Successfully passing the litmus test

Higher inflation and the subsequent rate hiking cycle have meant putting theory into practice for investors in infrastructure. A decade of low rates meant that it was easy for managers to talk about their theoretical inflation linkage and downplay financing risk. The past two years have shown that reality can be rather different.

For BBGI Global Infrastructure (BBGI), it has been more a ‘proof of concept’ for the fund, with management’s lower risk approach to infrastructure investing helping to protect the fund from much of the volatility we’ve seen in markets in that time.

BBGI invests solely in availability-style assets, backed by public sector counterparties in AAA/AA-rated economies. These are infrastructure projects, like schools or hospitals, which BBGI derives revenue from so long as they can be used.

Unlike its peers, BBGI is globally diversified, with only a third of its assets in the UK, compared to an approximate average of 75% for the wider infrastructure sector. The fund is also diversified across asset classes, with holdings in numerous sectors, including transport, healthcare, education, and clean energy.

BBGI is currently the only infrastructure investment company that is managed internally. This helps to reduce the costs of running the fund, something that has been particularly notable over the past five years as the NAV has increased but annual costs, in percentage terms, have fallen by over 5%.

Perhaps most importantly, the internal management structure of the fund is such that the management team are not incentivised to grow NAV for the sake of it. Indeed, the close alignment between management and investors means that BBGI will only invest in projects that are likely to be accretive to shareholders.

The proof is in the pudding here, with BBGI’s revenues proving resilient as higher inflation readings have come into play. That is due to the inflation-linked contracts that the managers make with their counterparties.

These operate in a mechanical way. Contracts are tied to a specific inflation index and when this increases, BBGI can simply mark up their invoices in line with it. This is done on a monthly, quarterly, semi-annually or annual basis, meaning there is minimal time lag between higher inflation readings and the subsequent markup to project revenues.

This process is also not capped in any way, so if inflation does run higher than expected, there is no ceiling where the public sector counterparty can stop increasing payouts to BBGI.

Interest rate hikes have proven more of a challenge, as bonds have become more attractive and BBGI has had to increase its discount rate as market observed discount rates have increased. It’s plausible the fund’s share price may also have been impacted by general market fears about leverage and refinancing risk now that rates have gone up, but these fears may be overstated in the case of BBGI.

With regard to the latter, BBGI is currently invested in 56 projects. Those assets are held in individual special-purpose vehicles and borrowing is undertaken on a non-recourse basis.

Moreover, of those 56 projects, 55 have fixed term loans that amortise across the lifespan of the project, meaning they are not subject to refinancing risk. The one remaining project has a tranche of debt that has a refinancing obligation in December 2025. However, BBGI has hedged out the risk of a change in the base rate for this borrowing, so that the refinancing risk only pertains to the lender’s margin in excess of this amount.

The result of this structure is that BBGI has been heavily protected from the risks that rate hikes have posed. Moreover, the fund has actually benefited from higher rates, due to the large amounts of cash it is required to hold as part of its loan covenants. BBGI’s proportionate ownership of deposits held by portfolio companies currently totals close to £400m. With cash holdings now generating approximately 4.5% on a weighted average basis, this has resulted in a substantial increase in interest-based income for the fund.

Combined with higher inflation levels, increased cash flows have meant BBGI has been able to increase dividends for 2023 and its projected dividend for 2024. As at 01/12/2023, the fund was trading on a forward yield of 6.2%.

We think this leaves BBGI at an interesting juncture for prospective investors. With a current discount rate of 7.2%, the fund offers a near 3% equity risk premium, despite the low-risk assets it holds, the strength of its counterparties, and the inflation protection its investments afford.

At the same time, the fund is trading at a more than 10% discount to NAV, compared to a nearly 17% average premium over the last decade. Assuming we have reached the end of the rate hiking cycle, it’s plausible that we’ll see this start to tighten as investors look again for higher yields, backed by lower risk investments.

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