Monday, 8 October 2007

Diving in the deep end - the valuation of infrastructure assets


News from Bloomberg that a JPMorgan-led group is buying Southern Water from RBS leads to the question How can market players disagree over the value of infrastructure assets? After all, these are amongst the easiest assets to value: they have stable cashflows in industries with very high barriers to entry and predictable demand. Surely valueing a business like this is little more than an MBA exercise -- so how can RBS and JPM both think they have a good deal?

One of the answers is funding. Whole business securitisation has transformed the market for utility assets as it allows much higher leverage than the traditional public equity/senior debt funding model. If JPM and friends believe that they can squeeze more leverage out of Southern then their equity stake becomes smaller and hence they may be able to get a higher ROE even after paying higher interest expenses.

Another perhaps less remarked upon issue is the assessment of the equity required to support the business. Suppose you want Southern to have a 1% PD. Then you calculate the economic capital required to support the business at a 99% confidence interval. Since cashflow volatility is low - the regulation of the water industry helps matters here - this capital estimate is low and hence your model suggests that a private equity model using double leverage of infrastructure assets is safe. But suppose you want more safety. At a higher confidence interval considerations such as possible alterations in the regulatory environment become significant. The business risk here is that changes in regulation will dramatically change the likely future cashflows of the business: suppose for instance the regulator decides that Southern has to spend more to renovate its pipelines. This risk makes the tails of the return distribution for utility businesses very fat, and hence the capital at a higher confidence interval is much larger. A more cautious owner, then, would assign much more equity and hence need to earn a rather higher return. Thus for instance a cautious RBS and a more aggressive JPM could agree on the all in cost of debt and return distribution yet disagree on the value of the asset. If this were true, RBS could be a seller and JPM a buyer.

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