23rd July 2021
We read some very good research (and some less good research!) and it’s great when you find someone who consistently writes well and posts their views via a publically available free blog – such as Joachim Klement’s “Klement on Investing” – see: https://klementoninvesting.substack.com/. It is also great when clever people agree with a view you hold strongly and you can bathe in the soothing waters of confirmation bias! This happened 2 weeks ago when Joachim wrote about infrastructure investments.
Quoting Joachim: “One of the most common reasons why investors want to get a hold of infrastructure assets is because they promise stable cash flows that often are linked to inflation. And in a yield-starved world getting a stable dividend of 5% or more is indeed very tempting… the underlying cash flows from the infrastructure assets are indeed very stable, but they only make a small part of the total cash flows of the investment. The bulk of the cash flows are generated by selling existing assets and distributing the proceeds to investors, just like a private equity or venture cap fund would do.”
In theory, we are big fans of infrastructure investment trusts: they utilise the closed-ended structure well in holding high-quality illiquid assets, and give investors access to attractive dividend yields with low counterparty risk. But it has always bothered us how the managers of the trusts make their money. They do so by charging an annual management charge (AMC) on the value of assets held. Their incentives are to grow the trusts as quickly as possible. They have no incentives to sell any assets. As Joachim shows by referencing an academic paper, no-one ever thinks far ahead enough into the future when asset classes mature and there may not be any buyers of assets that these trusts own. Every investment requires two decisions: when to buy and when to sell. The investment trusts that own these assets only ever seem to buy. In theory, the boards of these trusts should be making sure shareholders’ interests are looked after and that the manager is not growing the assets at the expense of future returns, but it is still puzzling how rarely any assets within these trusts are sold.
In addition, some infrastructure trusts – particularly those in the renewable energy space – own assets that not only have finite lives or clearly degrade over time, but also cannibalise their own revenue streams. Once built, solar and wind farms generate electricity with an almost zero marginal cost. As the nation’s renewable electricity generation capacity increases, there is therefore inevitable pricing pressure. Recently this is exactly what has been happening with forward assumptions about power pricing coming down, to the detriment of renewable energy infrastructure trusts’ net asset values.
In summary, these two issues explain our wariness of many of the major investment trusts owning infrastructure assets. We don’t have to own these larger trusts and we can find far better value elsewhere. We much prefer to own infrastructure assets that are scarce and currently valued with a significant margin of safety. Investment trusts holding energy storage assets and undersea cables that are vital for the world’s digital infrastructure fit the bill: Gore Street Energy Storage, Gresham House Energy Storage and Digital 9 Infrastructure. But we will be keeping an eye on how these assets are valued and will become concerned if they are valued at ever lower yields with no thought to any asset ever being sold.
Ben Conway – Head of Fund Management
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