Brent Sheather: If it's fashionable, it might not be profitable

The Brisbane tunnel was expected to make huge profits. Photo / David McKelvey

One of the most perplexing things about the financial markets is their propensity for misrepresentation. I'm not talking here about dodgy advisers or the crash you don't see coming.

They are bad enough, but there are more frequent mini-disasters where savings are lost because individual sectors, such as property, masquerade as being one thing when in reality they are just the opposite.

Examples of this perverse behaviour abound. Not long ago AAA-rated collateralised debt obligations were thought to be super-safe. But then the US housing market surprised everyone and many CDOs turned out to be worthless.

In 1999, tech stocks promised super-charged growth but failed to deliver. In 1930s Germany, the whole risk-return dimension of assets was turned on its head when hyperinflation made cash in the bank worthless and yet shares held their value. The list goes on and on.

This week's article is about a recent misrepresentation which has cost investors about A$1.4 billion ($1.85 billion) - so far.

Today's topic concerns an ostensibly low-risk infrastructure investment and how equity investors in the Australian IPO of the venture have lost 99 per cent of their money. The project was promoted as "a unique opportunity to invest in Queensland's first privately owned toll road".

More than 10,000 investors bought 734 million shares for A$1 each in 2006 in the expectation of high yields and low risk. However, today the object of that speculation is quoted on the Australian Stock Exchange at just 1.1 cent per share.

How could this happen and are there lessons to be learned from this series of unfortunate events?

Let's step back in time to 2006. Back then optimism was abundant, risk-aversion was nowhere to be seen and interest rates for risky ventures were, with the benefit of hindsight, lower than they should have been.

Investors craved income: the poorly advised bought finance company debentures, whereas those in the know bought high-yielding infrastructure funds. These vehicles promised higher levels of income than bank deposits for little more risk with some growth chucked in for nothing.

The fad really caught on in Australia and the infrastructure mania washed over these shores as well. A large number of infrastructure vehicles listed on the ASX. Toll roads, tunnels, gas pipelines, electricity distribution - all these intrinsically safe-seeming businesses were eagerly bought by investors and marketed by advisers.

But lurking beneath the glossy pictures of toll roads and pipelines were significant risk factors. Because these vehicles were externally managed, the manager was incentivised to earn as much in fees as possible by making the funds as big as possible.

That meant taking on lots of debt. Debt has the unfortunate characteristic that if you pile on enough of it you can turn even the lowest-risk asset into a high-risk asset.

Mum and Dad and their advisers looked at the stable demand characteristics of infrastructure and the 8 per cent yield. What they didn't pay so much attention to was the financial gearing - the size of the debt on the balance sheet.

The sad case at hand concerns Rivercity Motorway Group (RCY) which, in 2006, was awarded a 45-year licence to build and operate Brisbane's "exciting new A$2 billion north-south bypass tunnel" under the dirty Brisbane river.

Unlike the river, RCY looked attractive - forecast demand for the tunnel was underpinned "by its central position in southeast Queensland, which is the fastest-growing region in Australia".

Various forecasts predicted increasing traffic congestion in Brisbane. So far so good.

But, ominously, RCY began life with A$724 million in equity and A$1.4 billion in debt.

Infrastructure is particularly susceptible to financial gearing because, in many cases, the returns to investors are regulated by the government. So the only way to get high returns, then, is to borrow.

I have been a long-suffering shareholder in a listed-UK infrastructure fund which owns hospitals and the like, leased long-term to the Government.

Now, the UK Government isn't stupid - it knows it is the best tenant in town, so it will only pay a level of rent on a hospital which will give a marginal return to the infrastructure fund over government bonds.

The UK infrastructure fund gives quite a bit of detail on its individual projects and things like hospitals offer internal rates of return of just 8-10 per cent a year, for goodness sake. Knock off 2 per cent in fees and there is no way shareholders are going to get rich in a hurry.

Back in 2006 interest rates were lower so shareholders picked up the spread between the project internal rate of return and the cost of debt.

That reality and the fact that debt was being mispriced in 2006 (interest rates on risky assets were too low) were more reasons why the Australian infrastructure vehicle projects tended to have high levels of gearing. Rivercity is trading at A1c today because the experts grossly overestimated the number of cars going through the tunnel.

The tunnel only had value because of the cash flow it would produce in the future by cars and trucks paying a toll each time they travelled beneath the Brisbane river. In their initial modelling, the promoters forecast 60,000 average daily crossings one month after opening, with 100,000 average daily trips after 18 months.

They got it wrong. In August 2010, despite halving the toll, there were only 28,000 trips a day. That means cash inflows are much lower. Cash outflows, however, principally interest payments on the A$1.4 billion of debt, have not changed.

In fact, in its latest accounts RCY's cash flow didn't even cover its operating costs before its interest bill. That's the reason in the 2010 accounts RCY wrote down the value of the tunnel by $1.5 billion and today has net assets of - A$1 billion.

RCY has bank debt totalling A$1.4 billion and its situation is so dire that not only does it look like equity investors have lost all their money but its debt is trading, according to one broker, at about 50c in the dollar. If that is correct it means the banks that have loaned RCY money look set to take a A$700 million haircut themselves. That means total losses of A$1.4 billion from an infrastructure investment, so far.

There are three obvious lessons:

1. Buying individual stocks is risky, especially IPOs.

2. If it is fashionable, it probably isn't good for your portfolio.

3. Even low-risk businesses can become high risk if you load them up with enough debt.

* Brent Sheather is an Auckland financial adviser and his adviser/disclosure statement is available on request and free of charge.