Building Bubbleville?

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Emma Cusworth asks if there is enough infrastructure for sale to cope with investor demand - and how to buy it cost-effectively

As investors join the rush for infrastructure, inflows look set to rocket. During 2010 over €20bn of private-sector money flowed into European assets, and some of Europe’s largest pensions funds made considerable allocations. PensionDanmark, along with PKA, invested DKK6bn (€800m) in 50% of the Anholt offshore wind farm, while PGGM invested €19m for 25% of an Irish offshore wind farm.

Sovereign wealth funds (SWFs), which control over €2.7trn, have joined the fray. The proportion of SWFs invested in infrastructure jumped 14% to 61% last year, according to Preqin, with many looking to make large allocations. The world’s biggest, the €428bn Abu Dhabi Investment Authority (ADIA), which acquired 15% of London’s Gatwick Airport in 2010, is targeting a 5% allocation. Meanwhile, the Alberta Heritage Savings Trust Fund (€10.4bn AUM) will double its allocation to 8%, and Norway’s €363bn Government Pension Fund Global is also considering infrastructure. Average allocations range between 2% and 5%, although some, including PensionDanmark’s, are as high as 10%.

“The key attraction,” says Torben Möger Pedersen, PensionDanmark’s CEO, “is that this asset class, which has low correlation with the macro-economic cycle, offers stable, inflation-linked yields that are more attractive than bonds. Given the illiquidity premium should be substantial, infrastructure fits nicely in a long-term investment portfolio.”

Michael Barben, head of private infrastructure at Partners Group, notes that much more money was raised in 2010 than in 2009, and although 2010 was still substantially below the peaks seen in 2007-08, he thinks that hides significant latent demand. “People would allocate a lot more, but they are still getting used to a new asset class and new managers, and are analysing what appears to be disappointing performance from the 2005-07 vintages bought at high valuations with high leverage.”

So, is there enough supply to absorb those inflows, or will fierce competition push prices to bursting point? According to Preqin, renewable energy was the biggest sector by proportion of deals in Q4 2010, accounting for 35%, folloiwed by transport (33%) and energy (14%). The vast majority of deals (82%) focused on these three sectors, a trend expected to strengthen, following events in Japan and the Middle East (see figure). But historically, fierce competition for assets in a particular market segment has pushed prices to stratospheric levels before plummeting. The increase in available assets, and how closely it matches investors’ deadlines, will prove crucial in avoiding a bubble.
“There is plenty of capacity in infrastructure,” says Martin Lennon, head of M&G Investment’s developed market player, Infracapital. “Just considering current trends in corporate unbundling (notably of utilities), re-financing requirements, investment in renewable energy and privatisation, we are experiencing the broadest set of attractive investment opportunities we have seen for quite some time.”

Barben agrees: “The utilities and construction companies are still relatively highly leveraged, with capital needs for investments they still have to make, which has led to ongoing disposal programmes. Eon wants to sell €13bn worth of assets; RWE has announced €8bn worth of investment.”

The OECD estimates that average annual global infrastructure investment to 2030 will be approximately $2.5trn. The European Commission’s preliminary estimates for investment needed over the next decade is €1.5-2trn. Transport alone could need up to €21.5bn annually after 2013.

According to Möger Pedersen: “During the next decade the supply of infrastructure assets will likely match the rush in demand. The focus on deficits makes it necessary for all western governments to mobilise private partnerships. There will be a transformation in how big, publicly important projects are financed, forging a new kind of co-operation between the public sector and pension funds.”

The focus on reducing deficits has already begun shifting infrastructure ownership into the private sector. According to Ben Morton, co-head of Cohen & Steers’ infrastructure team. “Governments have targeted the sale of infrastructure assets as a means of paying down sovereign debt.” In Europe alone, the UK, Portugal, Spain and Greece have announced privatisation plans designed to raise a total of €32bn. And as Barben suggests: “We actually think that increasing interest from financial investors will stimulate a lot of these transactions.”

The threat of a bubble appears to be mitigated for now. “That is not to say individual deals might not be over-priced, particularly those sold through auction,” warns Duncan Hale, senior investment consultant at Towers Watson. “But investors are increasingly circumspect and have learned the lessons from the crisis.”

Timing, however, is critical. While supply could outstrip demand in the longer term, institutions often want assets invested within a tighter timescale. It will be important to avoid setting hard investment deadlines and being able to wait until assets are attractively priced - a key element of PensionDanmark’s strategy.

Investor preferences also play a role in supply/demand dynamics. So far, institutions have favoured existing (brownfield) rather than new (greenfield) assets, and developed markets over emerging. “Investors prefer more liquid, mature markets,” says Patrick Thomson, JP Morgan Asset Management’s global head of sovereigns. “Emerging markets are a relatively new segment of the infrastructure asset class and therefore capacity can be an issue.”

There is another important cost to consider in an asset class requiring a relatively high degree of hands-on management of underlying assets: whether in-house or external, paying for skilled managers is not cheap. Distinguishing between alpha and beta is key in determining the relative value of different entry points. “Even within sector, one project’s risk profile can differ greatly from another,” Hale says. “It makes more sense to break the asset class down in terms of core and opportunistic infrastructure.”

Core markets and brownfield assets producing long-term, stable and inflation-linked cash flows represent market beta. Alpha comes from opportunistic investment in greenfield and emerging markets, but also requires a greater degree of skill. “However, completely separating the two is impossible for infrastructure,” Hale adds.

For larger institutions with in-house expertise, direct or co-investment is the preferred option, particularly for core assets. As Möger Pedersen explains: “Direct or club structures are most efficient as they minimise costs and force us to look deeper into the characteristics of individual assets so we really know what we are dealing with. We have tried to move away from fund structures, which are expensive.”

Importantly, PensionDanmark has so far only invested in developed markets. Möger Pedersen says: “On our own, we would not be able to invest directly in emerging markets, so any exposure would be done through funds on an opportunistic basis.” For small and mid-sized institutions there is little option besides funds. “Direct investment requires a greater in-house capability, which can be difficult to justify,” says Niall Mills, head of European infrastructure investments at First State.

But investors will have to accept paying high fees for alpha. Hale says: “This is an expensive asset class. Good funds employ up to 30 experts with the appropriate skills. However, in some cases fees are too expensive to justify target return levels, particularly for core infrastructure. For a target return of 10-12%, fees of 1.5-2% start to erode value.”

However, he warns that it is “a recipe for disaster” to invest directly without the right skills. “To go direct is time consuming, resource intensive and risky,” says Barben. “It’s not a strategy pension funds are likely to pursue, except for one or two Canadian schemes. You may save some fees, but if one deal goes wrong in a concentrated portfolio this is likely to cost more than paying fees for 50 years.”

Whichever investment route is chosen, as deficits and tight lending continue to force an increase in the supply of assets, prices should remain attractive for funds looking to infrastructure for relatively uncorrelated, inflation-linked returns providing long-term liability matching.

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