Darryl Murphy assesses the current state of the UK infrastructure market and the likely drivers of activity in 2022.
Read this article to understand:
- An overview of the key drivers of infrastructure deal activity in 2021
- Why we expect a wide range of activity in 2022, but this won’t lead to materially higher volumes
- The likelihood of a pivot away from deals to support the post-COVID recovery to those helping the UK meet its net-zero ambitions
You cannot connect the dots looking forward; you can only connect them looking backwards. So you will have to trust that the dots will somehow connect in your future…
Rewind to the start of 2021; it promised to be a year we would slowly but surely move towards a post-COVID-19 world in our personal and working lives. One year on, there is an air of Groundhog Day as we remain under guidance to work from home with continued uncertainty as to when we will be firmly past the influence of COVID-19 on our lives.
The feeling we have been here before extends to the infrastructure market too, with activity continuing to be based around investment to stimulate the post-COVID economic recovery and support the UK’s pathway to net-zero emissions by 2050.
Connecting the dots in 2021
The most striking feature of activity in 2021 was that most of the largest deals closed in the final quarter. It may be coincidental, but this was a period when most people were working at least a few days a week in the office. It will be interesting to see whether the reverse happens if working from home continues for some time.
At a portfolio management level, demand-based transport projects – airports, toll roads and ferries – continued to face challenges. Despite this, asset performance remained strong, albeit in some cases due to the long-term commitment investors have made towards the recovery of these assets, particularly in the airport sector.
Based on available data, deal activity in 2021 was slightly down on the previous year, with debt volumes of around £17 billion.1 This total is adjusted to exclude short-term corporate revolving credit facilities, additional facilities for regulated utilities and a growing trend in extending credit facilities to infrastructure equity funds, all of which seems to support commercial bank activity but is less suitable for institutional investors.
Interestingly, there were far fewer deals last year, with around 45 closing compared to 62 in 2020 and 87 in 2019. This continues a trend that has been evident over the past six years. It is difficult to provide a simple explanation but is likely to be due to a combination of the demise of public-private partnerships (PPP), many assets ending up in the hands of investors with long-term capital structures, the impact of COVID-19, and a slowdown in small-scale renewable investment caused by the move to a subsidy free market, with limited Contract-for-Differences (CfD) auctions.
Around £10 billion came from mega deals – the refinancing of the Viridor and Enfinium waste-to-energy acquisition facilities, the Thameslink rolling stock refinancing delayed from early 2020, the Hornsea OFTO (offshore transmission owner) and the third part of the Dogger Bank offshore windfarm, which retained the asset’s place as the largest deal of the year for the second year running.
Borrowers are enjoying greater pricing and terms leverage
The abundance of liquidity in the market was evident across all these deals. With lenders scaled back materially on an individual deal basis, borrowers are enjoying greater leverage on both pricing and terms to get the best deal for equity investors.
Large-scale M&A activity was patchy, the largest deal being the acquisition of Western Power Distribution by National Grid ahead of several infrastructure funds. This points to the perceived value in distribution companies and their role in the energy transition to net zero. Another noteworthy transaction was the acquisition of John Laing by US private equity giant KKR to support its strategic move from PPP development to wider economic infrastructure. Digital activity remained high, with several processes in the fibre broadband market and the £1.4 billion acquisition of smart meter provider Calisen by a consortium including Blackrock, Goldman Sachs and the Abu Dhabi sovereign wealth fund Mubadala Investment.
There were also secondary sales of stakes in a range of assets in the regulated utility sector, rolling stock companies and renewables. The highest-profile transaction not to happen was the PD Ports sale, when the owners Brookfield decided to hold on to the asset in a process that hit the headlines due to the involvement of the Tees Valley Mayor with one of the bidding consortia.
Aside from the successful continuation of the OFTO programme, which will see two further assets heading to financial close in 2022, East Anglia and Triton Knoll, the largest transactions were actually conceived in 2019 or 2020 but were either delayed or refinanced.
What lies in store for 2022?
The past twelve months saw the emergence of macroeconomic factors that could have a more profound influence on infrastructure in future, namely rising inflation, the start of increasing base interest rates, supply-chain challenges and the dramatic increase in gas prices. These are all set to be features of 2022, which for some investors may represent increased asset valuations but may also put negative stress on the cost of delivery for assets immediately ahead or in the construction phase.
We expect the wide range of activity to continue during 2022
Looking ahead to 2022, we expect the wide range of activity to continue, although it is unlikely this will translate into materially higher volumes. This begs the question: did the UK market hit its high-water mark pre-COVID, when debt volumes were in excess of £30 billion?
One key underlying trend behind the data is the limited amount of greenfield investment. In 2021, the rollout of fibre broadband dominated new infrastructure activity, while beyond the Dogger Bank offshore wind deal, we saw limited greenfield renewable activity other than a number of new energy-from-waste plants reaching financial close.
In the absence of PPP, there was limited investment in new social infrastructure beyond a few student accommodation assets. This trend does not seem to concern the government, although data is difficult to source to compare investment into new assets from public borrowing.
