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Infrastructure's long-term payback

Pension funds are trying to spread their investments across a much wider spectrum of asset classes than in the past. More ‘alternative’ products are being offered on the market to meet the insatiable demand from institutions. One area now attracting increasing attention in Europe is infrastructure investment.
The term immediately strikes a chord with many pension plan fiduciaries, as it sounds like an asset of a very tangible and long-term nature. But what exactly is meant by “infrastructure”?
One dictionary defines it as: “The basic facilities, services, and installations needed for the functioning of a community or society, such as transportation and communications systems, water and power lines, and public institutions including schools, post offices, and prisons.”
In post-war Europe, most of the infrastructure was owned and controlled by public institutions. Since the 1980s the trend has reversed as many pieces of infrastructure have been (partly or fully) privatised in the face of stretched state finances. Furthermore, governments are increasingly subcontracting public services to private companies or proposing new forms of ‘public private partnerships’.
Different countries take different routes at different speed. In the UK, under the Private Finance Initiative(PFI), for example, the state changes its role from owner and provider to purchaser and regulator of public services. The private sector takes on the roles of financier and manager of infrastructure, obviously expecting an attractive return.

Australia and Canada are quite advanced in terms of private investing in infrastructure. Within Europe, the UK has the biggest market, where PFI extends over 400 projects and £50bn(E74bn), but other countries have become active, including Italy, Spain, Portugal and Sweden. Recent examples are motorways in France, tunnels in Germany, utilities in the Netherlands.
The involvement of private investors in infrastructure is also rising fast in Asia and some emerging markets. The European Investment Bank estimates a requirement for public infrastructure projects at E500bn and that is for Europe only.
Infrastructure assets are generally split into two main categories, and a wide range of sectors:
q Economic infrastructure: transport (for example,toll roads, ports, airports, tunnels, metros), utilities (for example, water, energy distribution networks) and communication ( TV/telephone transmitters)
q Social infrastructure, such as schools, hospitals and health care centres, prisons, police and military stations, and so on.
Physically, these are very different things but the investment industry highlights certain economic and financial commonalties.
q Monopoly situations: Some services are ‘natural monopolies’ (eg, gas distribution) while others enjoy exclusive concessions from governments (for example, toll roads).
q Regulation: Charges and fee increases are typically controlled.
q Long-dating contracts: Legally binding concessions granted by government department or agencies, often running for 25 years and longer.
Consequently, the proponents of infrastructure investments claim that they possess favourable investment characteristics:
q Stable and predictable cash flows;
q Often inflation-linked;
q Long-term maturity;
q In some cases, incomes can be tax-effective;
q Returns insensitive to the fluctuations in the business, interest rates and stock market volatility.
Of course, this is music to the ears of pension plan investors faced with a lasting stream of indexed pension payments. But how can you best invest in infrastructure? In principle, there are a number of options:
q Primary or secondary market? Primary means financing the capital-intense, start-up phase where the required internal rates of returns (IRR) are high to compensate for the substantial risks. Secondary investing relates to the operational phase with lower expected risk and return;
q Debt or equity? Debt financing (for example, through a bond issue by the owner of the infrastructure project) or equity participation;
q Direct or indirect? Direct partnership with other entities to own and operate the project or indirect investment through (listed or unlisted) infrastructure funds.
In practice, not all of these options are easily available to pension funds, and they may not all be equally suitable for pension funds. On the demand side, it all depends on the plans’ specific requirements and objectives. For example, a pension fund seeking a close match of assets to liabilities, will be more interested in the defensive characteristics of mature projects with high and stable dividend yields (similar to listed utility stocks), or even infrastructure bonds. On the other hand, a bigger, cash-positive pension plan may well be interested in the growth potential of
earlier-stage developments (with a J-curve effect in income similar to private equity).

What are the risk-return characteristics of infrastructure investment? There are big caveats when it comes to the figure work. First, data history is quite short. It is prudent for trustees not to extrapolate such figures for new asset classes.
Second, there are not many figures publicly available. Third, they relate to very different types of investments at different stages.
Return figures of 13-15% and yields of 7-8% are reported from Australia for primary investments made in the mid-1990s, combined with favourable risk statistics, also showing low correlation with other asset classes. Currently, return expectations for (secondary, unlisted) infrastructure equity are being put at 8–12 %, which includes expected capital gains on top of the current yield. But the significant financial gearing should be noted. Furthermore, PFI bonds have a yield spread of 50 to 200 basis points to UK gilts, depending on their risk grade.
This demonstrates that infrastructure is not a homogenous asset class. Interestingly, there are elements of investing in private equity and traditional equity, real estate and both conventional and index-linked bonds. As a result you may be able to tilt your portfolio in the preferred direction.
So, should infrastructure investments be included in your pension fund’s asset allocation? Plan directors cannot just look at historical or theoretical risk-return characteristics, but ought to be aware of the different nature of risks connected with infrastructure projects. These are:
q Construction risk (the project is not completed on time/on budget);
q Operational risk (unexpected problems in management);
q Business risk (for example, suddenly more competition brought in; change in consumer preferences);
q Gearing risk (high exposure to interest rate movements);
q Regulatory risk (for example, fee rises fall behind schedule);
q Legal risk from unknown future litigation and ownership risk – lease running out;
q Political risk, such as opposition from pressure groups or politicians changing their stance.
Delegation to skilled and experienced managers should help contain such risks. Appropriate diversification across projects, sectors and countries is another obvious risk reduction tool. Before going ahead, investors need to tackle further issues, in particular:
qLiquidity – ‘how important is this to you? It is difficult to reduce or liquidate investments, which is a problem familiar from property investments. The secondary market is still rather immature;
q Pricing – valuation of individual projects is complicated and similar to private equity;
q Benchmark – how to assess success or failure?
q Potential conflicts of interest – investment groups are often involved in different roles, such as financing, transactions and management;
q Fees – active management of a physical asset does not come cheap. So , how are fees and transaction costs structured?

In summary, all this amounts to a good governance challenge for trustees and others running pension funds. Does the pension fund have the resources to properly assess infrastructure projects? What about their advisers? Who will deal with all the small print in the notoriously voluminous paperwork? More often than not, a diversified infrastructure fund may be the only viable vehicle in practice, certainly for smaller plans.
And last, there is the question of timing. The ‘first mover advantage’ tends to run out over time. Institutional demand is on the rise but investment opportunities are limited. In fact, there are indications that bidding for infrastructure projects is heating up, which can push internal rates of returns (IRRs) below 10%.
Infrastructure investment has many attractions for pension funds but to expect a broad-brush 5% allocation of pension assets, as seen in Australia, would look premature.
Georg Inderst is an independent consultant based in London
georg@georginderst.com

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