A topic rather neglected in articles on Brookfield Asset Management's (BAM) listed partnerships (BIP, BEP, BPY and BBU) is that of fees. As those partnerships will grow over time and increase their distributions, fees will gradually become more and more of a burden on cash flows. I have analyzed the fees paid by Brookfield Property Partners (NYSE:BPY) in my recent articles (and I really encourage the reader to read "Incentives To Increase Return On Equity Should Lead To Nice Gains At Brookfield Property Partners" to better understand the method, its assumptions, shortcomings and implications). Now I will apply it for Brookfield Infrastructure Partners (BIP). I will start with a list of the most surprising and most important discoveries for BPY.
- BPY, over its 5-year public existence, has not paid any incentive fees on distributions yet thanks to some mysterious "accumulated credits".
- Even without those credits, the current rate of incentive fees would be about 3% of distributions to unitholders (compared to the 33% maximum allowed).
- Majority of BAM's fee income will be earned not through the seemingly high 33% incentive fee on distributions, but via the innocuously looking 1.25% equity enhancement fee (calculated from market cap). The reason is the growth of both distributions and market cap thanks to the earnings retained within BPY.
- The current unit price of ~$18 corresponds to a projected 8% return on equity. That would correspond to NAV of $25 out of which $7 will go to BAM as fees.
- Despite these seemingly obscenely high fees, unitholders would do great if return on equity was 12%+ as the management targets and has achieved in the past decades (but not over the last 5 years).
- In particular, if one aimed for a 12% return and assumed 12% ROE, then the current unit price would still offer a 25% margin of safety.
- The fee structure, together with BAM's large stake in BPY, incentivizes BAM to increase ROE (e.g. by recycling capital), not to issue new units. And that is what actually they have been doing most of the last 4 years.
Brookfield Infrastructure Partners
The fee structure at BIP resembles that at BPY, but there are minor differences. The fees are as follows:
- Base management fee of 1.25% p.a. of total capitalization (paid quarterly), where total capitalization is the sum of the values of the outstanding units (i.e., market cap, but a portion of the units is held directly by BAM and thus not part of the market) plus market value of the preferred units plus all recourse debt minus cash. At present, total capitalization consists of $15B of ordinary units, $1B of preferred units and $2B of recourse borrowings. We will henceforth calculate the management fee as 1.25% of market cap plus $3B, or 1.25% of unit price plus $8 if interested in per-unit fee.
- Incentive distribution (we might call it fee as well). From the first $0.203 of a quarterly distribution, nothing goes to BIP. Between $0.203 and $0.22, 15% goes to BAM, 85% to unitholders. Above $0.22, 25% goes to BAM and the rest to unitholders. (These thresholds are updated by amendments to reflect unit splits.) We are now at $0.47, way above the highest threshold, and can make the following simplification: the yearly fees paid on top of what unitholders receive will be $0.01 plus 33% of the difference between annual distributions and $0.88.
One can find this (and much more) in the 2017 annual report. The base management fee was $126M, $158M and $230M in the 2015, 2016 and 2017, respectively; the incentive fee was $64M, $80M and $113M in those years. (You can compare it with what ordinary unitholders received in distributions; in 2017, it was a bit less than $700M.) BAM owns about 30% of BIP (116M of 394M units outstanding); its stake is currently worth about $5B.
Instead of NAV and return on equity, the management refers to invested capital and return on invested capital (ROIC) - the ratio of adjusted AFFO to invested capital. Currently, invested capital is ~$8B, or about $20 per unit, and ROIC has very consistently kept between 10 and 13%, inching up over the years. However, ROIC of at least 11% is necessary just to cover the current distribution, and at 14%, the distribution growth based on retained cash flows would amount to only 3%, a far cry from the 6-9% anticipated by the management. Note that FFO is based on net income, thus already all gains on asset disposals, IFRS fair value gains, inflationary increases, etc., are included.
It took me considerable time to figure out this apparent contradiction. The key are the following two slides from the 2017 ID presentation. (I strongly encourage readers to study the financial considerations extensively discussed during that presentation. Read the transcript, compare it to the data in ARs and supplementals, read it again. It is a lifelong education on how to think about returns from long-life assets.)
The point is that with small incremental investments, a large growth of AFFO is achieved because the cash flows generated by the existing assets are growing with no need for additional capital. Even with no new investments, significant AFFO increases would come every year (75% is indexed to inflation). This also explains why ROIC has been creeping upwards over the years. For the purpose of my calculations, I will consider ROIC in the range of 12-24%; that is what is likely to be achieved when retained AFFO is reinvested. (Since inception, they managed to achieve 17% of this "incremental" ROIC.)
There is one other important difference. BIP already subtracts the base management fee when calculating FFO (it is part of the G&A expense). The management fee is roughly 3% of invested capital per unit, thus the correct rate to use should be those 3% higher than what BIP reports.
Finally, a word of warning. The calculations are performed to illustrate the effect of fees, and must not be misinterpreted as an attempt to pinpoint a precise value on BIP units. The assumptions I have used are too simplifying and the values derived highly depend on ROIC which is unlikely to be high and constant - the last decade was quite favorable for infrastructure, with growth coming from increased volumes, inflation escalators, etc.; it might not go as smoothly in the future, especially not during periods of economic unrest or much higher interest rates. Despite these drawbacks, I believe that the results at least illustrate the range of possible outcomes. The table below uses a 10% discount rate for the calculations of present value.
As we can see, BAM takes about 40% of the present value of cash flows, and this percentage does not depend much on the ROIC. The high fee is not necessarily bad if they provide ordinary unitholders with adequate returns. For instance, the present unit price of ~$40 roughly corresponds to the historical ROIC that has been achieved. That would mean that if future conditions do not change much, then distributions will grow by ~6% p.a. and total returns of about 10-11% p.a. can be expected practically ad infinitum, plus some upside from accretive issuance of new units. The fact that BAM extracts $36 (at present value) in fees over time does not interfere with it much.
The only problem could be with incentives: BAM might want BIP to extensively issue units to increase fees. In the last decade, they have not done it with value-destroying consequences, and I find it unlikely to happen in the future. The key reason is that they would not want to destroy or even just dent their reputation; even a couple billions of fees extracted from BIP is negligible compared to what they can earn on hundreds of billions of AUM in other listed partnership and institutional funds over the next decade (and to the loss of that opportunity caused by screwing unitholders over).
The "numerical" alignment is, however, much weaker compared to BPY: with BIP, BAM's unitholder stake is $5B, but the overall fee stream is worth $15B. Thus, if they decided to double the size of BIP by mediocre acquisitions financed by new units, decreasing overall ROIC by 2% in the process, they only lose $1.5B in invested capital, but gain $5B in additional fees.
Disclosure: I am/we are long BAM, BPY. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.