C ould Britain's exit from the EU be the trigger that reverses the recovery in infrastructure investment in the U.K.? After the country's June 23 vote to leave the EU, investment in infrastructure has experienced setbacks, with postponements of some asset sales and a downsizing of other projects. This includes not only projects supported by the U.K. government, such as the Hinkley Point nuclear power station, HS2 high-speed railway line, and the proposed Heathrow runway expansion, but also private deals such as the proposed sale of the Birmingham Toll Road M6, which now appears to be back on track.
- Since the Brexit vote in the U.K., investment in infrastructure has experienced setbacks, and we're expecting more moderate asset valuations.
- Overseas funding could decline, and the U.K. government's hands are tied.
- These factors, combined with a weakening sterling, could change market fundamentals for infrastructure investment in the U.K.
- As the dust settles, we expect strategic investors to find the U.K. increasingly attractive and play a major role in financing the sector.
Historically, Britain has attracted more foreign investment in infrastructure than any other European country, thanks to its stable regulatory environment and openness. Funding for infrastructure relies heavily on the private sector. The U.K. government has called on the private sector to fund over half of the £483 billion bill of necessary infrastructure investment through 2021. And the U.K. Treasury wants to rely even more on the private sector to set up and manage projects. However, private investors may not want to bear the risk of new investments in times of uncertainty, without the public sector bridging the gap.
Mergers and acquisitions (M&A) across all sectors, not just infrastructure, went on the decline from the moment the referendum was announced on Feb. 20, 2016. U.K.-based M&A deals in the first half of 2016 were down to $72.9 billion, the lowest first-half level since 2011, according to Dealogic, and 63% lower year on year since first-half 2015. European M&A also declined in the first half of 2016, possibly reflecting uncertainty concerning macroeconomic conditions in the EU overall (see chart 1).
From our perspective, we do not foresee an immediate decline in credit quality in the infrastructure sector. That might change in the longer run, however, if financial and operating conditions for projects worsen, such as:
- An increase in financing costs or more difficult access to financing for entities operating in the U.K.
- A decision by banks and institutional investors to charge higher risk premiums on lending. This would increase financing costs, which would prove extremely detrimental to the sector given the scale of investment required.
- A decline in demand for the country's infrastructure assets from more conservative investors resulting from the downgrade of the U.K. sovereign rating, and the negative outlook on the rating.
The Bank of England has nevertheless reacted quickly to the first signs of economic, monetary, and fiscal aftershocks to Brexit. On Aug. 4, the central bank cut the U.K. bank rate to 0.25% from 0.5%, and did not rule out further reductions. The BoE also announced a £60 billion increase in its asset purchase scheme, to £435 billion from the current £375 billion, together with the purchase of £10 billion of U.K. corporate bonds of firms--which should give the economy a shot in the arm. The four-year program aims to provide an economic stimulus, avoid a recession, and prevent a rise in risk premiums.
We're Expecting More Moderate Asset Valuations
We don't believe that infrastructure asset valuations will suffer in the short run, given the sector's typical resilience to downward phases in the economic cycle, its long-dated and beneficial yield characteristics, and strong underlying credit fundamentals. However, the vote to leave the EU represents a systemic change and presents risks for the economy, currency, and to political stability, exacerbated by the uncertainty about the form and timing of exit negotiations. Corporate credit conditions might worsen in the months ahead, and infrastructure M&A could remain slow for the rest of the year or more.
Instead, we believe the biggest risks for infrastructure companies could be a likely reduction in capital investment--both domestic and foreign direct investment. This would stem from an extended period, potentially running for many years, during which the terms of exit and replacement trade treaties with the U.K.'s partners are renegotiated.
In the long run, uncertainty about political, regulatory, and macroeconomic conditions could reduce infrastructure asset valuations in the U.K. The long-run performance of some infrastructure companies, such as transport, retains a strong link to GDP, which has weakened in the aftermath of the June 23 referendum.
In any case, in the near future we are not expecting to see EBITDA valuations comparable to those at the London City Airport's sale in February 2016. The extremely competitive bidding culminated in the purchase of the airport by a group of Canadian and Kuwaiti infrastructure funds for an estimated £2 billion. This represented an enterprise value-to-EBITDA ratio of 30x, and at more than 2.5x the price paid by the previous acquirer in 2006. The recent purchase of state-owned stakes of airports in France by corporate investors, valued at multiples ranging from 19x to 22x EBITDA, according to the press, could provide a useful benchmark to eventual sales and expansions of U.K.-based airports in the coming year.
Some Investors Could Find Opportunities
Even if financing conditions change, the U.K.'s underlying infrastructure needs won't, and infrastructure assets might become cheaper as sterling devalues. Yet, this change in market fundamentals may actually open up opportunities. Some investors may be able to capture higher returns on projects, making the infrastructure sector an attractive option for them. The U.K. has a significant infrastructure pipeline and the government has pledged funding of £100 billion by 2016-2021 under the National Infrastructure Delivery Plan. To be delivered, this public money will need to be matched by private investment for key U.K. projects.
