How to Assess Highly Regulated Infra Assets?

I'm trying to learn how to assess infra companies because I wanna eventually go to an infra fund, but I'm kind of confused as to how an investment analysis would work. For context, I'm approaching this from the typical expectation for a CIM in a PE interview, where you get thrown a CIM and are asked to provide a short walkthrough (maybe with PPT slides alongside it detailing the analysis) of your analysis, your rationale, etc. The reason I'm confused is because I'm having a hard time rationalizing how I'd demarcate the risks with say, something like a highly regulated generation or transmission asset that has returns that are sort of set in stone (maybe transmission is a better example in this case) since a good sum of their returns are contracted via things like PPAs (of course spot energy prices can be a consideration past PPA expiration, but I'm talking about the general risk analysis you perform when the interviewer asks you to 'give details' and such).

In essence, to make a long-winded question short, how do you go about assessing (regulated) infrastructure investments in a PE interview when it's a case study? There are sparse details as to how to do this online, unfortunately.

Comments (5)

  • Analyst 1 in IB - Cov
Jun 23, 2022 - 1:01am

analyst in IBD interviewing for associate position

Jun 23, 2022 - 3:55am
jenNberrys, what's your opinion? Comment below:

In the context of forming an investment thesis:

  • growth opportunities: diligence / explore where regulated capex could be spent, as would assume additional regulated capex spent = additional income earned
  • financial engineering: structuring the cap structure favorably when compared with regulated returns, here you can also take on additional backleverage risk at the holdco or revolver funding capex for example, and your returns here could be correlated to the delta between net financing cost and net equity return
  • market conditions: perhaps this regulated asset (say a transmission line per your example) connects what you believe will become highly congested parts of the grid, in this case you could perhaps assume an exit at an increased multiple (typically don't want to depend on this for returns but using as an example here) given increased importance of the asset or could go back to the first bullet and use this market assumption to justify future need for growth capex

Risks:

  • regulatory environment
  • credit risk of any counter parties in cap structure
  • supply chain disruptions
Most Helpful
Jun 23, 2022 - 8:41am
overandout, what's your opinion? Comment below:

Some other thoughts, using your transmission line example:

  • Demographics: It's true that regulated transmission lines have a regulatory rate of return, but that return is ultimately borne by a discrete set of customers. To use an extreme example, if I spend $1bn on a transmission line, and am expected to see a 10% yield on that annually (just as a random number), that's easy to do if the revenue is spread across 1m customers (that's $100 / year per person), and very difficult to do if the revenue is spread across 1 customer (that's $100m / year per person). For regulated assets, more often than not the key consideration from the regulator's perspective is customer rates. If customers see their electric bill double, they get angry and it becomes a political issue. So tying it back, you'd prefer to be in an area where you have a growing community vs a shrinking community, and (on the margin) a more affluent community.
  • Cost-cutting: Sticking with the concept that per-customer rates are what matter, the other component is opex. Are there opportunities to reduce operating expenses? Those are a pass-through to customers. If you can bring down operating expenses, it means that you bring down customer rates. If you bring down customer rates, it means you have more room to do new investment that receives a ROE, because the rate increases to earn that ROE are offset by the opex reductions, so you can do rate-neutral but cash flow-positive investment.
  • Capex deployment: To build on jenNberrys point, the name of the game in regulated assets is capex deployment. But you need something to spend on, so what is going to drive that? Maybe the area is seeing huge build out of renewables and so that is shifting the locus of generation which will require transmission expansion. Maybe the system is just old and requires a lot of replacement. Maybe there are some very discrete projects already planned but there is some degree of uncertainty around them.
  • Regulatory environment: Not every regulatory environment is the same. Some jurisdictions have much more favorable rules across a variety of measures including: commodity price pass-throughs, willingness to allow pass-through of administrative expenses, backward-looking vs. forward-looking rate setting (i.e., do they use last year's cumulative invested capital or next year's cumulative invested capital as the base for your earnings? Forward is better), frequency of rate cases, ability to do accelerated "rider" rate cases where you can just add annual investments to your earning base without a full hearing, etc...
  • Energy transition risks: Is there any risk that the asset your looking at could become stranded because of energy transition concerns? Maybe it is heavily serving a region that is seeing enormous growth of microgrids, which could be functionally similar to a negative demographic shift. Maybe you're looking at gas transmission in New Jersey when the state has said that new gas hook ups are banned. Or, maybe you think that your gas pipes will all need to be upgraded to move hydrogen so there is a huge investment opportunity. Maybe the utility running this transmission line has also been really forward thinking on integrating electric vehicle charging networks with some sort of regulatory backing.
  • Natural disaster risk: Is this transmission line in California, where wildfires have ravaged the state and transmission lines have been the cause, literally thrusting PG&E into bankruptcy and causing a state-wide insurance fund that has already been almost depleted? Is it in the gulf coast, where hurricanes tear down the system every couple of years, and you need to spend a bunch of money just repairing things, with no return allowed, but with an increase to customer rates? 

I'm sure there are others that I'm not thinking of this second, but those would be some key areas I would focus on.

Array
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  • Associate 3 in PE - LBOs
Jun 23, 2022 - 9:29am

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