Directors' valuation of the Investments portfolio

Infrastructure Investments

Financial review

The Investments business delivered another strong performance, having continued its strategy of optimising value through the disposal of mature assets, whilst also continuing to invest in new opportunities and expanding the breadth of assets.

During the year Investments made significant progress in simplifying its operations by exiting Balfour Beatty Infrastructure Partners (BBIP), an infrastructure fund run at arm’s length and focused on secondary opportunities, and exiting from the Australian market.

In total 16 assets were either sold or part sold in the period, with all transactions either at, or above, the Directors’ valuation. Underlying profit from operations at £89 million (2015: £132 million) was lower than the prior year, predominantly due to a reduction in profit on disposals as a different mix of assets was sold. Despite an increase in proceeds to £189 million (2015: £145 million) the reduction in profit on disposals reflected the accounting profile of the assets sold in 2016. Pre-disposals underlying operating profit decreased to £24 million (2015: £37 million) due to lost income from previous disposals. Net interest income remained broadly consistent year on year at £26 million (2015: £29 million). The lower underlying profit from operations resulted in a lower profit before tax at £115 million (2015: £161 million).

¹ before non-underlying items (Note 8).

² subordinated debt interest receivable and net interest receivable on PPP financial assets and non-recourse borrowings.

Operational review

The Investments business continued to grow with four wins on new projects where equity will be invested, comprising: three private rental housing projects and one data centre project. In addition, the Investments business was appointed as third-party manager on two fee-based projects located in Pennsylvania and Florida. In these fee-based projects no equity will be invested.

In the private rented and regeneration sector, the North American business continues to expand and successfully acquired a stake in two private rental housing projects in Mobile, Alabama and Atlanta, Georgia. The Mobile portfolio consists of three properties totalling 320 units and the Atlanta property consists of 437 units. Balfour Beatty Communities will perform property management services for the properties, leveraging its existing capabilities. In the UK the business acquired its first private development site at Manchester New Cross. This project will provide a number of units to the private rented housing sector and construction is expected to begin following financial close in 2017. The Investments business also won a data centre project in Ontario, Canada.

The project is located on the Canadian Forces Base in Borden, Ontario and covers the design and construction, financing and maintenance for a new 10,000m² data centre.

Financial close was reached on seven projects: a primary care centres project in Ireland; a student accommodation project in Glasgow; an offshore transmission project in the North Sea; an energy from waste facility in Gloucestershire; the two US private rental housing projects; and the data centre in Canada. Five projects have not yet reached financial close.

The Investments business continued to make substantial equity investments in the portfolio, with £65 million invested in the period (2015: £102 million), of which £8 million was invested in the BBIP infrastructure fund before its sale.

Interests in 16 assets were sold in the period, seven of which were partial sales, generating total book gains on disposal of £65 million (2015: £95 million from four assets).

The Investments business continues to see significant opportunities for future investment in its core geographic markets in the UK and North America, across its existing market sectors and as it continues to grow into new adjacent sectors. The business continues to monitor both the US and UK PPP markets for opportunities, especially following the recent announcements regarding PF2 in the UK and by the new administration in the US.

Directors’ valuation

The Directors’ valuation was broadly maintained at £1,220 million (2015: £1,244 million) despite material disposals in the period, as the number of projects in the portfolio decreased from 73 to 69. Two of these projects, Houston Baptist University in Texas and West Florida University, were won in previous years and have now been included in the project count at December 2015.

The Group continued to make substantial investments, with £65 million invested in new and existing projects. This reflected continued success in targeted sectors with four new projects included in the Directors’ valuation for the first time.

The business continued its strategy of realising value through recycling equity from mature, operationally proven assets, whilst preserving interests in strategic projects that offer opportunities to the wider Group. 16 investments were sold or part sold during the year, including the Group’s interest in the fund managed by Balfour Beatty Infrastructure Partners (BBIP). In total these sales generated £189 million in proceeds. All sales were transacted either at, or above, the Directors’ valuation. Cash yield from distributions amounted to £64 million (2015: £82 million). The portfolio again generated cash flow to the Group net of investment.

The methodology used for the Directors’ valuation is unchanged, producing a valuation that more closely 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.

UK portfolio

In 2016 £57 million of equity investment was made in projects across the portfolio: in the student accommodation project at Aberystwyth University; the Ayrshire & Arran community hospital; the regeneration development at Eastwick & Sweetwater; and waste projects at Gloucester and Welland. One new project, a property development at New Cross in Manchester, has been added to the UK portfolio.

Demand for high-quality infrastructure investments in the secondary market remained strong and the Group took advantage of this through further sales of mature assets. Investor appetite for yield in the ongoing, low interest rate environment continues unabated and pricing in the secondary market is therefore expected to remain strong for the foreseeable future.

Interests in 16 assets were sold in the period, seven of which were partial sales, generating total book gains on disposal of £65 million (2015: £95 million from four assets). The business sold its entire 50% interest in the Wollongong project in Australia, a 30% interest in the M1/A1 project (where the Group retains a 20% interest), a 40% interest in the Humber Gateway OFTO (where the Group retains a 20% interest), its entire interest in the BSF portfolio comprised of seven schools projects and an 80% interest in five street lighting projects (where the Group retains a 20% interest). The Group’s interest in Balfour Beatty Infrastructure Partners

(BBIP), which was included in the Directors’ valuation but not as a line item in the project total, was sold during the year. All disposals were either at, or above, the Directors’ valuation.

Operational performance movements resulted in a £27 million reduction in value. The most significant components of this were lower inflation, lower forecast deposit interest rates, and an increase in the assumed tax burden for potential purchasers. The operational movement reflects lower inflation in 2016 followed by a step-up in 2017 before reaching a 3% long-term assumption in 2018. The change to interest rates incorporates a lowering of the long-term rate to 2% as a consequence of the Bank of England’s 0.25% reduction in base rates in the second half of 2016. In line with government announcements in the year the corporation tax rate has been further reduced from a long-term rate of 18% to 17% from April 2020.

Discount rates applied to the UK portfolio range between 7% and 14% depending on project risk and maturity. The implied weighted average discount rate for the UK portfolio is 8.3% (2015: 8.3%). The impact of selling mature assets has been offset by a number of investments moving from construction to operations phase. A 1% change in discount rate would change the value of the UK portfolio by approximately £80 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 increased 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 on the tax deductibility of interest expense in 2015, HM Treasury and HM Revenue and Customs issued their consultation on policy design and implementation in May 2016 and published detailed draft legislation in early 2017.

The draft legislation preserves the concept of the public infrastructure exemption put forward by the OECD and also includes other helpful measures to protect such projects. The proposals and their application are complex and remain subject to further review, but the initial assessment is that the impact on the Directors’ valuation will not be material. Balfour Beatty will remain engaged with the UK Government to clarify and evaluate the impact of the draft legislation.

North American portfolio

In 2016, the business won three projects, two investments in residential housing developments at Mobile in Alabama and Atlanta in Georgia and a PPP data centre in Borden, Canada. In addition, a second phase of the project at University of Texas, Dallas has been included in the Directors’ valuation.

Operational performance movements resulted in an £88 million increase in the value of the portfolio, of which £85 million was due to the fall in the value of sterling.

Discount rates applied to the North American portfolio range between 7.5% and 10%. The implied weighted average discount rate is 8.2% (2015: 8.2%) and a 1% change in the discount would change the value of the North American portfolio by approximately £72 million.