Investment trust insider on discount rates – James Carthew: Rising discount rates could make loan terms a problem for ‘alt’ funds
Alternative assets have been the fastest growing part of the investment companies’ sector for many years now. At first, the real excitement was about hedge funds and funds of hedge funds (which largely came and went as their returns disappointed in the financial crash), but in March 2006, the idea of using alternative assets as a source of income really got going with the launch of HICL Infrastructure (HICL). Renewable energy funds didn’t get going until 2013, but since then the closed-end funds industry has been increasingly innovative.
All these funds are valued by discounting their predicted cashflows into a net present value. Those cashflows stretch out for many years into the future.
The infrastructure funds started off by focusing on UK PFI/PPP type assets – things like schools, hospitals and prisons, where the counterparty to the contracts tended to be the government or a government-backed entity. Investors were attracted by the returns that these offered compared to equivalent long-dated UK government bonds.
In HICL’s first accounts to end March 2007, the weighted average discount rate used to set the net asset value (NAV) of the portfolio was 7% and the UK 20-year gilt yield at that time was about 4.7%. One year later, the gilt yield had not much changed but the weighted average discount rate had risen to 7.5%.
The uplift reflected a change in the mix of investments; each investment is valued individually based on an assessment of risk. Projects under construction are riskier and attract higher discount rates, for example. The degree of leverage (debt) makes a difference too.
Remarkably, perhaps… read more here