A year is a long time in business, but in the case of Australia’s listed infrastructure trust (LIT) and listed property trust (LPT) sectors it is almost their entire lifetime. A glance at the list of The Diplomat Global 100 reveals that almost 20 per cent are property and infrastructure trusts. Until the debt crisis, these listed entities were seen as defensive stocks, offering excellent yields, with global tentacles. But now, their once-lauded business models have been thrown into jeopardy as investors become increasingly intolerant of complicated businesses laden with debt.
Indeed, the dominance by property and infrastructure trusts of The Diplomat Global 100 reflects the development of a real global niche. Over the past five years, having grown fat on Australian property and infrastructure assets, these businesses formed consortiums and bought big overseas. Many own major pieces of infrastructure, including airports, tollways, gas pipes, sewerage companies, and big shopping malls.
However, there are now serious questions about the sector’s future. All eight of Macquarie Bank’s infrastructure and property trusts, two Babcock & Brown infrastructure trusts, plus the other eight that make up the sector in The Diplomat Global 100, have seen their share prices fall sharply in the past six months, and some are battling to survive. These include David Coe’s Allco Finance Group (rank 69), and one of the three property trusts it bought and managed, Rubicon Europe Trust (rank 83).
The problems facing LITs go to the core of their business models. Macquarie Bank (rank 9) and Babcock & Brown (rank 20) have spent years buying offshore infrastructure assets – such as a long-term lease on a bridge, road, airport or power station – then packaging the deals, gearing them up, and selling them to one of the specialised funds that they manage. They entice retail investors to invest in them with the lure of “yield”, while taking management and performance fees.
Macquarie made its name as a long-term holder of big infrastructure assets, and its chief fame comes from toll roads. Interests in a host of them – from the Chicago Skyway to Britain’s M6 Tollway; from Highway 407 in southern Ontario to the Indiana Toll Road, the so-called Main Street of the Midwest – repose in the Macquarie Infrastructure Group (rank 23), the oldest and biggest of the bank’s 31 specialist infrastructure funds.
But the Macquarie and Babcock models rely on large sums of debt. As global financial markets have seized up and become more risk averse, their share prices have been battered by investors wanting to get out as well as hedge funds shorting stocks that promote “yield”.
Charlie Aitken, head of equities at Southern Cross Equities, recently said, “The hedgies (hedge funds) have had tremendous success in Australia shorting ‘yield’. Yield was meant to be defensive but the hedgies have successfully smashed the banking, LPT, asset manager, and diversified financial sectors. They have shorted the yield sectors and crushed share prices. ‘Yield’ reliant on debt-funded business models has been particularly attacked, and there is nothing surer than that the hedgies are lining up for an attack on the infrastructure sector where asset revaluations will be negative, funding costs rising, and most ‘distributions’ are paid out of borrowings.
“I just get the feeling the infrastructure bubble is going to burst in a world of much tighter credit markets and negative revaluations. If ever there was a sector ripe for hedge fund shorting it is the Australian infrastructure sector.”
Opaque problems
The LPT sector was the best performing investment asset class for a decade, but lost almost a quarter of its value in the year to January 31. Part of the reason is that the once simple LPT structure, known for its straightforward, income-earning capabilities, has morphed in recent years into complex stapled structures – structures that wrap up fees from funds management with the performance of property assets.
As long as banks lent cash, LPT fund managers bought properties to satisfy investors’ hunger for higher returns. This addiction to higher returns sent them searching overseas, often buying overpriced properties in the UK, Japan and Europe, and loading them with debt.
Soon, investors found that yield can be a trap when too much debt is involved. Indeed, when Centro Properties Group (rank 86) announced results in December, it became clear that yield can sink to zero under heavy debt.
Now investors, made wary by the yield trap, are turning a more cautious eye upon the cashflow trap in the LIT sector.
Brett Le Mesurier, banking analyst at Wilson HTM, believes the recent credit market crisis has accelerated a rethink of the Macquarie Bank and Babcock & Brown business models.
“In the listed trusts, what was happening was a high proportion of cash flow was going out in fees, which wasn’t a good look,” Le Mesurier said.
Le Mesurier says the LIT parents are responding by moving to the unlisted sector. The reason is simple: unlisted funds don’t require a prospectus. The value of the fund is not marked to market daily because they are private and the fee structure is more skewed towards a higher base fee and lower performance fee.
Le Mesurier says a further problem is that some of the financially engineered companies are secretive and keep investors in the dark about how all the pieces of the financial puzzle fit together. “Even the best brains would have little hope of putting together the true situation. Why? There is often leverage on leverage,” he says.
There is little doubt companies that lack transparency are now on the nose. A glance at the performance of listed stocks over the past year reveals that over 70 stocks fell more than 50 per cent in the past year, and most of them were in the LIT, LPT and biotechnology category, well beyond falls in the broader market.
