Frederic Blanc-Brude explains why it is important for the investment community to build a global database of infrastructure cash flows
Frequent calls have been made for data collection in infrastructure investment to be stepped up. But it is often unclear which data should be collected to achieve what end and how.
In early 2016, EDHEC launched a new initiative to collect infrastructure investment data for the purpose of building investment benchmarks corresponding to reference portfolios of privately held infrastructure debt or equity.
What are the relevant questions?
The need for infrastructure investment benchmarks springs from three areas of concern among asset owners:
• Asset allocation: Documenting the risk-adjusted performance of infrastructure investments compared to other public or private assets includes deriving measures of expected and realised returns, return volatility and of the correlation of these returns with the market. This determines whether there is such a thing as an infrastructure asset class that could improve existing asset allocation policies, or what combination of investment factors infrastructure debt and equity might correspond to.
• Prudential regulation: The current treatment of privately held infrastructure is debatable and certainly contradicts the investment beliefs that draw investors to these assets. Without adequate measures of extreme risks and calibrations of existing prudential frameworks, institutional investors are less able to invest in infrastructure.
• Liability-driven investment: Infrastructure investments may have the potential to contribute to asset-liability management objectives, even if they do not correspond to a well-identified asset class. Different duration and inflation hedging measures of infrastructure investments will play a key role in their integration in the asset-liability structure of investors. Arriving at such measures is an important part of the objective to create infrastructure benchmarks.
Why are these questions so hard to answer today?
These questions are important to the future of infrastructure investment by long-term investors, in particular investors with a liability profile and subject to prudential rules, such as insurance firms. But the current state of investment knowledge is not able to answer them well for the following reasons:
• Market proxies are ineffective: Looking for estimates of expected performance and risk of privately held infrastructure investments in the market for publicly traded securities has not delivered meaningful results; listed infrastructure equity and debt indices tend to exhibit higher risk than broad market indices (higher maximum drawdown, higher VaR) partly because they are concentrated in a few large constituents. Crucially, they do not suggest any persistent improvement of investors’ existing portfolios (see Blanc-brude et al 2016a, for a review and quantitative analysis).
• Existing research using private investment data is too limited: Existing sources and studies on the performance of infrastructure private equity funds suffer from major limitations and cannot be considered representative of the performance of underlying assets. In fact, it is because infrastructure private equity funds are not representative that a number of large asset owners have gradually opted to invest directly in infrastructure. Likewise, information available from rating agencies about infrastructure debt, while more detailed, is insufficient to answer questions about the performance, extreme risk and effective duration of reference portfolios of private infrastructure debt.
• Reported financial metrics are inadequate: The metrics currently reported in infrastructure investment are not fit for purpose. Appraisal-based net asset values (NAVs) suffer from the usual stale pricing issues, which lead to smoothing and underestimating the volatility of returns, and the use of constant internal rates of return (IRR) precludes building portfolio measures, identifying sources of return (factors) or computing the correct duration measures with risk profiles that are expected to change over time.
Recent progress: from definitions to data collection
In June 2014, EDHEC put forward a roadmap for creating infrastructure investment benchmarks (Blanc-Brude 2014). This roadmap integrates the question of data collection up front, including the requirement to collect information known to exist in a reasonably standardised format and limited to what is necessary to implement robust asset pricing and risk models.
Some of the recommended steps have been taken and the framework required to define and launch the data collection process now exists.
Defining infrastructure investments from a financial perspective – the only relevant perspective to build investment benchmarks – was a necessary first step.
A clear distinction must be made between infrastructure as a matter of public policy – in which case the focus is rightly on industrial functions (for example, water supply and transportation) – and that of financial investors, which may be exposed to completely different risks through investments providing exactly the same industrial functions (for example, a real toll road and an availability payment road).
Substantial progress has been made in identifying those characteristics that can be expected to systematically explain the financial performance of infrastructure investments. In particular, the growing consensus around the limited role of industrial sector categories in explaining and predicting performance, and the much more significant role played by contracts and by different infrastructure business models, such as ‘merchant’ or ‘contracted’ infrastructure, or different forms of utility regulation, is encouraging.
One result has been identifying limited-recourse project finance as a major and well-defined form of investment structuring for infrastructure projects. Benchmarking project finance debt and equity by broad categories of concession contracts, financial structures and life-cycle stage is one approach in creating reference portfolios that can be used as benchmarks, including for prudential regulation as the recent EIOPA consultations suggest.
