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 of the perception and price of the risks of such investments by the market?
Illiquid assets have a market price
Like long-term bonds, infrastructure is often associated with hedging or matching liability risks, especially for pension plans. 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 investment like infrastructure companies tend to have a “stale” pricing problem. It is difficult to find recent and comparable transactions because each infrastructure is rather unique. Discount rates used to value these companies are typically ad hoc and very “smooth” i.e., they do not change much year on year. Effectively, many investors have been marking unlisted infrastructure companies at or close to historical cost.
But in the case of airports, continuing to use the same discount rate in 2020 annual reports that were used in 2019 is clearly wrong.
Risk of airport cash flows has increased
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%.
However, this is 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, the perceived riskiness of these cash flows by markets definitely has. It is unavoidable that the risk premia used to discount the future cash flows of airports has increased.
In the Q1 2021 release of the EDHECinfra data, the average risk premia of the unlisted airport universe has increased by an estimated 230bps since the beginning of 2020. It follows that, even if risk-free rates have decreased somewhat, discount rates are higher and fair market prices must be lower.
Don’t wait for 2025
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.