Changing models
Some LITs are already restructuring. Babcock & Brown Capital (rank 15) is trying to restructure itself with the recent announcement it will buy back up to half its issued capital, returning more than $300 million to shareholders in the process, while Babcock & Brown Wind Partners plans major asset sales, to respond to the valuation gap between market price and underlying asset backing.
Challenger Infrastructure Fund (rank 95), the subject of a $1.2 billion takeover offer from a subsidiary of British based Consensus Business Group, is trying to restructure itself after its share price, and that of its parent, Challenger Financial Services, was bludgeoned due to the difficulty in understanding the business model.
Challenger houses four main divisions – funds management, mortgages, asset management (infrastructure, real estate and fixed income) and financial planning – and one of the ways it makes its money is to risk its balance sheet to earn a spread on its investments relative to its funding cost. This funding includes its capital-guaranteed annuity liabilities, which run into billions.
For this sort of model to work, it has to be very good at identifying assets that give an adequate spread with low risk of loss. In previous years, this hasn’t been a problem, with asset prices rising on the back of cheap debt. But the latest results show the risks that the company has been taking on the assets it has bought.
The latest results for the six months to December show that its infrastructure and property assets were not immune to the general market malaise, so it had to write down their value – a big factor in the firm’s 26 per cent fall in profit to $95 million.
Indeed, the underperformance of its Challenger Infrastructure Fund (CIF) and Challenger Diversified Property Fund (CDF) accounted for the bulk of $66 million in unrealised losses. And there are possibly more write-downs to come.
“If current conditions persist, we expect Challenger’s EBIT to fall in the next six months. We have downgraded our EPS forecasts by 14 per cent for 2008 and by 16 per cent for 2009,” says Le Mesurier.
Challenger boss, Mike Tilley, has made it clear that the company needs to do something to rectify the problem. The most likely scenario is that it will close the listed trusts, CIF and CDF, and follow the lead of Babcock & Brown and Macquarie Bank and start launching unlisted funds.
Tilley tried to quell market fears that Challenger was not like other financially engineered companies, but it fell on deaf ears. Tilley’s exact words were: “With conservative gearing levels across the group at 9 per cent and a strong capital position, we have the financial flexibility to be opportunistic in our approach.”
But doubts persist about the business model. While it is true the company has a 9 per cent gearing at the holding company level, this figure doesn’t take into account the debt and annuity liabilities in other parts of the business. Nor does it deduct the goodwill on the balance sheet. If these factors are taken into account, the gearing ratio would be 80 per cent, based on Wilson HTM numbers. (This does not include the debt in the securitisation business.)
The holding company has $345 million in debt from a finance subsidiary, there is $567 million in subordinated debt in its life business, Challenger Life No 2, and $3.8 billion in policy liabilities in this business have capital guarantees. There is also debt with limited recourse to assets that it owns.
The company argues that only the holding company debt is relevant, but the life company has more net tangible assets than the holding company. In other words, the life company is the holding company’s biggest investment. How can a gearing ratio not include the gearing in its biggest business?
LPTs will also start changing their models. Most LPTs have suffered a battering since Centro went into a trading halt in December. But the ones that suffered the most have four things in common: significant funds management exposure, high levels of gearing, large refinancing pending and lower-quality foreign assets.
Historically, LPTs were favoured for their defensive characteristics, not their growth prospects, but all that changed as they expanded overseas and pushed up gearing.
A year ago the yield on LPTs fell below government bond yields for the first time in a decade. As interest rates started rising, this pushed the yields further down.
Post Centro, the world has changed. LPT yields are at record highs due to their record low share prices. Analysts, auditors and investment bankers will now start discounting the valuation they place on growth businesses and put a premium on income streams.
This will ultimately change the models of LPTs. But the impending consolidation will no doubt kick-start the re-rating of a few stocks as the strong, such as Stockland Trust and Westfield Group (rank 22), pick over the weak.
Australian trusts that own Japanese property are particularly vulnerable to takeover or merger. Australian trusts that fall into this category include Babcock & Brown Japan, Rubicon Japan Trust and Challenger Kendix Japan Trust. These have the worst cost of capital of any LPTs and are trading on huge yields.
These Japanese LPTs have performed poorly mainly due to the perception that they are not adequately hedged against foreign exchange movements between the Australian dollar and the Yen.
The problems facing the sector are best summed up by Justin Blaess, director of ING’s listed property and infrastructure: “Centro epitomises the sins of the LPT sector coming home to roost.” ?Blaess says aggressive expansion, questionable real estate assets, high gearing, opaque accounting such as adopting equity accounting instead of consolidating risks, and expanding headlong into property development are just some of the sins the LPTs have been committing in the past few years.
He could be saying the same about infrastructure.
The reality is Australia has developed real global expertise in managing property and infrastructure assets. Now that expertise needs to be put into models that are more reflective of the times.
Adele Ferguson is a Business Journalist at The Australian.