HICL Infrastructure. Summary. Analysts: Portfolio

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1 is a client of Kepler Trust Intelligence. Material produced by Kepler Trust Intelligence should be considered as factual information only and not an indication as to the desirability or appropriateness of investing in the Update 14 February 219 Summary HICL offers shareholders an exposure to institutional quality, lower risk infrastructure assets. The manager, InfraRed Capital Partners, has an emphasis on achieving strong income returns, generated through sources as robust and diverse as possible. Certainly, with Carillion a relatively fresh memory, and with no corresponding adverse impact on the dividend paid by HICL, the diversified approach looks like it is, well paying dividends. The majority of the company s assets offer predictable cashflows, and are uncorrelated to the economic cycle. The manager has been investing a greater part of the portfolio in demand-based assets, which can have returns more correlated to GDP and inflation, but also have a significantly longer life than traditional PFI / PPP assets. Whilst allocations to these types of assets have risen from 9% of NAV in March 217 to 19% at the current time, the manager has a soft limit of 2% to ensure that the portfolio, as a whole, is largely uncorrelated with the wider market. At the heart of HICL is a portfolio of investments with annuity-type income. As such, in our view, the longevity of the assets owned by HICL is important, given that at the end of each contract s life there is a zero terminal value. The manager has been successfully extending the average portfolio duration over time. Indeed, over the year to 3 March 218, the managers succeeded in increasing the weighted average asset life from 24.4 years to 29.5 years. On a total return basis, HICL s NAV return has outperformed UK equities since IPO, delivering a total return of 9.5% p.a. to 3 September 218. The team performed a ten-year review of the various drivers of returns since inception to 31 March 216. InfraRed believes that the NAV was ahead of forecast by 44.2p, of which 3p was due to alpha (or portfolio outperformance derived from the actions of the manager), and 14.2p due to beta (or economic factors such as a decline in corporate tax rates, and discount rates declining). The company continues to deliver solid and consistent positive returns. However, infrastructure investment risks, as well as the value of having an experienced manager behind the wheel, were shown in early 218 with the insolvency of Carillion which in time (after the dust has cleared) is currently expected to have had an impact on NAV of around 1%. Distributable income, net of costs, according to the manager, is expected to cover the dividend. The Carillion insolvency has meant that income from several of the related projects has been locked-up within the special purpose vehicles (SPVs) through which projects are held, which meant that dividend cover for the six months to 3 Sept 18 reduced to 1.6x (excluding the one-off impact of profits from disposals). Analysts: William Heathcoat Amory +44 () Pascal Dowling +44 () Thomas McMahon, CFA +44 () William Sobczak +44 () Kepler Partners is not authorised to make recommendations to Retail Clients. This report is based on factual information only. The material contained on this site is factual and provided for general informational purposes only. It is not an invitation or inducement to buy, sell or subscribe to any product described, nor is it a statement as to the suitability or otherwise of any investments for any person. The material on this site does not constitute a financial promotion within the meaning of the FCA rules or the financial promotions order. Persons wishing to invest in any of the securities discussed in the website should take their own independent advice with regard to the suitability of such investments and the tax consequences of such investment. Portfolio HICL offers shareholders an exposure to institutional quality, lower risk infrastructure assets. The types of infrastructure projects that HICL targets are those that offer steady returns over long time-frames, with low correlation to changes in GDP (or equity markets) and those that produce strong cash-flows with low volatility. The 1

