This special guest commentary was written by Daniel Lacalle
“Price is what you pay, value is what you get.” -Warren Buffett
If we look at the latest market transactions, infrastructure assets of all kinds are being sold at multiples that move between twelve and eighteen times EBITDA. The brutal multiple expansion generated in infrastructure assets (the "penultimate bubble") coincides exactly with the bubble created by artificially low rates and the monstrous excess liquidity from central banks.
In a period when interest rates have fallen more than six hundred times, multiples paid for infrastructure assets have increased five-fold.
Demand for infrastructure is intrinsically linked to financial repression. Faced with the desperate search for a bit of yield, with 9 billion euros of bonds at negative rates and zero rates, investors look for relatively safe assets, with stable cash flows and acceptable returns.
When a fund or infrastructure company pays these multiples, it has to assume several requisites:
- That interest rates will remain low for a long time, since these are very long-term investments,
- That inflation expectations will remain very low, because even if the returns of these assets are adjusted by inflation within the regulation, we all know that when inflation rises, so does regulatory risk,
- That the regulation of these purchased assets will never worsen in the period of investment, and
- That a very low cost of capital (WACC c5%) is adequate for these cash flows.
Investors may take some of these factors into account, but we cannot help thinking that assuming them all is at least highly optimistic, and that the fact that market multiples soar does not mean that prices are adequate.
Another essential element to consider when assessing risk, is the degree of leverage that is used for these transactions. It is easy to fall into the temptation – as we saw in the renewable bubble – of thinking that project equity returns will increase exponentially with higher debt because “money is free”. If the market finances these projects with 80-90% debt and 1.5-2% interest rates “with guaranteed returns,” ROE (Return on Equity) will be very high, which justifies the huge multiples. Until the mirage fades, and even a small decrease in allowed returns destroys the entire equity because it does not cover the cost of debt.
Does this remind you of something? Do you remember when some funds leveraged assets up to 90% in renewable assets because returns were “guaranteed” to achieve ROEs of 15-20%? When revenues decreased ever so slightly, the entire bubble burst.
The problem of captive and very long-term assets is that this optimistic combination of estimates simply cannot be made. And paying 16 times EBITDA requires a lot of faith.
Infrastructure investments soared 14% in 2016 to a record $413 billion, doubling since 2009 and exceeding by $110 billion the pre-crisis peak of 2008. In Europe, this figure reached a record 555 transactions for $97 billion in 2015, 42% in renewable assets, according to Prequin.
Is This Time Different?
Infrastructure funds tell me that this time it’s different. That infrastructure gap in the world is c1.5% of GDP, and that demand and multiples are justified. I heard the same with housing, tech companies, renewables…
Not everything is a huge bubble, though. Some of these investors find a fifth reason to justify valuations. The possibility of increasing efficiencies and controlling costs can make a significant change.
One of the advantages offered by an infrastructure asset is that, with proper management, profitability and quality of service can be improved without demanding tariff increases because multiples paid have been too high.
Of course, many of these investments do not carry such an exorbitant level of debt and if they have a reasonable equity cushion, they will be able to absorb the risk of changes in revenues in the investment period.
What causes the bubbles to explode is the combination of excessive borrowing and perception of no-risk. There has not been a single crisis that was generated from assets that were perceived as high risk. Crises are always created on what we consider “safe”. Because the perception of “extreme safety” leads to excessive indebtedness and accumulation of risk in the allegedly “safe” asset.
The arguments I usually hear about infrastructure risk are the same ones I’ve heard all my life before a bubble:
- “Infrastructure needs far outstrip supply, so prices cannot go down (think ” house prices never fall”, or ” it’s a new paradigm “).
- “These are the market prices and if you do not accept them, you lose” (remember “the price is the price”, or “historical valuations are not applicable now”).
An essential factor to justify current valuations is that the last transactions have been made at a higher price. But falling into the ” greater fool theory” can be dangerous. That is why cautious funds use sensitivity analysis and contingency plans. Even worse than accepting any price at face value is estimating a level of liquidity and demand for captive assets that can quickly evaporate. The famous argument of “if you cannot pay, you can always sell in the market at more expensive prices” disappears quicker than the investor thinks, in the face of a slowdown.
Expecting increased guaranteed returns when revenues come from taxpayers is the biggest mistake. Bubbles are not guaranteed.
I can be totally wrong. I hope so. I only beg, I implore, to those who join this race of ever expanding multiples to have a cushion of sufficient equity and management capacity. If I am wrong, investors will continue to have very attractive returns, but if I am right, they will not be part of a bankruptcy domino that may start when the “guaranteed” word disappears.
EDITOR'S NOTE
This is a Hedgeye Guest Contributor note written by economist Daniel Lacalle. He previously worked at PIMCO and was a portfolio manager at Ecofin Global Oil & Gas Fund and Citadel. Lacalle is CIO of Tressis Gestion and author of Life In The Financial Markets, The Energy World Is Flat and the forthcoming Escape from the Central Bank Trap.
