Infrastructure as an alternative
Recent global market turmoil has seen a rebalancing of many pension funds’ portfolios away from listed equities and a greater willingness on the part of institutional investors to examine alternative asset classes. There have been many reports of increased allocations to private equity and hedge funds as well as a growing interest in inflation linked debt securities.
One class of alternative investments which deserves more attention in this context is infrastructure. This asset class offers long-term, stable and predictable cash flows with limited downside risk and an effective built-in inflation protection mechanism. Infrastructure assets provide a match for a typical defined benefit plan’s liability profile while delivering a risk adjusted return well in excess of the available alternatives.
In some countries, notably Australia, infrastructure forms part of the core investment focus of many pension funds, life companies and other holders of long-term liabilities. In the UK and the Euro-zone, this type of investment is still in its infancy. The investment characteristics of infrastructure assets are poorly understood in some jurisdictions and there exists a significant opportunity for information arbitrage – a first mover’s advantage.
What is infrastructure?
Infrastructure can be described as the ‘underlying foundation of basic services, facilities and institutions upon which the growth and development of a community depend’. This definition highlights the importance of infrastructure assets to the community and hence the intrinsically low risk nature of the asset class. Without effective infrastructure, societies and economies simply cannot grow. Reliable transport corridors, telecommunication networks or power distribution networks are as essential to the health of an economy as stable legal and political systems.
The need for private investment
Traditionally, governments have facilitated infrastructure investments, either by building roads and railways, electricity grids and telephone lines on behalf of their citizens or by subsidising those who built them. However, since the late 1960s, political pressure to lower taxes and balance budgets combined with the demands for a continuing improvement in the provision of social infrastructure has required governments to consider alternative funding options.
As a result, infrastructure investment in the developed world has been gradually moving from the public to the private sector. In the UK, for example, the proportion of public sector investment declined from about 12% of general government outlays in 1970 to around 3% in 2000.
The provision and ownership of infrastructure, traditionally seen as the domain of government, has undergone fundamental changes over the past few years. Many governments decided to sell off their infrastructure assets and to embrace a ‘user pays’ concept to introduce tolls on roads and charges on airports. This change has seen governments moving towards the role of regulator rather than provider of infrastructure services, leaving ownership and provision of services to the private sector.
Consequently, infrastructure is emerging as a new asset class, with increasing opportunities to invest in the development of new assets and acquisition of existing state-owned enterprises. There is also a growing secondary market.
Macroeconomic factors clearly point to this trend continuing for the foreseeable future with the ever-growing demand for infrastructure assets and services and the ever-decreasing ability of governments to finance them.
Types of infrastructure
Infrastructure assets have potentially attractive investment characteristics:
o they provide essential ‘backbone’ services to the community;
o they have a sustainable competitive advantage (often a natural monopoly) resulting in very low demand elasticity;
o and are highly capital intensive long-life assets usually with an immovable physical component.
Infrastructure assets range from ‘really boring’ (such as electricity transmission) to ‘mildly exciting’ (such as airports) and, can be classified into regulated assets, patronage risk assets, commodity risk assets and social infrastructure. From an investment perspective, it is the first two categories that are of particular interest.
Key investment characteristics of infrastructure assets
Many infrastructure projects provide a unique service to a segment of the population and are established under a long term concession agreement. For instance, airports and toll roads operate under concessions which can extend up to 100 years. The weighted average concession term in the Macquarie Infrastructure Group’s (it is a publicly listed global toll road fund) is approximately 60 years. During the concession period, the owner can normally expect the asset to retain its strategic advantage, as the only asset of its type in the relevant geographic area. The strategic position is further enhanced by the natural barriers to entry such as the high cost of development and construction of an alternative asset, the difficulty in obtaining suitable land and various environmental and legal impediments. These characteristics allow the cash flows from many infrastructure assets to be more predictable than those from other asset classes. This, in turn, reduces the risks inherent in an investment in these assets.
Due to their monopoly position combined with the essential service nature of the assets, owners of infrastructure assets can possess significant pricing power. This brings about government regulation, which provides both an upside and downside cap on the associated earnings and risks.
Owners of regulated assets are typically allowed by the government regulator to earn a specific rate of return on capital invested. This requires calculation of a regulatory asset base, assumed capital structure and allowable WACC. One of the regulator’s objectives is to ensure the ongoing financial viability of the essential service.
Patronage risk assets have pricing terms that are either regulated or set out in a concession deed.
Infrastructure assets with a long-term concession and an unrestricted or very flexible pricing mechanism are, not surprisingly, highly sought after. For example, a 10% toll increase may result in a traffic decline of, say, 2.5%, producing an immediate increase in the toll road’s revenue. As there is no corresponding in-crease in operating costs, the increment flows directly to the bottom line and, hence, the equity investors. During the 1980-82 recession, BAA (British Airports Authority)
aeronautical charges by 40%. BAA’s passenger numbers remained stable but the EBITDA has grown from £59.8m (E94m) in 1980 to £95.7m in 1982.