2 is a client of Kepler Trust Intelligence. Material produced by Kepler Trust Intelligence should be manager has built up the HICL portfolio over twelve years, with an emphasis on delivering as robust and diverse an income stream as possible. Certainly, with Carillion a relatively fresh memory, and with no corresponding adverse impact on the dividend paid by HICL, the diversified approach looks like it is, well paying dividends. Within the infrastructure investment opportunity set, the team aim to provide a broad spread of exposures to achieve cashflows with good correlation to inflation, as well as longevity. The income stream is designed to be as robust as possible, and within that context it is expected that investments will be made up of infrastructure assets at the lower end of the risk spectrum. As such, the manager s attention has thus far been focussed on three of the four areas that they view make up the infrastructure investment opportunity set see diagram below. Fig.1: Illustrative Opportunity Set For HICL Infrastructure Assets Investment Opportunity Set correlated to GDP, such as toll roads, are restricted to 2% of NAV at the time of investment. In fact, this type of asset has been a key area of attention for HICL in the last two years, with allocations rising from 6% of NAV in September 216, to 19% in September 218 (22% in total, with the balance deemed uncorrelated to GDP). The key driver for the manager in investing in demand-based assets is that the returns are generally more correlated to inflation, and typically have a longer life than traditional PFI / PPP assets. That they offer better returns in absolute terms is also attractive, but they also come with slightly greater, but different and complimentary risks, and hence the soft limit of 2% of the portfolio. Overall, the current split of asset types in the portfolio can be seen below. The vast majority of assets are UK based (79%), with Europe representing 13% and North America 8%. Currently, only 1% of assets are in construction (ie preoperational) phase. Fig.2: Portfolio Breakdown Portfolio breakdown as at 3th Sept 218 Government Contracts, incl PPP Regulated Assets Regulated Assets Demand-based assets Corporate Assets Demand-based assets Government Contracts incl PPP HICL is not expected to have a significant exposure to corporate assets which, in the view of the manager, typically offer too much exposure to the economic cycle. Instead, at the current time, the majority of the company s assets sit within the Government Contracts or Regulated Assets sub-sectors which offer predictable cashflows, and are uncorrelated to the economic cycle. Government contracts are typically long-term contracts to provide facilities like hospitals, which depend on them being available for use by the local authority or NHS Trust in order for the payments to be made. These are known as Private Finance Initiative (PFI) or Public Private Partnerships (PPP) contracts. PFI and PPP are essentially the same thing, in which private investors shoulder the risk of asset delivery, through a series of sub-contracts, for the public sector in return for a pre-defined return. Regulated assets are those which (like water companies) have an acceptable return determined by a regulatory body. On the other hand, demand-based assets earn a return depending on the volumes using them. A subset that are Within the construct of having assets which are at the lower end of the risk spectrum, they also aim to provide a wide range of underlying project exposures. The company is of a size that it can invest considerable amounts of capital in single projects, which helps in terms of access and the ability to control or influence the strategic plan for each asset. Given the global nature of the infrastructure market place, and the considerable firepower of other investors competing to put capital to work in this sphere, InfraRed Capital has a track record of finding strategically aligned co-investors to take some of the equity in larger deals, ensuring that HICL maintains a balanced portfolio by limiting the size of positions it takes. We show the top ten holdings in the chart below (totalling 47% of the portfolio), set alongside the rest of the portfolio illustrating their relative size. The portfolio is broadly exposed to different types of asset, although given this is infrastructure it is not surprising that the majority of exposure is to transport 2

3 is a client of Kepler Trust Intelligence. Material produced by Kepler Trust Intelligence should be (mainly roads and HS1), health (mainly hospitals) and education (mainly schools). Fig.3: Top Ten Investments Relative To Rest Of Portfolio Other investments Overall, the portfolio is represented by 117 different assets, with a weighted average life of 3 years. At the heart of HICL is a portfolio of investments with annuity-type income. As such, in our view, the longevity of the assets owned by HICL is important, given that at the end of each contract s life there is a zero terminal value. The managers have been successfully extending the average portfolio duration over time. Indeed, over the year to 3 March 218, the managers succeeded in increasing the weighted average asset life from 24.4 years to 29.5 years. Six months later, at the interims (Sept 218) the weighted average life was 3 years. Gearing Portfolio breakdown as at 3 Sept 218 Affinity Water High Speed 1 A63 Motorway Northwest Parkway Southmead Hospital Home Office Pinderfields & Pontefract Hospitals Dutch High Speed Rail Link Allenby & Connaught Queen Alexandra Hospital Fig.4: Breakdown By Sector Exposure Electricity, Gas & Water Accomodation Education Portfolio breakdown as at 3 Sept 218 Fire, Law & order Health Transport Structural gearing