This article was originally published in the Wall Street Journal in April 2021.
The impact of Covid-19 lockdowns on the airport sector highlights a dilemma about how investors approach the valuation of private, illiquid infrastructure assets. On the one hand, there has been a clear, large shock to the revenues of airports that cannot leave the value of these companies unchanged. On the other hand, airports must retain some value because they are expected to pay dividends for another 30 or 50 years, and so losing a few quarters of revenue may not be that material.
Some will consider that, because airports are long-term illiquid investments, like the vast majority of other infrastructure assets, short-term events need not be taken into account. But is this a reasonable and coherent position if such events lead to a significant reassessment by the market of the perception and price of the risks of such investments? Like long-term bonds, infrastructure is often associated with hedging or matching liability risks, especially for pension plans.
“Investors should not wait for 2025 to find out how much they lost due to Covid-19. Booking that loss then could be even more painful.”
It seems difficult to accept that bonds should be valued as a function of the risks to which they are exposed, while unlisted infrastructure assets are not, even if it is more difficult to do. Indeed, private illiquid investments such as infrastructure companies tend to have a ‘stale’ pricing problem. It is difficult to find recent and comparable transactions, because each infrastructure tends to be unique. Discount rates used to value these companies are typically ad hoc and very ‘smooth’: they do not change much year-on-year. Effectively, many investors have been marking unlisted infrastructure companies at, or close to, historical cost.
But continuing to use the same discount rate in 2020 annual reports as in 2019 is clearly wrong in the case of airports.
“Being a long-term, buy-and-hold investor does not change the reality that all financial assets create risks of losses,” says Frédéric Blanc-Brude, Director of EDHECinfra. “Future cash flows may be paid over a long period, but knowing their present market value is necessary to ensure prudent and compliant risk management. Even if the short-term volatility of infrastructure investments is not a concern for long-term investors, their prudential and fiduciary responsibilities require them to conduct impairment tests and to know the liquidation value of their assets. Long-term investment should not mean blind investment.”
Say the fair market value of an airport is the discounted sum of all future dividend payouts using the latest market price of the risk of these cash flows. The sum of future dividends is now lower in airports because fewer dividends are going to be paid for at least a couple of years. The latest estimate is that the sum total (before discounting) of all future dividends in the EDHECinfra airports index, which tracks 27 major airports, has decreased by about 5 percent. The estimate is based on traffic levels returning to their long-term path within two to three years, says Mr. Blanc-Brude; permanently lower passenger numbers would reduce future dividends more than 5 percent.
However, this represents only half of the equation: these cash flows are now more uncertain than they used to be. First, the risk of default in airports has increased, as has the risk of bankruptcy. Second, exactly when airports will return to a normal state of operation is currently unknown. Future business and financial conditions for airports are equally fuzzy.
In other words, while the future cash flows may not have changed significantly, their riskiness as perceived by markets definitely has. It is unavoidable that the risk premia used to discount the future cash flows of airports has increased.
In the Q4 2020 release of the EDHECinfra data, the average risk premia of the unlisted airport universe has increased by an estimated 300 basis points (bps) in 2020. It follows that, even if risk-free rates have decreased somewhat, discount rates are higher and fair market prices must be lower.
Investors should not wait for 2025 to find out how much they lost due to Covid-19. Booking that loss then could be even more painful. For pension plans in particular, ignoring this shock increases the risk of future funding shortfalls, says Mr. Blanc-Brude. He adds: “They should book the losses now instead of waiting to find out that the value on their book does not correspond to reality in the future, when plan members will need the money.”