The sector offers a range of investment opportunities, but don't underestimate the risks. Michael Barben and Benita von Lindeiner report
Infrastructure is a buzzword often heard since the start of the financial crisis. While real estate - and sub-prime mortgages in particular - was perceived by the public as the root cause of the financial turmoil, infrastructure is seen as a potential safe haven in a more uncertain environment.
In order to prevent a prolonged, deep recession, governments around the globe have initiated extensive infrastructure programmes and committed themselves to spend large sums - up to $584bn (€430bn), in the case of China - over the coming years to improve their infrastructure and to support the economy by creating domestic demand.
Furthermore, infrastructure in many developed-world countries is crumbling as a consequence of decades of underspending, while developing countries urgently need to upgrade and expand their infrastructure if they want to maintain economic growth. The combination of massive capital needs and traditional government funding constraints is creating the opportunity for institutional investors to invest in infrastructure on a large scale.
Infrastructure is commonly defined as comprising all physical structures, facilities and networks that provide essential services to an economy. Historically, infrastructure assets belonged mostly to the public sector. In the late 1980s, governments began to turn to the private sector for building, maintaining and operating infrastructure assets, either through outright privatisation or public-private partnership (PPP) aiming to build strategic alliances between the private and the public sector.
In a PPP, a private sector company develops, builds, maintains and operates an infrastructure asset for a contracted period of time, thus assuming substantial technical, operational and financial risk. In exchange, the company receives a fee from the public sector - either for the provision, similar to a rent, or for the utilisation of the asset. PPPs have spread from Australia, Canada and the UK, and today governments around the world are increasingly embracing PPP legislation in the light of tight fiscal budgets.
Infrastructure has unique characteristics that justify looking at it as a separate asset class. Infrastructure assets are usually long-life, real, tangible assets with concessions that can be as long as 75 years, as in the case of the Indiana Turnpike. Revenues are usually long-term, contracted with creditworthy counterparties providing stabile cash flows. Another important aspects is that revenues are often independent of demand or utilisation, creating high visibility of cash flows over the project's life. Even where infrastructure assets face demand risk, fluctuations of demand are often very small because of the essential nature of the service provided. Furthermore, many assets profit from inherent inflation protection as cash flows are linked to the consumer price index. As infrastructure assets are often in a quasi-monopoly position because of very high barriers to entry based on the heavy upfront capital outlay necessary to build them, they are often closely regulated.
The fundamental characteristics of infrastructure can add significant benefits to a traditional portfolio of equities and bonds. The most important economic factors driving asset class returns are economic growth and inflation. Because of the defensive nature of infrastructure investments and the inflation protection that many sectors offer, a portfolio that incorporates infrastructure can be more effectively diversified across different economic environments, which is especially valuable in scenarios where inflation exceeds expectation and/or growth undershoots expectations. Specifically, private infrastructure could improve the expected performance of a portfolio in situations of rising inflation but also in environments of falling growth; both scenarios where traditional portfolios are often significantly negatively exposed. Figure 1 shows the different asset classes that it is desirable to hold in different economic environments.
In addition, for a heterogeneous segment such as private infrastructure, on the asset class level, the main task in portfolio construction is to identify sectors, regions, strategies and individual assets that benefit from different economic environments, thereby diversifying the portfolio across these environments. Infrastructure investors need to be aware of the peculiarities of an asset's maturity profile and the different infrastructure sectors - and need to choose a specific sector and maturity profile to complement existing investments in their portfolios.
Despite the generally defensive nature of infrastructure assets, diversification is crucial because of the independent (and hence significantly uncorrelated) nature of the risks that infrastructure assets are exposed to (eg, political and regulatory risk). Investors who used to believe, for example, that the mature and established UK water sector was a safe haven have gone through a difficult time after the regulator's decision to reduce allowed rates of return. Other investors committed to funds that had acquired seed assets in the expectation of a much larger fund size; when fund-raising stalled, these funds were overexposed and had no shooting power left to acquire additional assets. Consequently, careful portfolio construction and a clear view on diversification are pivotal elements of successful infrastructure investing.
Infrastructure in the risk/return spectrum
Investment opportunities in infrastructure vary from low-risk, bond-like investments to high-risk, venture capital-like structures. Generally speaking, there are three main risk dimensions in infrastructure that relate to country, maturity stage, and sector characteristics.