at a fund level is not part of the strategy with HICL. However, the company has a multi-currency revolving credit facility (RCF) to fund acquisitions. The broad strategy is that HICL typically uses this facility to acquire assets, and then repays it from the proceeds of share issuance. The company has a gearing facility of a maximum of 4m, of which is currently drawn circa 7m (as at 2 November 218) and costs LIBOR +165bps on drawings. On an underlying basis, HICL s projects almost all employ gearing. This is all non-recourse debt, meaning that if one project gets into trouble for whatever reason, any liabilities are not recoverable from projects in other SPVs. Within each PFI project, the interest rate is fixed, and the loan is amortised over time meaning that at the end of the asset s life, there will be no liabilities. The average remaining maturity of these long-term financing structures is 17.9 years (as at 3 September 218). Within the SPVs with which HICL owns its underlying projects, gearing is relatively high, and can be up to 9% of construction value / capex. These levels of gearing are fairly typical in PFI investments, reflecting their highly robust nature and the relatively low likelihood that anything will go wrong. As we note above, 7% of the portfolio is availability based. Most of the risks of these assets not being available rest with another party, although Carillion illustrated that these investments do not come risk free. Overall (aside from changes to discount rates), Carillion is likely to have cost a total of 4m (or 1.4% in NAV terms). Returns The aim of the company is to provide investors with a longterm, stable income. In addition to generating sustainable dividends, the company aims to, over the long term: (i) preserve the capital value of its investment portfolio, with the potential for capital growth; and (ii) provide a degree of correlation between the return to shareholders and changes in inflation rates. At the time of the company s launch in 26, the aim was to grow dividends from 6.1p paid in the first year, to 7p per share by March 216. As we illustrate in the dividend section, this target was met ahead of schedule (the company paid a dividend of 7p in March 213). Since then, the company s dividend policy is to pay out at least as much as paid in the prior year, which it has continued to more than achieve. The company paid an annual dividend of 7.85p in the last financial year, representing a compound annual growth in dividends of 2.3% since IPO. As we discuss in the dividend section, the board provides guidance for dividends up to three years ahead, such that 8.45p is currently targeted for 221. Whilst the company has been achieving its income objectives, HICL has also been achieving its objectives on the capital side of the equation. As the graph below shows, the company has outperformed UK equities and the Morningstar Sector Specialist Infrastructure average since 3

4 is a client of Kepler Trust Intelligence. Material produced by Kepler Trust Intelligence should be IPO on a total return basis. Overall, it has delivered a total return of 9.5% p.a. from IPO to 3 September 218. Fig.5: Nav Total Returns Since IPO 3 vs indices since inception be able to write back the rest over time. It is worth noting that following the Carillion debacle, Bouygues and Engie are the largest facilities management and operations counterparty exposures at 12% and 11% of portfolio value respectively. Interserve represents less than 2% of portfolio value. Fig.6: Five Year Nav Total Return Performance 2 vs indices over five years % % 25 HICL Morningstar IT SS: Infra UK RPI (Gross) FTSE AllSh Ex IT Morningstar IT UK Equity Income More recent performance is equally impressive, as the graph below shows, with the company continuing to deliver solid and consistent positive returns. It is worth noting that the slightly negative NAV performance in early 218 was attributed largely to the insolvency of Carillion. Given the insolvency of a third party is one of the main risks that infrastructure investors (and thus shareholders) are exposed to, we think it s worth digging into the detail of how InfraRed mitigated these risks. First of all, InfraRed aims to have a broad exposure to third party service providers. Carillion provided facilities management services to 1 of the PPP project companies in which HICL is invested, representing approximately 14% of the portfolio at the time. InfraRed had developed a contingency plan for the scenario that Carillion was made insolvent, and once it was clear the direction Carillion was taking, they were quick to put that plan into action. Responsibility for securing replacement contractors for PPP projects sits with the project companies, and ultimately on their owners. The company announced that the total impact provision was estimated at approximately 59m of NAV (equivalent to 2.8p of NAV per share, or 1.8% of NAV per share as at 3 September 217). This provision reflected various costs, including a) the cost of agreeing new