Infrastructure pipeline needs guidance to secure funding flows

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  • The spending boom creates opportunities for entrepreneurs
  • New funding sources are needed to replace the “dead” PFI model

When the UK government announced its intention to “build back better” after the pandemic in 2020, newly installed Chancellor Rishi Sunak said it would embark on “the highest levels of investment in real terms since 1995” ( infrastructure), pledging more than £600 billion. by mid-2025.

As with most political statements, there was an element of bluster. An early pipeline released by the government’s Infrastructure and Projects Authority (IPA) included a range of programs that were already underway or would have needed funding anyway, such as new rounds of multi-year frameworks covering roads, railways and utilities.

Still, there are signs that the commitments made are spilling over into the market. Figures from the Office for National Statistics show new infrastructure orders hit £2.26bn in the first quarter, up 34.5% on the same period a year earlier. Even if other segments of the industry are slowing, the Construction Products Association expects the infrastructure sector to grow 8.8% this year and 4.6% next year.

But there are questions about how this pipeline will be funded, given the move away from the previous private funding model.

A big pipenot

The IPA’s public and private project analysis forecasts £21-31bn worth of contracts will come to market in the financial year ending March – part of a pipeline of 10 years worth £650 billion. More than £200bn will be committed over the next three years, he said.

The heads of the contracting companies that will be responsible for delivering much of this are unsurprisingly optimistic.

Balfour Beatty (BBY) general manager Leo Quinn told the FinancialTimes in April, the UK was “entering a 10-year era of infrastructure growth”.

Kier (KIE) Chief executive Andrew Davies said on his recent capital markets day that his outlook was supported by government spending commitments.

“Given that our business is counter-cyclical and Kier is a strategic supplier to the UK government, we believe there is a significant medium-term opportunity to drive growth,” he added.

Investors are still unconvinced, however, and seem more concerned about inflationary headwinds affecting the sector and their potentially damaging effect on margins. The FTSE 350 Construction & Materials Index has fallen 16% since the start of the year, further depressing the values ​​of poorly rated contractors.

Kier, for example, has a market capitalization of £345m, just four times expected earnings or around two-thirds of its net asset value of £509m at the end of last year.

“Ratings, in my view, don’t reflect the opportunity there,” said Peel Hunt analyst Andrew Nussey. He thinks investors are somewhat scarred by the past performance of entrepreneurs.

Along with the resounding failures of industry giants Carillion and Interserve, Kier also had to complete two capital raises in three years and sell its housing construction arm to shore up its balance sheet after racking up losses on problem projects.

With entrepreneurs typically operating on single-digit margins, it doesn’t take much to derail a business.

Yet the industry “has now found itself in a position where it is able to deliver projects on time and within budget,” Nussey argued.

Attempts to make relationships between customers and contractors less adversarial date back about 30 years, but contract terms have improved to encourage greater transparency and fairer sharing of risk, Nussey said.

“Behaviours – whether it’s customer behavior, contractor behavior or supply chain behavior – are so different today than they were five, 10 or 15 years ago,” he said. he declares.

Contract blowouts may be less likely, but margin pressure has not been completely removed. Some projects operate on target cost mechanisms, where the pain of exceeding budgets is shared between the contractor and the client. Others are linked to inflation, but when the year-over-year prices of materials like wood and steel soar, they offer little protection.

Count ethe cost

“We are seeing…challenges on project budgets,” said Alasdair Reisner, chief executive of the Civil Engineering Contractors’ Association. “We are seeing prices for certain materials increase by as much as 50% in a very short period of time, something we haven’t seen in decades.”

Rising prices could also cause delays. The £650bn projects identified by the IPA have been budgeted for, but if the costs exceed these “we can see the value of the activity but not the volume”, said Noble Francis, economic director of the Construction Products Association.

If the Treasury remains committed to its spending review commitments, “something is likely to give way and we’re likely to see projects towards the end of five-year spending programs slipping” in subsequent periods, Francis said.

