Water tension
Write-downs and the long run
There was an interesting story in the FT and elsewhere recently about the Universities Superannuation Scheme writing down the value of its holding in the unlisted Thames Water (or rather in the parent company Kemble Water). This follows a similar smaller writedown by OMERS.
This is not really surprising. I’ve been struck listening recently to investors who have exposure to the sector that they say that the reality of what they own looks very different to what they thought they were buying. The FT quotes a consultant making this point with a bit less sympathy: the risks were always there, they were just under-appreciated.
It’s notable how far we are from industry talking points around the time of the 2019 election, when nationalisation seemed like a credible threat. Then public ownership of utilities was characterised as a risk to public sector workers pensions. Thames Water has proved that private ownership can create risks of its own to those same pension funds.
This example has also demonstrated the muddle of different interests at play between companies, investors and other stakeholders. One of my favourite lines on this subject - because it is obvious nonsense - comes from a McKinsey article on long-termism in HBR from over a decade back:
“[I]n truth there was never any inherent tension between creating value and serving the interests of employees, suppliers, customers, creditors, and communities, and proponents of value maximization have always insisted that it is long-term value that has to be maximized.”1
The big sell of investing in real assets is something similar: that it contributes to renewal of vital infrastructure, and sustainability, as well as generating a decent return. But in Thames Water’s case it has been made clear that generating a decent return actually comes higher up the priority list than other concerns, to the extent that the company has called for a cap on environmental fines and an increase in permissible returns in order to give investors confidence.
The counterposing of the payment of fines and the need to generate returns might look like the type of inherent tension that the HBR articles says does not and never did exist. Perhaps that is because we’re just not looking long-term enough [insert the obligatory line from Keynes here]. One point worth considering is to what extent the writedown is significant for some investors. After all, if pension funds are in the business of long-term ownership of infrastructure, and therefore principally interested in stable income, a notional market value perhaps becomes less important - provided that the business can be put back on an even keel.
However it seems likely that any investor with a more limited expected holding period will see things quite differently. Brett Christophers has a very clear take on this in Our Lives in Their Portfolios:
For all asset managers' and institutional investors' pervasive rhetoric of real assets being an asset class favoured specifically for the stable and predictable income flows they generate, such flows ultimately - and perhaps paradoxically - are not how most housing and infrastructure funds mainly make money. How could they be, if assets are only ever held for a few years (and, in some cases, even just a few months)?
This is not to say that these income flows are unimportant. On the contrary, they are indispensable. But their significance lies less in their substance as actual fund earnings than in the signal that they send to the market. They are, in short, more a means to an end than an end in itself... But the end is clear, and crucial: to maximise the disposal consideration.
The wealth that, say, housing rents or road tolls directly create for a closed-end fund manager and its limited partners while the housing or road is under the manager's control is largely incidental. The reality is that the flows of income generated by a portfolio asset create wealth for investors in such a fund primarily indirectly - specifically, by persuading third parties that the asset is worth buying, and at a premium price. This reality is structurally rooted in the closed-end model.
The ceaseless churn of assets substantiates this reality. And so also do relevant data. Andonov and his co-authors, for example, expressly asked the question: What principally drives the returns generated by closed-end infrastructure funds - dividend yields or asset sales? The answer was asset sales. Indeed, the utter triviality of yields (i.e., recurring income) qua yields was underlined by the authors' analysis of the significance of speed of exit from a fund's investments. They found strong evidence that, the quicker the exit, the more beneficial the impact on fund returns, the positive relation between performance and exit rates being driven mainly by 'relatively quick exits within the first 5 years after the investment date.
In the case of numerous infrastructure assets the shareholding is split between pension funds with a notionally open-ended commitment and asset managers running closed-end funds for whom quick, profitable sales are good for the IRR. This is not to argue that one approach is superior to the other, but rather that perhaps not even all investors are on the same page.
Once again we might be tempted to think we see an inherent tension. That is why, as always, we must look to the long-term future. Things are much simpler there.
Here’s the whole section of the article for completeness (let’s leave aside for the mischaracterisation of shareholders as ‘owners’ of companies): “The inspiration for shareholder-value maximization, an idea that took hold in the 1970s and 1980s, was reasonable: Without some overarching financial goal with which to guide and gauge a firm’s performance, critics feared, managers could divert corporate resources to serve their own interests rather than the owners’. In fact, in the absence of concrete targets, management might become an exercise in politics and stakeholder engagement an excuse for inefficiency. Although this thinking was quickly caricatured in popular culture as the doctrine of “greed is good,” and was further tarnished by some companies’ destructive practices in its name, in truth there was never any inherent tension between creating value and serving the interests of employees, suppliers, customers, creditors, communities, and the environment. Indeed, thoughtful advocates of value maximization have always insisted that it is long-term value that has to be maximized.”