With pension funds looking out for less traditional long-term investment opportunities, infrastructure could be the ace in the pack of alternative asset classes. Jane Welsh reports
Many investors, including pension funds are looking to diversify away from quoted equity markets within the return-seeking segment of their portfolios. This has generated interest in a range of alternative asset classes, including infrastructure. But what exactly are the investment characteristics and implementation issues of this new asset class?
In general terms, infrastructure refers to any investment in a project which:
As a result, this broadly defined asset class encompasses a large and varied number of investments, such as toll roads, airports, pipelines, telecommunication networks and electricity generation plants. The key for investors therefore, is the robust revenue streams and associated cash flows that can be derived from these essentially monopolistic services. Although the monopolistic nature of infrastructure would seem to give these assets significant pricing power, pricing is often regulated to some degree.
Depending on the project, infrastructure can include varying degrees of involvement with the public sector. At one end of the spectrum infrastructure investments involve a high degree of participation and interaction with government. For instance, in public private partnerships (PPP) - or private finance initiative (PFI) in the UK - a consortium of investors bids on a project from the public sector, for example constructing a hospital or a school.
At the other end of the spectrum, investors might bid for the infrastructure assets of a public company, such as a water treatment plant, aiming to realise a return on their investment via operational control of the asset. The government might play no part other than a role in regulatory environmental oversight. The risks and potential rewards are likely to be quite different depending where on the spectrum the particular asset lies.
One of the main attractions of infrastructure is the stable, inflation-sensitive nature of the cash flows, a characteristic that would appear to be a good fit for most defined benefit pension funds. In addition, there is the attraction to the diversification benefits of investing in an asset class which is less economically-sensitive than other such asset classes, like public or private equity.
Infrastructure's range of possibilities offers an array of trade-offs between risk and return. The sector also provides varying degrees of diversification compared with other ‘traditional' asset classes. Investors must consider the investment characteristics of each project both individually and as part of a total portfolio.
Since infrastructure assets have a long life (often 30-50 years), they require investors to take a long-term view of returns. Infrastructure assets generally provide cash flow or dividend payments from the more mature assets - for example, the tolls collected on roads and bridges - and the potential for capital appreciation for investors who participate in the riskier development stages.
In general terms, investors who are involved during the entire life of the asset will require a higher expected return than those who invest in a more developed, cash-generating asset. Given the asset's potential for capital appreciation and regular cash flow, it should not be surprising that the expected risks and returns generally fall somewhere between those of equities and bonds.
From a pension fund's point of view, this asset class has several appealing features, including:
We share some of these concerns. But investors should note that the demand for infrastructure investment capital is expected to increase. This pipeline of possible infrastructure projects is being driven by a number of factors, including:Restructuring in the utilities sector around the world; Increasing use of private capital to finance infrastructure projects by governments and large corporations as they focus on their core activities; Reinvesting in infrastructure after decades of underinvestment, especially by the public sector, accompanied by continued population growth; Burgeoning prospects for infrastructure investments in less developed economies. Some of these countries offer less legal protection and market development, so these projects often pose greater risks. But with the large population base and relatively high demand for infrastructure, notably in India and China, this segment represents a huge potential market.
In light of these trends, we expect that the global demand for infrastructure capital will be healthy for some time to come. At this point, specialised institutional asset managers make up only a small part of the market. However, pension funds are becoming bigger participants in this arena, and institutional investors are poised to become larger players as the market continues to mature.
Investing in infrastructure might not be right for everyone, particularly those funds with a low governance budget. Like private equity, this asset class can involve a lot of time and energy, even when investment is limited to 5-10% of an overall portfolio. However, for those with the appropriate governance structures in place, whether in-house or delegated, there are three main ways to invest in infrastructure.
As with direct infrastructure, it can take a number of years to achieve a target allocation to infrastructure assets employing a pooled fund approach.
The manager of the fund is likely to take two to three years to invest the capital raised. Pooled funds also vary in terms of duration. Many of the pooled funds have a 10-year life but some are even longer duration, reflecting the life of many of the underlying
As with other asset classes where information advantage is key, infrastructure managers employing either the direct or pooled approach may charge relatively high fees. The deals themselves are labour intensive and require a significant amount of due diligence and ongoing management. The fee structure is similar to that of private equity: a management fee of 1-2% on commitments and a performance fee of 10-20%, usually with a preferred return of 8-12% before performance fees are paid. In addition, there can be additional charges, for example transactions charges.
The infrastructure asset class is gaining increased interest from investors around the world. The implementation issues are significant but investors are starting to make investments in pooled funds, thereby gaining experience in the asset class. Over time, more investors may gain enough expertise to consider co-investment or direct investments. It is also sensible to adopt a phased approach to allocation in this asset class. As with private equity, there are likely to be better (and worse) times to invest and therefore spreading the allocation over time (and over managers, geographies and industries) is likely to be a prudent approach to choose.