What we're seeing in the U.K. is that while some pension funds and more conservative investors have been holding back post-Brexit, strategic investors, mainly corporates, have been more eager. While in the U.K. various transactions are being postponed, in other countries such as France, privatization processes are proceeding. In the privatization of Nice's and Lyon's airports, the remaining investors that are competing for the contracts are corporations, as opposed to pension fund investors, who bowed out. Deterring institutional investors could be a boon for strategic investors, which have been struggling of late to match aggressive price bidding from pension funds.
In today's environment of low and negative yields on government bonds, interest could pick up in infrastructure investment. Global infrastructure fund INPP states that U.K. government bond yields will decline and in comparison, infrastructure would be more attractive for investors needing a safe return, even though this is a long-term, illiquid asset class. Indeed, INPP just raised £125 million in a capital increase, 66% more than the targeted £75 million. In addition, Prequin reported a record in the number of fund managers raising capital for unlisted infrastructure funds in July 2016.
For Now, The Government's Hands Are Tied
Among the uncertainties dogging the infrastructure sector, the future willingness of the U.K. government to invest is also unclear. Given the likely continued decrease in FDI and EU funding, the private sector is going to have to fill the gap. The U.K. government faces budget constraints, a large debt burden, and a wide current account deficit, which are tempering its own ability to invest in the sector. In 2015 and first-quarter 2016, we saw the sale of stakes of several state-owned assets (such as Royal Mail, Lloyds Bank, and Royal Bank of Scotland), since one of the current administration's main goals is public debt reduction.
The government is not only less willing and able to directly fund infrastructure projects, but it's also dragging its heels about making decisions to promote large-scale private-sector investment:
- No decision has yet been taken concerning the Heathrow runway expansion, which was to be decided in July--nor on the HS2 railway line connecting London and the north of England. Meanwhile, the Institute for Public Policy Research recommended giving priority to the HS3 line, connecting Leeds and Manchester, to foster economic growth in northern England. However, if a decision is taken on the HS3 line, it is likely to imply a reduction in resources for the HS2 railway project.
- The £24.5 billion Hinkley Point nuclear power station on July 28 received the long-awaited confirmation from Electricité de France to proceed. Since then, however, the newly elected government under Theresa May decided to postpone the decision to the autumn. The estimated cost of the project to the consumer, due to the contract for difference, has ballooned to £30 billion, according to a report published on July 13, 2016, by the government spending watchdog National Audit Office. A final decision on Hinkley Point is still pending.
Some private-sector sellers may want to wait for the situation to stabilize, in a bid to obtain the highest possible selling price. The sale of Birmingham Toll Road M6 is an example. The sale, by a consortium of banks, was announced in February 2016 and the transaction had already been prepared by underwriter UBS. However, following the Brexit vote, estimates and forecasts have needed to be revised, since they were based on a Remain scenario. The release of the information memorandum (IM) for the sale was delayed after the June 23 referendum. Although the sale is now back on track following the IM released at the end of August, the process is now said to be delayed by 10 weeks.
Overseas Funding Could Decline
With a current account deficit standing at 6.9% of GDP in first-quarter 2016, the U.K. relies heavily on FDI. Until the environment stabilizes, FDI is likely to drop. Moreover, the European Investment Bank (EIB), which has invested more than £16 billion in U.K. projects in the last three years, is expected to partly or fully reduce funds allocated to U.K. infrastructure. Despite the fact that the EIB does fund some investments in non-EU countries, it does so to a much lesser extent.
While public EU investment had been declining in the years following 2009, it stabilized in 2014 and 2015 to slightly above $2.9 billion. In contrast, private investment had been trending upward from 2009 until 2015, resulting in an increase in total investment in the EU. Although, as we've argued, depending on a continued rise in private investment is no sure thing.
Many sovereign wealth funds invest in the U.K. Before the Brexit vote, Norway's wealth funds before Brexit held £7.4 billion in U.K. government debt, and their exposure to sterling in the fixed-income part of their portfolio stood at 5.2%. After the vote, Norway has confirmed its willingness to invest in the U.K. Likewise, Singapore's GIC wealth fund extended its exposure in the U.K. by investing in low-risk student accommodations, but its investment in other high-risk infrastructure subsegments remains uncertain. Some wealth funds are not currently willing to increase their exposure to U.K. assets. This is the case for Qatar, which has a total of $44 billion invested in the U.K. and $7 billion in equities traded on the London Stock Exchange through the Qatar Investment Authority wealth fund alone.
The U.K.'s decision to leave the EU has led to uncertainty in infrastructure investment, which we believe will dissipate sooner rather than later. Furthermore, despite the delay in some decisions concerning infrastructure projects, and uncertainty about funding from traditional players, such as the U.K. government and sovereign wealth funds, we believe that the new post-Brexit investment landscape may provide opportunities for new players. In particular, we expect private investors to find investing in infrastructure increasingly attractive and play a major role--as the dust settles.
The authors would like to acknowledge the contributions of Agnese Gavella of Bocconi University, Milan.