The appeal of infrastructure has not been lost on institutional investors, but the asset class comes with its own challenges, writes Maha Khan Phillips

The financial crisis has left institutional investors desperately seeking stability and long-term growth. It is one of the reasons why infrastructure is developing into an asset class in its own right, and shedding its private equity and property origins.

"Interest in infrastructure is increasing because of the crisis," says Surinder Toor, managing director and global head of asset management for infrastructure investments at JP Morgan Asset Management. "Only fixed income has outperformed infrastructure over the last three or four years, although it has not been immune."

Infrastructure fundraising peaked in 2007, but struggled over the following two years, largely because of an overvaluation of assets, overleveraging of companies, and because of liquidity concerns. The asset class is rising again. By the third quarter of 2010, fundraising had already reached $16.1bn (€11.6bn). As of October 2010, over 100 funds were in the market seeking total commitments of over $100bn, according to a report by Probitas Partners.

Market volatility over the past year and a half, which has been difficult to forecast, has pushed asset growth. The sovereign debt crisis has not helped, and analysts say they are finding it difficult to make long-term predictions about growth. Some types of infrastructure can offer a five to 10-year investment horizon, with a predictable and steady income stream.

"The recent crisis has helped infrastructure managers because some infrastructure assets have proved very resilient," says Philippe Taillardat, co-head of European infrastructure investments at First State Investments. "The provision of electricity and water to end-users, for example, is not correlated to GDP growth. Even during a crisis, people continue to drink water."

Core infrastructure
It explains why infrastructure fund managers are again offering core infrastructure. The focus, generally, is on regulated energy and water assets; airport and port assets that are either regulated or have positions of market dominance; and operating renewable projects that have contracted tariff protection arrangements, according to the global consultancy Deloitte.

In its 2011 report, The Fork in the Road Ahead, Deloitte points out that five or six years ago there were probably only two or three players that were actively educating and encouraging investment by limited partners in their funds. Today there are more than 40 distinct infrastructure fund managers in Europe that actively invest on behalf of their limited partners.

Infrastructure can fulfil a number of different roles within a portfolio, explains Amarik Ubhi, lead researcher on infrastructure at Mercer. "Broadly, it can be classified along the lines of defensive investments, diversifying investments and, potentially, growth investments," he adds.

Investors use infrastructure to protect against inflation, because the rates that are charged for usage of infrastructure assets are usually linked to inflation in the long run. With the majority of funds targeting annual cash yields of 5-9%, according to Deloitte, investors can use infrastructure to target growth. Unlisted infrastructure offers diversification from many markets. Consultants, however, warn their clients not to think about infrastructure in the context of asset liability modelling.

"We believe these are growth assets and not matching assets," says Greg Clerkson, head of alternative investments consulting, EMEA, at Russell Investments. "There are people trying to sell them and put them into an asset liability modelling portfolio, but that portfolio is marked off a 10-year government swap and is extremely liquid. Infrastructure is an illiquid investment."

Investors are worried about the liquidity issues that come with long-term investments, an issue that is being addressed by a growing number of listed investment vehicles.
"The big plus of our fund is liquidity," says Dirk Kubisch, product specialist in equities at Swiss & Global Asset Management, which manages the JB EF Infrastructure Fund, offered in Europe. "Shares are trading on stock exchanges around the globe, and you aren't bound to your investments across a timeline."

Investors do not seem to be convinced by listed vehicles, however, because of their correlation to equity markets and because, in some cases, funds invest in infrastructure companies, rather than underlying infrastructure assets.

In a high-profile case, 30 pension funds that invested in the Henderson PFI Secondary Fund LP and Henderson PFI Secondary Fund II LP argued that Henderson had purchased property developer John Laing when it should have acquired PFI projects, rather than a PFI contracting firm.

However, that situation is not likely to become a trend. "Most listed funds invest directly in infrastructure projects themselves, rather than in infrastructure contracts," says Rollo Wright, partner at Gravis Capital Partners, which launched its fund last year after raising £40m. Data from Preqin shows that 82% of institutional investors prefer unlisted infrastructure, versus 8% that prefer listed vehicles (see figure. Close to one-third (31%) of institutional investors are also making direct investments in addition to, or instead of, fund investments; the Universities Superannuation Scheme in the UK, and OMERS, Ontario's pension scheme for public sector workers, are among the most high-profile of these.

Investors do need to understand what they are signing up for, regardless of how they choose to invest in the asset class.

Regulatory risk
Risk is a consideration, particularly regulatory risk. In Spain, for example, the government has taken steps to make retrospective adjustments to tariffs for certain photovoltaic projects, according to Deloitte, leaving investors holding the bag. Political risk is also an issue, with governments conducting cost-cutting austerity measures, which could hurt some projects. However, on the reverse side, governments that can no longer afford critical infrastructure projects will have to put the projects out tender.

Duncan Hale, senior investment consultant at Towers Watson, does not see regulatory and political risk as major obstacle. "Regulatory risk cannot be completely removed from infrastructure portfolios but you can provide a good service and manage it," he says. "Politicians and regulators are generally quite reactive. If people are happy with the value provided, then politicians don't generally get involved."

Hale believes that infrastructure should make up between 2% and 10% of institutional investors' portfolios. "Less than 2% and it's probably not worth it, given it is a complicated asset class; more than 10% and you are coming up against some liquidity concerns."

Not surprisingly, managers say it has never been more important to include the asset class in a diversified portfolio. "The only way that investors are going to benefit from this stable asset class is to allocate more," says Boe Pahari, head of infrastructure in Europe for AMP Capital Investors. "Some of the larger pension funds are increasing their investments quite a lot, going up to 10% and also 20%." Pahari says that infrastructure is one of the few asset classes that can provide stable returns, moderate cash yields, and lower risk.

When stocks are volatile, investing in sovereign debt is actually considered risky, and hedge funds are underperforming, it is clear to see why infrastructure can be so attractive. Investors do need to read the fine print, though, before they make their commitments.