“Substantial progress has been made towards identifying those characteristics that can be expected to systematically explain the financial performance of infrastructure investments. In particular, the growing consensus around the limited role of industrial sector categories in explaining and predicting performance, and the much more significant role played by contracts and by different infrastructure business models”
Other families of infrastructure assets can gradually be integrated in this approach, such as regulated utilities and other types of infrastructure business models.
Once infrastructure investments are well defined, the second necessary step is to design a performance-and-risk-measurement framework that can provide robust answers the questions identified above.
Privately held infrastructure equity and debt instruments are not traded frequently and cannot be expected to be fully ‘spanned’ by a combination of public securities. Hence, they are unlikely to have unique prices that all investors concur with at one point in time. A two-step approach to measuring performance is therefore necessary: documenting cash-flow distributions (debt service and dividends) to address the fundamental problem of unreliable or insufficiently reported NAVs or losses given default; and estimating the relevant discount rates, or required rates of returns, and their evolution in time.
Here, too, progress has been made and recent research reviewed in this paper provides a framework to address both steps, taking into account the availability of data while applying best-in-class models of financial performance measurement. The result is a list of data items required to implement adequate methodologies and answer the all-important benchmarking questions. It includes base case and revised cash-flow forecasts for equity and debt investors, as well as realised debt service and dividends, and key financial ratios, in particular debt service and equity service cover ratios, and their determinants. Finally, modelling cash flows requires knowledge of loan covenants and expected and realised investment milestones.
Once the expected value and volatility of cash flows to creditors and investors is known, as best as current information allows, the relevant term structure of discount rates needs to be estimated to derive past and forward-looking measures of performance, risk and liability-hedging.
Starting from a distribution of cash flows, several approaches are available, such as factor extraction from initial investment values, following Ang et al (2013), Blanc-Brude and Hasan (2015) provide an application to infrastructure project equity. A second option is the risk-neutral valuation approach described in Kealhofer (2003). Blanc-Brude et al (2014) provide an application to private infrastructure debt that integrates the Black (1976) extension of the Merton (1974) structural model, and allows for debt restructuring post default, hence valuing the option for lenders to restructure infrastructure debt.
Implementing these methods requires collecting another set of data items, including initial investment values and credit spreads, all of which are observable. The detailed list of the required financial data items is presented in a new EDHEC paper developed with co-authors from the World Bank and the OECD (Blanc-Brude et al 2016).
Towards investor-friendly benchmarks of infrastructure returns
Having progressed towards clear definitions of underlying assets, and built robust, state-of-the-art pricing and risk models that avoid the pitfalls of existing practices (for example, averaging IRRs) and are designed to deliver the answers needed by investors, regulators and policymakers, our roadmap provides a rationale to collect data effectively and efficiently to build infrastructure investment benchmarks.
The newly created EDHEC infrastructure Institute (EDHECinfra) launched in Singapore this year has begun to collect the relevant information on a global scale.
Collecting this information now requires co-operation between investors, creditors, academic researchers and the regulators that can help make such reporting part of a new standard approach to long-term investment in infrastructure by institutional players.
What will these benchmarks be like? As well as a new research institute, EDHECinfra is also a forum for the financial industry to provide regular input on the design of useful investment benchmarks for long-term investors of different categories, with varying liability profiles and investment objectives.
For instance, today the most sophisticated investors are aiming to develop a factor-based approach to infrastructure investment. It makes sense: infrastructure is too illiquid and large to be rebalanced annually or even bi-annually. In an environment where strategic asset allocation and the concomitant portfolio rebalancing are the highest order questions faced by investors, understanding the contribution of infrastructure and other illiquid investments across asset classes (and rebalancing the more liquid ones instead) requires a risk-factor approach to investing.
EDHECinfra is developing the technology and the empirical knowledge drawn from a global database that will reach hundreds of investments going back 15 to 20 years by 2017. Thanks to this work and with the support of the public and private sectors*, new, better benchmarks can be built for infrastructure investors.
*EDHECinfra would like to thank Natixis, Meridiam, Campbell Lutyens, The Monetary Authority of Singapore, the members of the Long-Term Infrastructure Investment Association, the Global Infrastructure Hub and the World Bank for their long and continuous support of this project
Frederic Blanc-Brude is director at EDHEC Infrastructure Institute