contracts with other third parties to take over contracts from Carillion, b) the direct liabilities that Carillion had to clients or the owners of the projects (HICL), and c) a mark-to-market loss from changing the discount rate applied to those contracts reflecting the now greater risks. It is likely that the first two costs are sunk and are not expected to be recovered, but in September the company wrote back half the losses from the mark to market discount rate changes (representing less than 1% of NAV), once the new contractors were up and running within the projects. The managers hope that they should HICL Morningstar IT SS: Infra UK RPI (Gross) FTSE AllSh Ex IT Morningstar IT UK Equity Income The graph below shows calendar year total returns against UK equities and inflation. In our view, the main points to highlight are the consistency of returns, but also the lack of correlation to equity markets. The consistency of positive annual returns illustrates the tortoise and the hare parallel that HICL has with equity markets. Over the short term, equity markets might easily show HICL a clean pair of heels, but over a cycle, the charts above and below show that HICL very much proves itself on a total return basis. Fig.7: Calendar Year Nav Total Returns % HICL - Total Returns calendar year NAV performance Company Ord (Cumulative Fair NAV) FTSE AllSh Ex Investment Trust TR GBP UK RPI Overall, aside from assembling the portfolio, using their contacts and network to ensure deals are done at the best price (and one at which the company can achieve its objective), the managers aim to add value in various ways over the life of the asset. The manager groups its activities in three main areas: value preservation, value enhancement and accretive investment. 4

5 is a client of Kepler Trust Intelligence. Material produced by Kepler Trust Intelligence should be The team performed a ten-year review of the various drivers of returns over the ten years from inception to 31 March 216. InfraRed believes that, at that time, the NAV was ahead of forecast by 44.2p, of which 3p was due to Alpha (or portfolio outperformance derived from the actions of the manager), and 14.2p due to beta (or economic factors such as a decline in corporate tax rates, and discount rates declining). The alpha delivered came through management activities such as pursuing cost saving initiatives, trying to benefit from economies of scale and recognising when to, occasionally, dispose of assets. This clearly represents significant value-add from the manager. Over time, it remains to be seen whether the team can continue to extract synergies and cost savings. However, it is worth noting that reflecting the limited life nature of these assets, over the very long term (and assuming the manager is unable to extend the overall life of the portfolio or boost returns through asset management initiatives) the NAV will decline. As we discuss in the portfolio section, at the heart of HICL is a portfolio of long-term stable cashflows, and it is the manager s aim to extend the asset life of the portfolio, thereby staving off this inevitable decline as much as possible. Fig.8: Project Distributions And Portfolio Value from the portfolio, before costs borne by HICL which approximate at 1.9% pa. If we then adjust for the current premium that the shares trade at relative to NAV, then we can arrive at an estimated share price IRR for HICL of c. 5.7%. This is the internal rate of return one might expect from HICL, if held to maturity. Any deviation from this, could be a result of alpha delivered by the manager, the manifestation of portfolio risks (downsides), or changes to underlying valuation assumptions. According to the managers, the portfolio is most sensitive (in terms of a 5bps shift in the long-term rate) to changes in the discount rate and inflation assumptions. Fig.9: Nav Sensitivities Discount rate Inflation GDP Interest Rate : NAV Senstitivities Impact on NAV of +.5% / -.5% change in long-term assumptions Dividend Pence per share Since 215, HICL has paid a quarterly dividend to shareholders (prior to that, a semi-annual dividend), which at the current share price yields 5.1%. Source: HICL As regards outlook, the directors value investment cashflows using discount rate, which can be used to guesstimate an expected return (IRR) based on the current share price, and all the future cash flows attributable to shareholders. The weighted average discount rate (as at 3 Sept 218) was 7.2%. This is based on the cashflows Translating Discount Rate To Share Price IRR % SOURCE Discount rate 7.2 HICL OCF 1.9 HICL Premium adjustment.4 IRR 5.71 Source: Kepler Partners Kepler using HICL sensitivity analysis HICL s dividend policy is to pay out at least as much as paid in the prior year. The company s cashflows are largely uncorrelated to the economic cycle. Distributable income, net of costs, according to the manager is expected to cover the dividend. The dividend cover clearly varies over each year, depending on the underlying performance of the assets and to what extent the short-term gearing facility is deployed. As we refer to in the portfolio section, the company was exposed to the Carillion insolvency, which meant that income from several of the related projects has been locked-up within the special purpose vehicles (SPVs) through which projects are held. This has meant that in the six months to September 218, dividend cover reduced to 1.6x. This compares to dividend cover in the same period last year of 1.26x. 5