Country-specific risk comprises political and regulatory issues. These risks are independent of each other, hence significantly uncorrelated in nature and thus require broad diversification across different geographies. It is important to note that even countries perceived as ‘mature' and ‘developed' carry a significant degree of regulatory risk, as an unexpectedly harsh outcome of the fifth regulatory review in the UK water sector in 2009/2010 has proven.
Risks also vary across the different maturity stages of an infrastructure asset. Greenfield investments where an asset is built from scratch carry the highest degree of uncertainty, but at the same time also entail the greatest potential for value creation. Brownfield investments, ie, investments into an existing, mature asset, can be bond-like in nature, with known demand patterns and high visibility of cash flows. However, there is little potential for value uplifts. Rehabilitative brownfield represents a third category and a mixture of pure greenfield and pure brownfield assets: it relates to an existing asset that is cash flow generative but also carries a significant expansion or upgrade potential, thus potentially allowing for value creation. These three categories are depicted in figure 2.
Finally, risk varies across different infrastructure sectors. Infrastructure can be subdivided into four main sectors: transportation, utilities, communication and social infrastructure. The least risky investments are usually in mature, brownfield social infrastructure assets and comprise assets such as existing school buildings, hospitals, judicial buildings or military housing. The investor is paid for the availability of the assets and receives a fixed monthly payment from a municipality or the government. Payments are usually inflation linked, thus offering excellent protection in case of an economic slowdown or rising prices. Returns for such an asset should be expected to be between 8-9%, mainly as cash yield. Investors seeking a higher return, but wanting to stay in this sector because of its defensive characteristics, can turn to greenfield social infrastructure, thus taking construction (and potentially development) risk as well, which would raise expected returns to about 11-13%.
At the opposite end of the risk/return spectrum, transportation assets have economic exposure, while usually still offering inflation protection: a toll road, for which payments are based on traffic volume, has the ability to profit from an economic upturn; however, in most countries tariffs are directly linked to the consumer price index. Returns for newly built toll roads should, depending on the jurisdiction, lie in the range of 13-15%, rewarding investors for development and construction risks and uncertainties with respect to traffic volume. Utilities and communication assets lie somewhere in between with their risk-return profile, offering defensive investment opportunities due to long-term concessions (eg, in the water sector) or contracts (eg, mobile tower operators), but some upside potential as well.
The communication sector is the smallest private infrastructure investment opportunity, with limited transaction activity. Utilities, however, comprise a variety of different assets, such as distribution networks in the power sector, renewable energy power plants or water and wastewater treatment plants. All these assets profit from long-term contracts such as capacity leases (pipelines), concessions or offtake agreements (power plants) that allow for high visibility of cash flows; pure brownfield assets are expected to yield between 9-12%, with approximately 200bps more for fully contracted assets under construction.
The attractiveness of infrastructure hinges on three main issues: valuations, flow of funds and fundamentals. While fundamental economic aspects need to be supportive for any kind of investment, valuations and flow of funds are crucial when determining the right point in time to enter the asset class.
Due to its specific characteristics and the high visibility of future cash flows, infrastructure is a classical value asset class in which the price paid to acquire an asset is crucial for expected returns. It is a fundamental aspect of most infrastructure assets that there are typically only a limited number of operational levers to compensate for a high price paid at entry. Consequently, overpaying will have severe repercussions on expected returns.
During the course of the financial crisis, valuations dropped across all infrastructure sectors as capital became scarce. Today, fund-raising has started to recover, but the actual amount raised by private infrastructure funds continues to fall short of what funds were targeting. This illustrates a persistent scarcity of capital while funding requirements continue to grow.
Consequently, because of the relative scarcity of capital in infrastructure, today's investors are still profiting from attractive valuations and limited competition in most sectors. As figure 4 - the example of the airport industry - illustrates, EV/EBITDA multiples for private market transactions are still below historical averages and well below the demanding prices paid in 2006 and 2007 when cheap leverage, rosy growth assumptions and intense competition for assets led to lofty valuations for the sector.