And a project shelved runs the risk of becoming an abandoned project.

“It’s harder to tell if things will move further down the pipeline, especially if they extend beyond a spending review,” Reisner said.

So far, funding commitments made by the government are being met, he added.

“At the moment the government is actually writing the check and it has the lowest cost of capital,” Peel Hunt’s Nussey said.

Combined capital and operating expenditure on infrastructure has amounted to around £7,000 per household over the past two decades, according to the National Infrastructure Commission, an independent body advising the government on delivery.

The substantial increases planned will eventually have to be funded by either taxpayers or consumers, or a combination of the two, but delays in getting funding models in place are “now holding back infrastructure provision”, it said. he said in a review published in March.

The government ended its use of Private Finance Initiatives (PFI, or later PF2) in 2018. It had been used to fund over 700 programs with a capital value of £60bn, but whose annual charges stood at £10.3 billion until it was scrapped, with future liabilities worth £199 billion through the 2040s.

The National Audit Office found that it had been unable to properly quantify the performance of PFI schemes and that contract rigidity made savings difficult. The Office for Budget Responsibility also warned of heightened fiscal risks due to the off-balance sheet nature of the liabilities incurred.

“PFI is dead,” said Duncan Ball, co-CEO of BBGI Global Infrastructure (BBGI) – a London-listed fund with a market capitalization of £1.2 billion.

Yet with more than half of the UK’s existing infrastructure provided by the private sector, there is a need to clarify which models will be used, said Julia Prescott, one of NIC’s 10 commissioners and co-founder of the infrastructure manager. assets based in Paris Meridiam.

In nuclear, the government uses the regulated asset base structure, where a commitment of £1.7 billion to build new plants is ultimately paid for by energy customers through bill mark-ups .

In Wales, an A465 upgrade program has adopted a mutual investment model, in which the Welsh Government development bank has taken a stake in the vehicle delivering it, which should make the structures more transparent pricing.

“When you look at how much spending is planned…they [the government] are going to need the involvement of the private sector to help deliver on those commitments, especially if they want to do it effectively and quickly,” Ball said.

Banking on success

A new UK infrastructure bank has £12bn to deploy and has already secured six deals, three of which have funded the rollout of fiber broadband. He also made two co-investments, the latest being a £100m injection into an Octopus Investments vehicle providing debt for sustainable infrastructure projects.

These are not without controversy, however. Lord Aamer Safraz, the Prime Minister’s trade envoy to Singapore, told the FinancialTimes that the bank should “do the difficult direct transactions, not outsource its responsibilities to third-party fund managers”, adding that this would give it little control over where the money is invested.

Demand for infrastructure investments is strong given that it offers inflation protection, predictable returns and has only a low correlation to stock markets, said Edward Hunt, who manages HICL Infrastructure (HICL), an investment company with a market capitalization of £3.4 billion.

He believes that with government balance sheets stretched after the funding of Covid-19 aid and cost-of-living economic programs, “fully government-funded initiatives around these infrastructure development ideas seem unlikely” .

“But there is no clear replacement for PFI” and the basic regulated asset model will not work for all types of investment, he said.

One response could be for the government to continue funding infrastructure construction and then agree sale and leaseback structures with infrastructure investors, allowing capital to be recycled, Nussey said.

There is certainly a lot of money available. In March 2022, there were £8.1bn of UK-domiciled infrastructure funds tracked by the Investment Association. Alternative asset managers held $22.5bn (£18bn) in UK-focused infrastructure funds as of September 2021, according to Preqin Pro. Nearly $5bn of that was in dry powder or in capital awaiting deployment.

In theory, the visibility afforded by creating a multi-year pipeline of projects offers great potential for investment, whether in the contractors who will build the projects or in the funds that will provide the capital. However, as recent days have proven, short-term politics can derail the grandest of long-term plans.

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