6 is a client of Kepler Trust Intelligence. Material produced by Kepler Trust Intelligence should be The graph below shows dividend progression over the past nine years, as well as the board s guidance for the current and next two years. Fig.1: Dividends Per Share of the financial year. As the graph illustrates, HICL has been successful in increasing its dividend, but whilst the dividend increase lagged RPI in 21 and 211, in the years 215, 216 and 217 the company increased its dividend ahead of RPI for the previous year. pence per share HICL: Annual Dividends (financial year ending March) since 21 Management InfraRed has a 2-year track record in infrastructure and real estate funds, with over US$1bn of equity under management. InfraRed is responsible for all aspects of the management of HICL s investments, including operations management, financial management, sourcing and executing of new investments Historic dividend paid Dividend guidance from board Part of the objective of the company is to provide an IRR that has a degree of correlation to inflation. As such, managers currently model that if inflation turns out to be 1.% p.a. higher than currently expected in all future periods, the expected return from the portfolio would increase by.8% from 7.2% to 8.%. The majority of returns for shareholders come in the form of dividends, but it is worth noting that the dividend is not directly linked to inflation. Indeed, the managers believe that the majority of the increase in the dividends paid since launch has been due to their delivering outperformance over and above expectations of when assets have been bought. In terms of benchmarking the dividend growth achieved by HICL, in the graph below we compare the annual increase in the dividend to UK RPI (the more demanding measure of inflation), rebased to 21. In each of the company s financial years (ending in March), we compare the dividend increase with the previous year s RPI figure, which better reflect the inflation rate which applied to the majority Fig.11: Dividend Growth Vs UK RPI Values HICL Dividend Growth vs RPI Annual dividends for financial year ending March compared to RPI in previous year Harry Seekings has overall responsibility for HICL, which was the first infrastructure investment company listed on the main market of the London Stock Exchange. Harry is Co-Head of Infrastructure business at InfraRed. He joined InfraRed in The InfraRed team employs around 14 staff and is London-headquartered, with offices in New York (since 28) and Sydney (since 213). Discount HICL has been a huge success since it IPO d in 26, when it raised 25m of equity as the first listed infrastructure fund in the UK. In total the company has now raised 2.2bn of equity. Until 218, the company has largely traded at a premium to NAV. The premium started coming down in 217 with sabre-rattling from the Labour opposition, who threatened to nationalise PFI / PPP projects should they be voted into power. This caused a steady narrowing in the rating, which was then compounded by the insolvency of Carillion in early 218. As such, HICL suffered some negative share price pressure, and at one point the discount to NAV reached double figures. The trust bounced back to a premium when Equitix made an unsolicited bid for one of HICL s peers (John Laing Infrastructure Ltd ( JLIF )). The takeover completed in autumn 218. Taking into account updated valuations, we understand that the successful bid for JLIF represented a premium to NAV of around 8%. This catalysed the sector and meant that HICL regained some of its poise in terms of trading at a premium to NAV. The current share price implies a 5% premium to the cum-income NAV estimate from JPMorgan Cazenove of 157p (as at 11th Feb 219). We expect HICL to release an updated NAV at the end of May, for the full year to 31 March , Statistica Dividend Growth (%) UK RPI in previous year 6

7 is a client of Kepler Trust Intelligence. Material produced by Kepler Trust Intelligence should be Fig.12: Premium (Discount) To NAV Discount Jan 14 - Jan Values Charges HICL Infrastructure Sector The managers charge a tiered management fee on gross assets. This is 1.1% on assets up to 75m, 1% to 1.5bn,.9% to 2.25bn,.8% to 3bn and.65% thereafter. With gross assets (as at the last valuation date on 3 September 218) of 2.9bn, HICL is close to reaching the lowest tier of management fee for some of its assets. The company s on-going charges figure (OCF) (as at September 218) was 1.9%. 7

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