Rising stakes

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:

Provides essential services to businesses and/or communities, for example, schools and hospitals; Is a capital investment; Has a long asset life;  Is monopolistic in nature, with relatively high barriers to entry or competition.

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:

Attractive returns - Proceeds are generally composed of capital appreciation and income. Income-generating assets are expected to return in the mid to high single digit returns, while the growth component (eg, development projects) can return 15-20%; Predictable revenue - Given the relative stability and growth in revenues, this asset class is especially attractive to pension funds that want higher-yielding assets; Liability-matching characteristics - Some infrastructure assets provide a natural inflation hedge because their revenues are contractually related to inflation (Consumer Price Index or Retail Price Index). Also, the capital appreciation assets offer an inflation hedge similar to that offered by equities. More importantly, since these assets are often long-lived, they may more closely match a pension plan's liabilities than many other traditional asset classes; Diversification - The returns generated by infrastructure assets are not expected to be highly correlated with many other asset classes. However, as with all asset classes there are general risks that prospective investors should be mindful of. For some, these will be a deal breaker. For investors who can overcome these risks and issues, infrastructure can be an attractive asset class. Operational risks - Infrastructure assets are real assets — bridges, tunnels, hospitals, power plants, etc. But any physical asset may not work properly or be finished on time. Therefore, prospective investors must make sure that those who form the management consortium have operational experience in the specific area and can manage the risks by passing them on to the constructor/operator; Counterparty risk - Investors must rely on the stakeholders remaining involved and motivated throughout the life of the project; Risk posed by transition from the public sector - Where an asset is a PPP, the transition from the public sector to the private sector can be difficult. For instance, the government might not be adept at passing control of the asset. In addition, there is always the risk that a change in government could lead to a change in the way the assets and their transfer are viewed; Financial risk - Project finances must be structured properly, with the contract specifying an appropriate pricing mechanism that will lead to an appropriate rate of return on the investment. Infrastructure assets are typically highly leveraged (between 40 and 85% of economic value) which is supported by strong reliable cash flows. However, if there is any risk to these cash flows (poor utilisation rates for a road, requirements for capital expenditure above expectations), the leverage could jeopardise the cash flows and even the viability of the project; Liquidity risk - Since infrastructure assets have long investment lives — often more than 30 years - and secondary markets for these investments are not well developed, a lack of liquidity can be a concern; Diversification challenges - Given the large scale required by these projects, building a well-diversified portfolio of infrastructure projects can be difficult, since many infrastructure funds may be dominated by one or two investments; High entry prices - Some early adopters have increased their allocation to infrastructure, financing a large number of projects in recent years. Other investors might be concerned that there is already too much capital in pursuit of too few deals, leading to a reduction in expected returns going forward.

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.

Direct infrastructure - Building a portfolio of direct investments in infrastructure projects usually by co-investing with other investors. This is time consuming but potentially the most rewarding way to invest. However, in addition to the huge time commitment for investment and ongoing monitoring, an investor must have good access to deal flow, to negotiate terms and, if not a minority investor, to arrange financing. Portfolios can take a long time to build and may be under diversified. Generally, only the largest pension funds with the best governance choose this approach. Pooled products - Various pooled products - often, limited partnership vehicles similar to those used in private equity - are available for investors, and the number is increasing all the time. While these products provide more diversification than the direct approach, a single asset can represent up to one-third of the assets in the fund. If such an approach is adopted, investors should think about spreading exposure across a number of funds to ensure adequate geographical and sector diversification, as well as achieving a spread of individual investments. This approach should also help address the issue of ‘vintage-year risk' ie, the risk that a client's capital is committed at a particularly disadvantageous time in terms of pricing of infrastructure assets, leading to disappointing returns.

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
investments.

Listed infrastructure - Lately, listed infrastructure in the form of funds has become increasingly available. These vehicles offer a more liquid approach, albeit with a higher correlation to other assets than a diversified, unlisted fund. It is also possible to build a quoted equity portfolio of infrastructure-related companies (for example, airport operators that are listed on stock exchanges around the world) but such portfolios are subject to quoted equity market risk, though the beta of infrastructure stocks is generally lower than the market.

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.