Directors' valuation of the Investments portfolio

The Directors’ valuation remained stable at £1,244 million (2016: £1,220 million) despite £105 million being realised from divestments in the period. The number of projects in the portfolio increased from 69 to 71.

The Group invested £35 million (2016: £65 million) in new and existing projects. This reflected continued success in targeted sectors with three new projects included in the Directors’ valuation for the first time. Cash yield from distributions amounted to £53 million (2016: £64 million) as the portfolio continued to generate cash flow to the Group net of investment.

The business continued its strategy of maximising value through recycling equity from operationally proven projects, whilst preserving interests in strategic projects that offer opportunities to the wider Group. Two investments were sold or part sold during the year for £105 million. In June, the business disposed of its interests in one residential housing project at Carmendy, Florida for a cash consideration of £2 million. In December the Group made a 12.5% partial sale in Connect Plus, the company which operates the M25 orbital motorway, for a cash consideration of £103 million.

Unwind of discount at £97 million (2016: £90 million) is a function of moving the valuation date by a year with the result that future cash flows are discounted by one year less. Operational performance movements resulted in a £33 million increase in the value of the portfolio (2016: £61 million), consisting mainly of an increase of £106 million due to the change in Federal corporate income tax rates enacted in the US and a £56 million reduction due to the rise in the value of sterling. The remainder was due to a number of changes in cash flow forecasts, discount rates and economic assumptions.

The methodology used for the Directors’ valuation is unchanged, producing a valuation that reflects market value and which therefore changes with movements in the market. Cash flows for each project are forecast based on historical and present performance, future risks and macroeconomic forecasts and which factor in current market assumptions. These cash flows are then discounted using different discount rates based on the risk and maturity of individual projects and reflecting secondary market transaction experience. As in previous years, the Directors’ valuation may differ significantly from the accounting book value of investments shown in the financial statements, which are produced in accordance with International Financial Reporting Standards rather than using a discounted cash flow approach.

Demand for high-quality infrastructure investments in the secondary market continues to exceed supply and the Group will continue to sell investment assets timed to maximise value to shareholders. With the low interest rate environment likely to continue, the secondary market is expected to remain strong for the foreseeable future.

The Investments portfolio is split relatively evenly across the UK and North America (UK 51%, North America 49%). Within the UK portfolio roads is still the largest sector, despite the 12.5% partial sale of the Connect Plus M25 asset completed in 2017, whilst in North America US military housing dominates the portfolio. The Investments portfolio includes over £1 billion of projects that have completed the construction phase and are now operational.


Movement in Directors’ valuation

 

2016

Equity invested

Distributions received

Sales proceeds

Unwind of discount

New project wins

Gain on sales

Operational performance gains (inc. FX movements)

2017

UK5

707

6

(21)

(103)

56

3

(12)

636

North America

513

29

(32)

(2)

41

14

45

608

Total5

1,220

35

(53)

(105)

97

14

3

33

1,244

 

UK portfolio

In 2017 £6 million of equity was invested across four projects in the portfolio: the student accommodation project at Foundry Court in Glasgow; the regeneration development at East Wick & Sweetwater; and the biomass projects Birmingham Bio Power and Welland Bio Power.

During the year, there was a partial sale of 12.5% of the Connect Plus M25 project which generated proceeds of £103 million, above the Directors’ valuation of the asset. The Group agreed the sale of a further 7.5% on 29 December 2017 for £62 million, reducing its interest in the asset to 20% at the year end. The proceeds from this sale were received in February 2018 and so are included in the Directors’ valuation at year end.

In aggregate operational performance movements resulted in a £12 million reduction in value arising from the net effect of a number of changes to assumptions including higher short-term inflation rates, lower short-term interest rates, higher discount rates on projects where the risk is assumed to have increased and revised cash flow forecasts for certain projects.

Discount rates applied to the UK portfolio range between 7% and 12% depending on project risk and maturity. The implied weighted average discount rate for the UK portfolio is 8.5% (2016: 8.3%). A 1% change in discount rate would change the value of the UK portfolio by approximately £62 million.

Consistent with other infrastructure funds, Balfour Beatty’s experience is that there is limited correlation between the discount rates used to value PPP (and similar infrastructure investments) and long-term interest rates. In the event that interest rates increase in response to rising inflation, the impact of any increase in discount rates would be mitigated by the positive correlation between the value of the UK portfolio and changes in inflation.

Following on from the OECD BEPS project’s recommendations, the UK Government passed legislation in 2017 restricting the tax deductibility of interest expense. The legislation is complex and its application in certain areas will require further clarification, but the current assessment is that the impact on the Directors’ valuation is not material.

In 2017, the business won three projects: two investments in private rental housing portfolios at Wilmington in North Carolina and Atlanta in Georgia; and a student accommodation project for Purdue University in Indiana.

Investment of £29 million was made during the period in three existing and two new projects: two hospital projects in Canada and a student accommodation project at the University of Texas; and the two stakes acquired in private rental housing portfolios in Atlanta and Wilmington. Carmendy Square, Florida, was sold in the period, generating a net £2 million in proceeds.

Operational performance movements resulted in a £45 million increase in the value of the portfolio, consisting of an increase of £106 million due to the change in Federal corporate income tax rates enacted in the US, a £56 million reduction due to the strengthening of sterling against the US dollar and a £5 million reduction due to revised cash flow forecasts for certain projects.

Discount rates applied to the North American portfolio range between 7.5% and 10%. The implied weighted average discount rate is 8.2% (2016: 8.2%) and a 1% change in the discount rate would change the value of the North American portfolio by approximately £84 million.

Under the Tax Cuts and Jobs Act passed by the US Government in December 2017 there are provisions to restrict the tax deductibility of interest expense. The provisions are complex and their application requires clarification in a number of areas, but the initial assessment is that the restriction will not have a material effect on the Directors’ valuation. The Group will monitor the application of the rules and any forthcoming guidance.

For more information, see pages 26-28 of the 2017 Annual Report.