In an environment of volatile equity markets and negative real bond yields, investors are increasingly looking for alternative forms of investment in order to generate attractive yields. Infrastructure assets, with their defensive, stable cash flows, inherent inflation protection and high cash yields are therefore bound to invite increasing interest. Brownfield, yielding assets in Europe and in the US are expected to profit from this development, and asset prices are expected to rise given this macroeconomic backdrop. Renewables and PFI assets, for example, with low to no demand risk, long-term contracted cash flows and high-quality operation and maintenance contracts in place, are currently generating returns in the range of 9-14%, mostly in the form of cash yield. Prices for such assets are almost certainly going to rise, and such opportunities will be increasingly scarce.
The situation is different in emerging markets. With strong growth and an obvious need for infrastructure investments, brownfield asset prices have already risen to a significant premium to replacement value. Therefore, brownfield investments are less attractive than greenfield opportunities that not only offer significant growth potential, but also an attractive exit market given the high prices paid for operational assets such as toll roads or power plants. Investing into greenfield assets in the developing world, however, requires strong local networks and local partners.
To sum up, the current market environment is highly attractive, but investors need to invest today to profit from the rising asset prices we expect to see. Yielding brownfield assets in Europe and the US are offering highly attractive risk-adjusted returns, and investors should focus on greenfield assets in the emerging world.
Investors seeking to both diversify their portfolios and receive attractive risk-adjusted returns should be able to profit strongly from infrastructure. Accessing the asset class, however, and profiting from the current opportunities, is not easy. While a variety of infrastructure funds offer exposure to different sectors, geographies and maturity stages, this primary fund route still continues to pose trouble. Investors deciding to invest in primary funds will have to decide whether their manager can achieve sufficient diversification as well as profitably deploy capital. A slower transaction pace implies that it might take several years to put money to work, the J-curve will be accordingly deep and there is hardly a chance to profit from the attractive opportunities that the current environment offers. Consequently, investors are faced with the risk that they will not be able to capitalise on the market environment through fund investments only - if they want to profit now, they will need to combine primary fund investments with secondaries and direct investments.
Secondary deal flow has been strong during the past 18 months- at least for investors who possess a strong network and good sourcing contacts within the industry. Fund portfolios that are for sale were often fully invested in the high valuation vintage years 2006 and 2007, often facing issues with high leverage levels as well as (in)stability of the management teams. Investors need the ability to independently value the portfolio assets bottom up and to understand the capital structure and the refinancing risks in the portfolio - and they have to be able to take the manager risk into account.
The best risk/reward profile was offered by secondaries stemming from independent and specialist funds that have only limited exposure to highly levered legacy assets and still have unfunded commitments at their disposal to exploit the current opportunities; identifying these funds requires even more sourcing capabilities and industry contacts.
In addition, some of the fully invested 2006-07 vintage funds should be able to offer attractive exposure to yielding brownfield investments in the mature world that should profit from rising valuations. Analysing the stability of the capital structure and the debt burden is crucial for these opportunities, however.
Executing direct investments is time and resource intensive and therefore only feasible for large and skilled institutional investors, especially if they want to build up a diversified exposure to the asset class. Deal flow has increased over recent months as projects that were put on hold during the financial crisis have come up for tender or sale again.
In addition, transaction activity is expected to pick up in all infrastructure sectors as the corporate sector will most likely remain a net seller of assets in order to reduce leverage or focus on core competencies. E.ON, for example, a large German utility, just announced plans to sell assets worth €15bn until 2013.
Furthermore, governments will be increasingly forced to attract private capital to finance public infrastructure and sell state-owned assets in an attempt to raise capital and reduce fiscal deficits. Investors with local offices and networks - which are indispensable in an asset class as sensitive in public perception as infrastructure - will be able to acquire high-quality assets at favourable terms.
The most promising areas for infrastructure investment can be found in energy-related utilities in North America which are characterised by a keen demand; in brownfield social infrastructure, regulated utilities and renewable energy in Europe where valuations have moved to attractive levels, and in growth-sensitive sectors in Asia that should profit from the economic strength of the region.
Investors that engage in careful portfolio construction and thorough diversification will be able to achieve lasting and effective portfolio benefits by including infrastructure in their asset allocation.
Michael Barben is head of private infrastructure, and Benita von Lindeiner is assistant vice-president, private infrastructure, both at Partners Group