Inflation Assets: Infrastructure coming of age
Infrastructure assets are a great fit for pension fund portfolios, argues Danny Latham, but the sector needs more standardised risk and performance measures
The prospect of a predictable, inflation-protected income stream means that infrastructure is now increasingly attractive to long-term investors. But they also want clarity on the risk and return expectations for different types of infrastructure and many feel that this is missing. To explain why there is a lack of robust data on infrastructure and how it can be overcome, it is necessary to look at the nature of the individual assets and the recent evolution of the asset class.
Infrastructure consists of a very broad and diverse set of assets, which can be placed along a risk and return spectrum.
Global demand for infrastructure means that it has the potential to rival property as a source of an income linked to inflation. Booz Allen Hamilton, the leading strategy and technology consulting firm, estimates that €49trn in infrastructure investment is needed globally over the next 25 years, to maintain existing first world infrastructure and build new networks in developing countries. Europe is the biggest market for infrastructure investment (current value €4.6trn), and it is estimated to grow by about 10% per year in order to meet existing construction, upgrade and maintenance requirements.
Infrastructure investment has a natural fit with investors like pension funds that are looking to match long-term liabilities, because the are characterised by long-term, predictable and sustainable cash flows. This may be underpinned by a regulated environment, which has created the income stream for the holders of an infrastructure asset, such as electric transmission or water companies. Additionally, its growth profile is relatively insulated from business and economic cycles, partly because infrastructure assets typically have high barriers to entry and may enjoy a monopolistic position in markets, such as utility businesses providing water or gas to households or airports.
Unlisted infrastructure, by nature, has a low level of volatility, particularly when compared with the listed markets. This is not just because many assets in the sector are valued only periodically, but also because of their characteristically inelastic pricing, which is underpinned mainly by the regulatory environment or well understood volume, demand or patronage risk. Depending on the particular segment involved, the income from infrastructure can be inflation linked and often has a low correlation to other assets over the long term. Not only has the investment environment changed in favour of investments like infrastructure, but demographic and regulatory factors, such as increased longevity and accounting standard IAS19, mean that future portfolios will need to be lower risk, with an emphasis on yield and inflation protection, as well as liquidity and duration.
Given the positive attributes of infrastructure, why haven't more investors in Europe placed funds in it? The sector, overall, can be described as being at the adolescent stage of its development. However, infrastructure as an asset class has been around for 15 years or so in Australia and Canada, where it is most developed, and historical data on infrastructure performance is concentrated on these two countries. Yet, regional differences mean that it is not possible to simply take performance data from these countries and apply it to infrastructure opportunities in other countries.
As well as its relative immaturity, the existence of many differing regulatory regimes governing infrastructure is another factor obscuring market data. Regulatory regimes are invariably different in each country and can range from a lack of regulation to onerous regulations that undergo changes every few years, with different regulations for different industries within the infrastructure sector in the same country. Infrastructure currently lacks transparent, standardised benchmarks which investors can use to monitor and judge performance: there have been some attempts to create infrastructure indices, but these indices are often too broad, with the inclusion of companies engaged in activities unrelated to infrastructure, such as shipping or mining, for example.
Some sectors in infrastructure, such as offshore windfarms, or geothermal, or solar energy, are also new and risk-return estimates in these areas are still evolving and have a relatively short history. In any case, investors need to look at the historic performance of any fund they are considering investing in, as this may not be correlated to a broad index for infrastructure.
Another issue is the lack of transparency over past performance in state-owned utilities, for example. Infrastructure companies are now disaggregating assets from vertically integrated businesses, where performance data was not readily transparent in their consolidated financial statements. For example, the data for transmission and distribution grids in electricity and gas utilities may not be readily transparent in consolidated financial statements of the parent company.
However, investors are now starting to take a more proactive role in obtaining and measuring performance, and in the creation of infrastructure indices. We believe it is significant that Dr Christoph Schumacher, head of indirect investments at Generali Deutschland Immobilien, has recently argued for a European industry body in his article on institutional infrastructure investment in Germany. "Many investors, including ourselves, who have extensive experience in real estate are working collectively towards a standardised system of best industry practices and reporting procedures for the infrastructure industry," he has written. Such an industry body, representing investors in infrastructure, would help educate and promote transparency, professionalism and best practice, as well as lobby governments on behalf of the industry in an increasingly regulated environment.
As infrastructure investment evolves in Europe, we can expect to see a number of themes and developments. There will be a greater focus on governance and transparency and a trend away from an ‘investment banking' model towards a fiduciary model. Secondly, as the sector matures, there will be greater segmentation by sector, geography and style, allowing investors to tailor strategies according to their risk/return and liquidity preferences. Some fund terms are now more ‘investor friendly' including enhanced liquidity options and investor protections such as no-fault divorce and key-man rights which promote alignment.
Fee structures are also evolving to become more transparent, with a better alignment of the respective interests of the agents (professional infrastructure managers) and principals (long-term owners such as pension funds). We can expect to see a move from ‘2 and 20' fee structures (2% annual and 20% performance fees) to ‘1 and 10' or less.
There is no doubt that infrastructure has a place in the portfolios of long-term investors, due to its characteristics of a stable, inflation-protected yield and diversification away from public markets. As David Gamble, a pension fund investment adviser and ex-CIO of the British Airways pension funds, has commented: "It is clear to me that infrastructure has many of the characteristics that a pension fund will increasingly require to meet its liabilities. The model must be conservative, with leverage only applied at the company level and a more appropriate fee structure. It is an asset class in its own right and I believe that infrastructure will be an essential part of a well constructed diversified pension portfolio."
While lack of transparent market data for infrastructure in Europe is an issue for investors, it should not be an insurmountable one. As infrastructure matures as an asset class, this issue should be resolved, enabling investors to properly assess the risks and rewards of different types of investment offered by the sector and to benchmark them against other opportunities in the wider market.
Danny Latham is head of infrastructure investments, Europe, at First State Investments