We should see the return of private investment into social infrastructure in 2022 in Wales
We should at least see the return of private investment into social infrastructure in 2022 in Wales through the mutual investment model, with the first deals in the schools’ programme reaching financial close and the Velindre Hospital reaching the tender stage.
We may also see selective refinancings of PPP assets from sponsors seeking to maximise value. Sponsors will continue to consider the hand-back arrangements with public authorities as the early PFI/PPP deals come towards the end of their contract period. Although the majority of contracts will expire later in the decade, we are already seeing the need to consider appropriate arrangements well in advance.
The increased focus on net zero will require significant private capital. As stated in the government’s Net Zero Strategy paper published in 20212, the majority of the estimated £50-60 billion of increased annual investment needed over the next ten years is expected to come from the private sector. Nevertheless, the impact on 2022 deal activity is likely to be muted; the pivoting of the market towards net zero is likely to take a few years before it becomes readily apparent.
As highlighted in my recent article3, much of the additional investment is required in sectors that involve early-stage technology or in markets where there is no defined demand. This will require financial investors to work collectively with industrial sponsors and the government to transform these markets from early-stage to mature technologies.
While the scale and urgency of the task is significant, change will not happen overnight. Investors will need to be patient and spend the necessary time to understand the risk-return dynamics. However, we should see real progress in new markets such as carbon capture and storage and electric-vehicle charging, and nuclear power’s return to prominence with Sizewell C formally coming to market.
In terms of more readily identifiable transactions supporting net zero, electricity interconnectors utilising regulatory support should reach financial close in 2022 via the first project-financed transactions under the UK cap and floor regime.
Five themes to shape the market (reprise)
In my outlook article for 20214, I highlighted five themes that would shape the market; perhaps not surprisingly, these should remain the primary drivers of activity, but we have updated how these will evolve in 2022.
1. Recovery from COVID-19
Although we had hoped this would be less relevant for 2022, it continues to impact assets in the transport sector. Airports remain the most acutely affected and the recovery remains long and slow. We remain optimistic these assets will recover steadily and, as predicted last year, we should see refinancing opportunities and sales processes in 2022 for investors willing to take a longer-term view on the value of these assets.
2. Growth of the UKIB
The formation of the UK Infrastructure Bank (UKIB), the decision to base its head office in Leeds and the appointment of John Flint as its CEO were significant announcements in 2021. A more-detailed strategy is expected from UKIB in 2022 but it has already made three investments into Tees South Bank Quay, the Next Energy subsidy free energy fund and the Gigaclear fibre debt financing. Given its clear policy to crowd in, not crowd out, private capital, these first investments provide a guide to where there is a lack of appetite, notwithstanding excess capital in the market.
UKIB could play a critical role in helping investors access emerging technologies and markets
UKIB could play a critical role in helping investors access emerging technologies and markets resulting from the strategy to net zero, although the details on how this will happen need to be developed through engagement between the bank and private investors over the course of 2022.
3. Net zero gets real
Last year was defined by the publication of various strategy and policy documents by the government in advance of the historic COP26 event in Glasgow. The key focus for investors is on delivery and granular details as to how the government’s interim net-zero targets will be met.
This time last year, we predicted the return of mainstream renewables through the fourth CfD auction; however, this was delayed and awards are now set to be made later into 2022. The successful assets may start to seek investment in 2022, although many of these are more likely to close in 2023.
As discussed above, the emergence of new technologies is not likely to lead to large volumes, but we should see growth in various sectors. Aside from electricity generation, the development of low-carbon transport continues. In addition to EV charging, we are also beginning to see wider interest in hydrogen trains and E-buses that could lead to deal activity in the next 12 months.
4. Fibre 2.0
Fibre continued to dominate 2021, with numerous alternative networks (alt-nets) in the market for financing and investment. We saw the first signs of increased competition, with various announcements from Openreach on discounting and the growth of some alt-nets into wholesale platforms. Alt-nets are estimated to invest around £12 billion in full-fibre connectivity from 2021 to the end of 2025 according to the Independent Networks Cooperative Association’s latest market report; as such, investor appetite will remain focused on this sector.
5. Regulation to competition
In 2021, we continued to see scrutiny on water companies and their investments in leakage, flooding and pollution. Investment continued from infrastructure funds, most notably the acquisition of a majority stake in Southern Water by Macquarie.
Investor appetite will remained focused on fibre broadband
The first Direct Procurement for Customers regime will take an increased focus given its role in supporting large-scale capital investment to water companies from third-party investors. The first scheme, Haweswater Aqueduct for United Utilities, should finally hit the market in 2022.
Same same, but different
This year may start with a familiar feel, but it is ultimately likely to be defined by how far the market pivots from the COVID recovery to the delivery of capital towards net zero. While the latter theme is not likely to immediately push activity dramatically higher from the historically low levels witnessed in 2021, its influence should provide a huge boost for the market over the longer term.