The need for unlisted equity valuation reporting
Direct investment in unlisted infrastructure has become a staple of long-term investors (such as large domestic super funds and a small number of ASX-listed vehicles) over the last two decades and can represent as much as 5% of portfolios of diversified funds.
The asset class is attractive to long-term investors as it typically exhibits long-lived assets, a regulatory ‘moat’ or contractually-based revenues (or a combination of each).
A large infrastructure manager sought valuation of a minority equity interest in a special purpose vehicle [“SPV”] established to bid, own and operate a significant public health facility under a 30 year PPP arrangement with a state government.
As an ASX-listed company and SEC registrant, the client required the valuations to comply with both AASB 1056 and US ASC (IFRS) 820.
The equity interest was acquired by the client on the secondary market as a result of the exit of a founding investor.
Valuation issues and considerations
Given the choice of market, income and cost approaches to valuation, most infrastructure interests are valued using an income approach with cross-checks to market data.
With a corporate structure typically comprising 5-25% equity, strict debt covenants, and scheduled refinance arrangements, it is necessary to understand debt spreads and the appetite of senior and junior debt holders to roll tranches of debt through the life of the PPP.
Given the detailed multi-year cashflow forecasts developed by the asset operator and investment manager, a thorough review of the forecasts alongside the contractual arrangement which give rise to the forecast is essential. This includes reviewing the shareholder agreement and debt refinance arrangements.
The complexity of corporate and debt structure requires specific consideration of the dividend capacity of the head entity and the extent of dividend franking. This results in the valuation approach essentially reflecting discounted expected dividends incorporating an assessment of the likely value of franking credits.
PPP agreements dictate cashflows including base fees and penalties for failure to meet service standards. Revenues payable by the State Government have 10 separate components – all governed by a very lengthy and detailed PPP deed (often in excess of 1,000 pages).
Assessment of the equity discount rate includes benchmarking across domestic and international PPP projects.
Consideration of the shareholder agreement is also essential as most infrastructure interests provide for director representation at certain equity levels (typically a minimum 5%, 10% or 15% depending on the scale of the asset and the number of shareholders).
In addition to a shareholder agreement and PPP deed with the state government, this PPP structure included 6 key commercial agreements:
- Construction contract
- Project agreement
- Facility management agreement
- Information & communication technologies contract
- SPV management agreement
- Financing arrangements
Over 90% of revenue and costs of the head entity is subject to these agreements and the PPP deed.
Delivery of critical operational capabilities occurs under back-to-back agreements with contractors.
As a result of highly-contracted cashflows and high leverage, equity value is very sensitive to relatively modest movements in input assumptions and outcomes under the various commercial agreements.
Risk exposure for equity investors is tantamount to a BBB-rated debt instrument given the operating and financing risks and AA-rated counter-party (a State Government – noting that there is a non-trivial ‘sovereign’ risk due to political agitating exhibited at both State and Federal levels in recent years).
There is an absence of ASX-listed PPP equity investors and the closest comparable companies are UK listed PFI portfolio investors.
For these reasons, a CAPM-based cost of equity assessment is often inappropriate and instead Peloton constructs a cost of capital through benchmarking of contractual and sovereign risks to (often confidential/proprietary) analysis of similar PPP’s and UK PFI’s.
This results in a bond-equivalent spread and ability to check against the debt beta of similarly-risky debt instruments. For concession-based PPP’s the outcome is an implied asset beta which is less than the lowest listed equities. On a releveled basis, concession-based PPP equity often reveals an equity beta of around 1.0 (due to leverage often around 80-95%).
Debt profile/leverage changes through the PPP life requiring consideration of appropriateness of a single estimate of the cost of equity.
Risk analysis across the key contractual agreements informed the equity discount rate assessment.
Consideration of minority discounts is required as the shareholder agreement provides veto rights at equity interest greater than client holding. However, after discussion with the client (which had a director representative on the board) Peloton identified that all shareholders were aligned on the corporate issues to which veto rights exist.
Consequently no minority discount was applied (this is consistent with most PPP equity interests in Australia – reflective of a highly-sophisticated governance regime underlying substantial unlisted infrastructure investments).
A discount for lack of marketability is typically considered in regard to unlisted company equity interests. However, the governance arrangements ad shareholder agreement together with a consistent appetite for secondary equity interests in PPP projects resulted in a conclusion that no discount for lack of marketability should be applied.
ESG issues also require consideration and are typically dealt with through review of key documents, discussion with the operator and investment manager along with board minutes. Some key ESG issues are contractually embedded in cashflows and often no adjustment is required to cashflows or discount rate for specific ESG risks.
Peloton solution
Peloton provided a detailed valuation report which addressed:
- the contractual arrangements underpinning the expected cashflows to equity holders;
- an assessment of the equity cost of capital/discount rate;
- consideration of minority discount, marketability issues and franking credit availability; and
- cross-checks of the assessed equity value to a variety of benchmarks and transactions.
Presentation of the valuation outcomes was made by the Peloton team to the investment committee of the client as part of its valuation governance regime.
The valuation was undertaken annually and incorporated detailed consideration of cross-checks to transactions in SPV equity, UK PFI risk premia and domestic corporate bond spreads to Commonwealth Government Bonds.
Over a three-year contract period, Peloton delivered annual equity valuations which were employed in the client’s public financial reporting without any challenge or variation due to independent audit review.
Peloton also considered implied bid IRR’s associated with similar scale and risk PPP’s.
Detailed sensitivity analysis across a range of key variables was provided in the report to demonstrate the impact on equity value of changes in key input variables.
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