the phenomenon.

Availability-style assets

One asset class that may be of use in this regard are availability-style critical social infrastructure assets of the kind that BBGI Global Infrastructure (BBGI) invests in.

For those unfamiliar with the term, availability-style infrastructure assets, which could include things like roads, bridges, schools or hospitals, are infrastructure assets that the government has outsourced the construction and management of to a private company. The private company receives contractually defined revenues in return for its services, so long as the infrastructure is available for use – hence ‘availability-style’.

BBGI’s co-CEOs Duncan Ball and Frank Schramm invest in government-backed availability-style assets around the world, all of which have contractual long-term income streams with genuine links to inflation. The trust has strong ESG credentials, building and managing critical infrastructure but still managing to deliver positive outcomes for all stakeholders, including shareholders, governments or the people and communities using the infrastructure.

Inflation-linked contracts

Duncan and Frank only invest in assets with government or government-backed contracts, in AAA or AA-rated countries. These contracts have strong inflation-linked provisions, with payments tied partially or fully to inflation, like the RPI in the UK. This means a public-sector client commits to paying an availability fee including an explicit inflation pass-through providing direct contracted inflation protection. What this means in practice is that BBGI has inflation-linked investments backed by counterparties with a high level of creditworthiness.

BBGI also mirrors these contracts with their own sub-contractors, who are hired to ensure that the assets BBGI holds remain functional. This is a win-win for both sides, as the subcontractors are appropriately compensated for their work and there is more certainty around keeping assets available, while BBGI has a hedge against price hikes that means it is able to effectively manage its cost base.

The dangers of demand-based assets

Readers may argue that similar provisions exist among other funds. That may be the case but what makes BBGI unique is its exclusive focus on availability-style assets which provides an inflation pass-through providing direct contracted inflation protection, something that provides arguably the most crucial component of the trust’s ability to offer secure and attractive income protection against inflation.

As noted, revenue from availability-style assets is consistent so long as those assets remain in use. So if the managers invested in a road, as long as the road was available for use, they would be paid the same level of income – it would not matter how many people were actually using it.

That should be contrasted with ‘demand-based’ infrastructure, where the investor’s income depends on usage. For example, the amount of revenue a toll-road produces will depend on how many people drive on the road.

This is what made BBGI a compelling investment during the pandemic. It continued to generate the same level of revenue, even as usage of many of its assets fell dramatically. In contrast, investors in demand-based assets were hit seriously hard.

In theory, the owner of the toll-road could raise prices to match inflation. But in practice they would likely be subject to the price elasticity of demand. In other words, the more they hike prices, the less likely it is people will use the toll-road.

A similar process may end up playing out in the near-term as demand-based asset holders see a drop off in demand as they try to raise prices in line with inflation. BBGI won’t be subject to the same phenomenon and the creditworthiness of its counterparties also means the likelihood of them failing to pay is very low.

Interest on cash holdings

An additional factor in the trust’s ability to navigate the inflationary environment we find ourselves in are its cash holdings. The trust currently has 56 portfolio companies, which manage individual infrastructure projects, and these tend to have substantial cash holdings on their balance sheets, mainly to meet working capital requirements and in reserve accounts.

As a result, the trust stands to benefit from the interest rate hikes that central banks have attempted to use to counter rising inflation, with these larger cash holdings now capable of generating meaningful returns.

Compounding this is the manner in which Frank and Duncan structure their investments. Deals are made with long-term financing, meaning they aren’t subject to refinancing risk. As a result, higher interest earnt isn’t cancelled out by higher interest paid on borrowings. BBGI has also implemented an active treasury management process to ensure maximizing of interest income.

A tightening premium

Despite these positives, BBGI has seen its premium narrow significantly over the past 12 months. The average premium for that period was 11.9%. Today it stands at 1.4%, which is among the lowest levels the shares have traded at, relative to NAV, since BBGI’s launch in 2011. The trust pays dividends semi-annually and has set a target dividend of 7.63p per share for 2023. That would imply a forward yield, at the current share price, of 5.2%.

The narrowing of the premium suggests concerns about increases in the discount rate, which would lead to a fall in NAV. These are understandable but Frank and Duncan noted last year that they saw read across from other transactions in the market which helped to support the trust’s last discount rate, which will be updated at BBGI’s annual results due on 30/03/2023.

BBGI’s updated NAV to 31/12/2022 is also due then, and the negative effect from a potential rise in discount rate may be offset by the inflation outperformance seen in the second half of 2022 and any increased assumptions for 2023, as well as substantial interest earned from money held on deposit at the portfolio companies due to higher deposit rates.

If that’s the case, it’s plausible infrastructure investors are looking to lock-in a long-term attractive yield, given the possibility that interest rates may come down again. BBGI arguably offers the same opportunity today. The trust’s current share price offers a long-term, relatively low risk yield, with the added benefit of it being heavily shielded from the risk that inflation poses.

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