Plotting a soft landing

Alternatives have taken a beating over the past two years. We may not be through the shoals yet but some trusts offer both upside potential and downside protection…by David Kimberley

 
The announcement on Friday morning that Round Hill Music (RHM) had received a takeover bid at a 67% premium to its share price, with the caveat that this was still an 11% discount to NAV, followed up on a couple of other pieces of good news flow for the alternatives space.

Earlier in the week, Caledonia Investments (CLDN) announced the sale of its stake in retail investment platform 7IM to Ontario Teachers’ Pension Plan Board. The sale was at a c. 31% uplift to the carrying value as 31/07/2023, according to analysts at JP Morgan.

HgCapital (HGT) and Literacy Capital (BOOK) also announced sales this week. In both instances these were at substantial premiums to the carrying value of the assets being sold.

Discounts in the alternatives sector have widened significantly over the past couple of years. This has centred around rate hikes, with investors finding bonds more attractive and uncertainties arising around valuations and high levels of debt that are often used to fund acquisitions.

This week’s asset sales and the proposed acquisition of RHM may provide some validation of valuations in the market. However, the volume of deal flow in the sector is still comparatively low and it is too early to tell whether investors can really say we’re past the worst of it.

Nonetheless, if we are at the end of the rate hiking cycle and achieve that much vaunted ‘soft landing’, then it’s plausible that we’ll see discounts tighten again across the sector. That is clearly a big ‘if’ but there are arguably some ways to play that potential rebound, which also offer a level of downside protection.

For example, BBGI Global Infrastructure (BBGI), trading at a 7.0% discount as at 08/09/2023, invests solely in availability-based assets that are backed by government or government-backed counterparties. Availability-based assets, which includes things like hospitals or schools, are paid for so long as they can be used. As a result, the revenues they generate are not dependent on usage.

As we noted in our analysis of the trust’s latest results, BBGI has a mechanical form of inflation-linkage with the contracts it forms. When inflation rises, the trust’s revenues rise. It then mirrors those contracts with its subcontractors, mitigating the risk that they’ll increase their fees in excess of the amount BBGI receives from its counterparties.

Loans that the trust takes out to fund acquisitions are largely fixed rate and then amortised over project lifespans. Indeed, of the 56 projects the trust is invested in, only one is subject to refinancing risk – and even here the managers have hedged out their base rate exposure.

What this means is that BBGI offers a secure, growing dividend, which is backed by high quality counterparties. The risk of inflation rising is mitigated by the contracts the trust takes out. The availability-based assets they invest in are also not subject to the price elasticity of demand, so an economic downturn would not dampen revenues.

The story is somewhat similar with Greencoat UK Wind (UKW), which is currently trading at a 16.3% discount as at 08/09/2023. Like BBGI, UKW has inflation-linked contracts and has proven extremely cash generative since its IPO in 2013, enabling the managers to reinvest and grow the trust’s NAV.

The trust’s latest results also include a range of scenarios that should provide reassurance to investors. For instance, even if inflation continues to run at a high level and the power price fell by 90% compared to the average price in July 2023, the trust’s dividend would be secure.

The trust’s current discount rate implies a NAV net annual total return of 10% for shareholders. However, this rises to 12% if you factor in the current discount at which the trust is trading.

Although they both offer a level of downside protection, it’s entirely plausible further macro volatility would crimp returns for both UKW and BBGI in the short term. However, if they continue to prove that they can withstand the impact of higher rates and inflation, then it’s plausible investors will ultimately take note and we’ll see discounts tighten.

On the other hand, a soft landing and the end of the rate hiking cycle would also prove beneficial, with investors likely looking again for the sorts of secure, growing dividends that both trusts offer.
 

 

Disclaimer

This is not substantive investment research or a research recommendation, as it does not constitute substantive research or analysis. This material should be considered as general market commentary.