Both regulatory and concession based pricing models typically contain a mechanism for RPI related adjustments.
Most infrastructure assets provide an essential service to the community and, as such, are more likely to be dependent on demographic factors than the economic cycle. Infrastructure assets are therefore effective defensive investments in an economic downturn.
Infrastructure assets typically have a predictable life cycle, with the majority of the risks and potential rewards arising from development risk, construction risk and, for patronage-related assets, patronage ramp-up risk.
As these risks reduce over time, the appreciation in the value of the asset is likely to occur, resulting in capital gains. The ability to predict and manage these risks with more certainty than is possible with other asset classes has the potential to provide returns well in excess of the cash yield earned.
Infrastructure assets are subject to low levels of operating risk. Operating costs on toll roads for example are typically below 20% of revenue. The management of financing and the capital structure are the critical factors in delivering excess returns to investors.
Considering the importance of funding costs in the overall cost profile of infrastructure assets, active financial management can add substantial value. As the risk profile changes, credit ratings typically improve. The value of this improvement can be realised through re-gearing and re-financing. As an example, a recent refinancing of the M5 Motorway in Sydney, brought equity distributions forward by nine years.
Why should infrastructure assets be attractive to pension funds?
Pension funds require stable real returns to match their liability profile. The low-risk, low volatility, long life and inflation protected nature of infrastructure assets provide an attractive solution.
Infrastructure assets can enhance a pension fund’s typical alternative asset portfolio of real estate and ‘traditional’ private equity (both of which are cyclical, correlated to the public equity markets and have a higher risk profile). When compared to other asset classes, infrastructure assets can offer an attractive combination of low/moderate risk levels and moderate /high inflation protected returns.
The infrastructure sector should be of particular interest in the current market conditions of volatility and decline in the public equity markets. It is also a time of a significant overhang of traditional private equity funds chasing a decreasing number of quality transactions in the MBO/LBO market. In addition, with the drying out of the IPO market and declining valuations, traditional private equity has been showing annualised 10 year returns in low teens. This is easily within reach of infrastructure investments, even without the necessary adjustment to reflect the significantly lower risk profile of infrastructure.
Infrastructure assets typically demonstrate a return profile similar to inflation linked bonds, but with a significant return premium and longer duration. On a risk adjusted basis, the returns offered from infrastructure assets are very attractive. While real return bonds oscillate in the sub-RPI +300bps area, even the most ‘boring’ regulated assets can produce RPI +600 bps. With an appropriately structured investment vehicle, equity internal rates of return can range between 10% and 25% with cash yields up to 15%.
How do you access infrastructure investments?
Despite the inherent attractiveness of the asset class and the large volume of assets available, the practicalities of an institution accessing these investments present a number of issues.
There are quite a few publicly listed infrastructure companies, however, they may not necessarily be the most effective way of investing, considering that they:
o are often prevented by the public market from employing the most efficient capital structure;
o are often single asset vehicles;
o are subject to the vagaries of the general public equity market; and
o often have management that pursues expansion and growth strategies which compromise the stability and purity of the core asset.
To date, the private market in infrastructure investments in the UK has been largely limited to a small number of funds, which focus solely on the relatively narrow UK PFI (Private Finance Initiative) market. There are a number of primary funds and two or three secondary funds, all of them subject to the limitations imposed by the underlying PFI structure.
Whilst some of the mainstream private equity firms occasionally invest in infrastructure-type businesses, the traditional private equity model is ill-suited to this asset class, which rewards long term ownership and, hence, suits long term liability holders with a lower requirement for liquidity.
In addition, specialised assets require specialised management, and infrastructure assets are typically outside the traditional area of expertise of these firms.
How best to access this asset class ultimately depends on each institution’s investment style, size and preferences. Considering the high value of the projects, it would be difficult to achieve an acceptable level of diversification other than through a managed diversified infrastructure investment fund. Another way, of course, would be to invest in projects or assets directly, however, that would require both significant in-house skills in evaluating each investment and on-going monitoring and management as well as very substantial commitment of funds to achieve diversification.
In most cases therefore, it would appear that some form of a managed, diversified infrastructure investment vehicle with a specialised manager would be the logical answer. As an example, Macquarie has recently raised from UK, European, Australian and North American institutions a E600m unlisted airport investment fund, which is now fully invested in Birmingham, Bristol, Sydney and Rome airports.
One thing is clear – this asset class will gain importance over time as a result of macroeconomic factors. We can therefore expect a strong and growing supply of new transactions and an increased investor interest consistent with a flight to defensive investments.
In time, infrastructure assets may well (and should) become an important alternative to traditional real return assets. As economic uncertainty continues, the long-term and comparatively secure cash flows characteristic of infrastructure investments will ensure sustained growth for this rapidly emerging asset class.
Arthur Rakowski is a London-based division director of Macquarie Bank, an international investment bank specialising in infrastructure finance