Wrong formula? RAB Multiples analysis fails the test
Recent large transactions for listed network firms have led to intense debate about what the prices paid do or do not show about expected regulatory returns in the Australian network sector. Last month Cambridge Economic Policy Associates completed analysis which sought to peer through the complexities and reach some conclusions. So-called ‘RAB multiple’ analysis has many known pitfalls and limitations. The analysis starkly reinforced the dangers of placing weight on RAB multiples, as the national regulator moves closer to estimating required regulatory returns on more than $100 billion of critical network infrastructure.
Few unambiguous measures exist for an infrastructure regulator asking itself the question: are regulatory returns sufficient to ensure the right level of new and ongoing investment in networks to securely deliver the services customers require?
Those measures that seem superficially easy to use or estimate can have a complexity that lies in wait for the unwary. One of these measures is ‘RAB multiples’, which were in the news and under debate earlier this year.
A simple formula – with complex inputs
The term ‘RAB multiple’ refers to the equity or ‘enterprise’ value of a regulated firm, divided by its regulatory asset base.
Under a set of conditions never met in the real world, it is possible mathematically to show that in theory a RAB multiple ‘should’ equal around 1.0. At least, that is, if elements of the incentive-based regulatory framework are entirely ignored.
The problem is that while the theoretical formula is simple, the real world is messy.
In particular, reaching a RAB multiple means making sure we ‘count what counts’ in estimating the enterprise value.
In practice this means removing those revenue elements that might impact enterprise value, but which are irrelevant for assessing the sufficiency of the rate of return, or overall framework.
A recent report for the Australian Energy Regulator attempted to do this. Cambridge Economic Policy Associates, at the request of the AER, analysed information on two recent transactions involving energy network infrastructure firms – AusNet Services and Spark Infrastructure.
Counting only what counts – dealing with unregulated revenues
The first step in counting what counts is removing the effect of unregulated revenue streams.
Clearly, it would be wrong to draw conclusions about the adequacy of expected regulatory returns if the RAB multiple actually reflected the value assigned to the unregulated business revenues of the firm. This would be like trying to assess the price of bread, by looking at the entire grocery bill.
The CEPA analysis sought to adjust for these unregulated revenue streams for AusNet Services and Spark Infrastructure, but in a highly contentious way.
Independent expert valuation reports undertaken as part of the takeover and delisting of each firm valued these unregulated business revenues through detailed modelling of different scenarios. In the case of AusNet, this led unregulated business activities to be valued at around $3.15 billion.
CEPA took an alternative approach of valuing the revenues at approximately 1.5 times historic revenues, effectively paying no heed to future investment plans or likely growth. As a result, CEPA determined a mid-point estimate of their value of just $370 million.
The result of this estimation approach is to create a large ‘unexplained’ gap between the market value and theoretical value – which the CEPA report says could be the result of expected regulatory returns being above that truly required.
Yet that possible conclusion is entirely hostage to the contentious valuation assumption made.
There is no clear basis given or explained to prefer CEPA’s estimate over the professional expert valuation reports delivered as part of the actual transactions, and in the public domain.
Price check – what is the value of $100?
Even more problematically, the CEPA valuation approach – which reaches a mid-point value of $370 million – appears to defy simple mathematical logic.
The public independent valuation of AusNet’s unregulated business unit showed it holds receivables of (i.e. is owed by others) $480 million, with no suggestion of these being at risk.
That is, the CEPA analysis effectively values the unregulated business unit, in the fast-growing area of renewable and energy services, at less than the contractual payments it is already due to receive.
This is akin to valuing a wallet with a $100 note in it at just $77.
A disappearing RAB multiple gap?
Once this peculiarly downbeat assumption is replaced with a more realistic mid-point valuation of unregulated revenues backed in the independent expert reports, the resulting multiple for AusNet is 1.06. That value is entirely inconsistent with a hypothesis of allowed returns being too high.
This highlights a central truth about RAB multiples.
Layers and layers of assumptions underpin any ‘simple’ seeming multiple reported, and each of these need to be tested and considered.
Making two further reasonable assumptions – that investors continue to price additional sources of business value at approximately the same level as today, and that the regulated network will continue to make investments into the future, has further significant effects on measured multiples.
In the case of the AusNet reported multiple, making these two additional assumptions results in an actual RAB multiple of 0.87.
This would appear to suggest real-world equity investors may be valuing the regulated firm at below its regulated asset base – a circumstance indicative of allowed returns being below those required to attract efficient levels of new investment.
In short, once unreasonable assumptions are replaced with a set of more plausible assumptions around future investor behaviour and needed capital investment, the CEPA approach would seem to show exactly the opposite conclusion to that claimed.
This suggests multiple analysis may be a less than a useful guide going forward.
Reviewing the meaning and value of multiple evidence
Rather than there being an unexplained ‘gap’ that might be attributable to overly generous rates of return, once corrected, the CEPA approach would appear to reinforce other evidence presented by AER consultants Brattle Group that regulatory rates of return appear to be below international comparators.
With the AER’s draft rate of return proposals due out this week, it is a good time to look closely at the evidence about the investment incentives required and work to minimise the number of assumptions we need to make.
Further detailed analysis by Frontier Economics on the CEPA analysis is available here.