It’s no secret that in the period following the global financial crisis, the pipeline for greenfield infrastructure projects in many developed countries has slowed. This has led many funds and investors to switch their focus to purchasing brownfield assets in the secondary market.
Brownfield assets are typically viewed as the choice appealing to those who do not want to take construction risk and are looking for a steady return. However although the projects have already been built and there is a proof of concept, there are a number of hidden risks involved and vigilance is paramount.
At Operis, we work with a wide range of investors who know their sector inside out. However the financial model is key to determining the correct valuation and we’re surprised by how many fail to recognise factors that can impact this valuation, and ultimately their return. I’ve picked out five tricks that are easy to watch out for when investing in secondary assets.
1. Go beyond the yield
The first thing most buyers look at in the model is the yield figure. A secondary investor in the infrastructure and renewables sector might be looking for a return in the 6-9% range. This number will often dominate conversation about the value of the investment. I would argue that instead of focusing purely on yield, the buyer’s focus should be on the cash flows and the assumptions driving them.
Many buyers aren’t aware of all the ways cash flows can be manipulated to make them look more attractive than they really are. This can be done through taking aggressive tax or inflation assumptions, or altering the timing of payments.
This is why the people buying or selling an asset shouldn’t get ‘tunnel vision’ on a single number. If you take everything in the model that you’re being given at face value then you’re probably going to overpay for the investment. Similarly if you’re selling an asset and you’re not spending some time to optimise the model then you’re probably going to end up selling your asset for a lower price than you could achieve.
Let’s look at a few more of these mitigating factors in detail.
2. Before or after inflation?
Early on, it’s important to establish if you are targeting a real or a nominal return on your investment – a return before or after inflation? A 7% return in a financial model which assumes 3% annual inflation is very different from one which assumes a lower rate of 2% or 2.5%. This may seem obvious, but this is an area that trips up many models. It’s vital to understand whether there is a clear link between high inflation and the value of the asset and how that suits you as an investor.
The impact of this assumption greatly depends on the asset, if you take something which has user charges like a toll road, all of that income is linked to inflation and it should go up with an index each year. But a lot of those assets where the government makes an annual payment only link quite a small proportion of their revenues to inflation. It is important to understand this and what the target company’s inflation hedging strategy is.
3. Understand the sensitivity of the model
Understanding the sensitivity of the financial model is essentially knowing whether you are very close to a cliff edge that you’ve not realised. There are cases where changing an input assumption by a relatively small (seemingly immaterial) amount could make a big difference to the value of the yield.
Financing agreements have covenants that prevent the payment of dividends or other distributions in certain situations, for instance if the cover ratio dips below a certain level. This is likely to be the case where an asset is performing below its base case assumptions and close to triggering this distribution block. Assets outperforming their base case assumptions are a lot less likely to suffer the same issue. The buyer needs to ensure all relevant covenants are correctly reflected in the model so the impact on yield and returns is built into the valuation.
4. Interest on cash balances
This is a simple one to check but many people can be unaware of how much difference this makes to their ultimate return. Quite often people will hold cash accounts and assume that they won’t get any interest on them at all. This isn’t necessarily anything more than a very conservative assumption, and it certainly gives a model a degree of upside potential.
Taking this no-interest position, however, is a relatively recent phenomenon. Projects signed 8-10 years ago, before the financial crisis, assumed interest rates would be higher, earning sometimes three or four percent on cash balances, which is completely unachievable in today’s market.
If selling an asset, it makes sense to ensure interest is set at the highest number that could reasonably be justified. Buyers shouldn’t be opposed to this, but they should absolutely be aware it has been done, and be able to re-run the model based on different, more realistic assumptions.
5. Tax and accounting assumptions
Models that assume tax relief measures or capital allowances have inherent risk as those measures or allowances might not be available throughout the lifespan of the asset. It’s important to know what would happen in these models if a different tax treatment had to be endured.
Taking an example from the renewable energy space: the UK Government recently abolished the Climate Change Levy from electricity bills for businesses. This may have been a money saving move but the returns from this levy were an important pillar of support for the renewables sector. This change has probably reduced the revenues of UK renewables assets which produced Levy Exemption Certificates by about 2-3% – a reasonably big change, especially if the asset was geared with senior debt. Building models which can account for the changing political winds, especially over multiple decades, is perhaps impossible. But, again, savvy investors will want to have highlighted very clearly in the model where the return is dependent on a tax or accounting system that may change.
Conclusion
When evaluating projects with a long time horizon, it is extremely difficult to account for the unknown. If funds and investors are going to buy based on a yield, making sure the assumptions that underlie that number are clearly highlighted, understood and can be manipulated is key.
Without this level of understanding, sellers are at risk of presenting undervalued assets to the market, or buyers may end up overpaying for valuations that exist only in the most imaginative and optimistic minds of the seller. Operis works on around 100 project finance deals every year and we know the ‘tricks of the trade’. We are always on the lookout for new clients active in the secondary market who want to benefit from the experience we have built. Here’s how to find out more about our asset and portfolio valuations service.
