Inflation Assets: Intricacies of infrastructure
Infrastructure can offer some inflation protection, but pension funds must know what they are doing, writes Maha Khan Phillips
Infrastructure managers are quick to point out that, with its long-term asset life and predictable, often inflation-linked cash flows, infrastructure can help pension funds manage their liability risks. However, others warn of the risks as well as the benefits of adding infrastructure for portfolio optimisation.
"Infrastructure is a great sector, but it is full of traps for the unwary," says Giles Frost, head of the international advisory team at International Public Partnerships (INPP), the London-listed fund. "There is an assumption somehow that infrastructure is safer than other investments, that it is a bit like earning a bond. That's dangerous."
Infrastructure opportunities have grown significantly, pushed by governments turning to private funds to refinance projects, according to a 2010 report from Swiss & Global Asset Management. In OECD countries alone, state assets worth some $1trn have been sold in recent decades, with the most recent example being the sale by the UK government of High Speed 1, the railway line between London and Folkestone. Europe remains the largest market for developed infrastructure, at €4.6trn, with expected growth of 10% per year, according to First State Investments. In the period January 2006 through March 2010 there were 122 transactions representing approximately €206bn in core/core plus infrastructure.
Rates charged to use infrastructure assets are usually inflation-linked in the long run, whether they are determined by regulators, concession agreements, or long-term contracts. Regulated electricity, gas, water, and sewage utilities have periodic ‘rate cases', for example, where regulators determine the allowed return on equity based on capital and maintenance costs, with variable costs such as the price of wholesale natural gas or electricity passed on to consumers.
Concession agreements, mainly used for public-private partnership (PPP) in the transportation sector, define the upper limit on rate or toll increases, usually linked to inflation.
Finally, there are long-term contracts, where regulated electricity utilities provide long-term resource plans to the regulators, based on reliability and minimum costs. Qualifying power generators, especially generators that produce energy from clean sources, usually have 20-year-plus contracts where payments depend on availability and can be indexed to inflation.
JP Morgan Asset Management analysed how the annual cash flows of 256 mature infrastructure assets in the US and EU performed from 1986-2008. Cash flows grew steadily, at a rate above CPI, regardless of the global economic environment.
"Most institutional investors who invest do so because they believe in the inflation protection link," says Arthur Rakowski, executive director responsible for investor relations at Macquarie Group. However, not all infrastructure assets provide protection. "Infrastructure is a generic term encompassing a broad range of businesses and services, from a green field project in India to an existing electricity network in the Netherlands."
That means investors need to understand what they are getting into. The high-profile court case involving 30 pension funds that invested in the Henderson PFI Secondary Funds illustrates that investors not only need to read the small print, but also access the underlying infrastructure rather than the companies that build it: at the heart of investors' grievances is that Henderson purchased property developer John Laing, a PFI contracting firm, when it should have acquired PFI projects. Their investment has reportedly fallen by around 60%.
"If you are looking at inflation protection, I would limit yourself to the real asset part of infrastructure," says Dirk Kubisch, head product specialist, Swiss & Global Asset Management.
Robert Howie, a principal with Mercer, argues that investors are limited to looking for assets with regulatory inflation protection in place, but also warns against high expectations: "If you want guaranteed inflation protection, only inflation-linked bonds give you that."
Investors must also realise that much of what is considered low-risk infrastructure, such as patronage assets like toll roads and airports, are actually linked to GDP growth. That left many infrastructure managers in difficulty when the financial crisis began. "The analyst would say, here is a toll road, and our projection is that traffic will grow by 4% per annum andrevenue will increase at 4% plus inflation," says INPP's Frost. "Those funds caught a huge cold when the recession hit and the growth rate of cars going down toll roads and passengers going into airports changed direction."
Others wonder just how useful infrastructure inflation is for investors. It cannot protect against sudden spikes in inflation, for example, which are often the source of most harm to investors. Commodities are the best protection against that. "Think of how much of infrastructure is in utility-type assets," notes Greg Clerkson, head of alternative investments consulting in EMEA at Russell. "Utilities' short-term profitability can be negatively affected by inflation. Certainly one of the short-term effects is on energy prices."
Steef Bergakker, managing director of the Robeco Infrastructure Equities fund, also suggests that CPI measures are not always accurate. "Most contracts are typically linked to CPI measures of inflation which do not always capture the real inflation risks that that infrastructure assets are exposed to," he warns. Labour, equipment and materials costs on heavy construction are not typically in the CPI basket.
For pension funds, allocations to infrastructure differ, depending on why infrastructure is being used in the portfolio. For those who want to generate return, emerging markets offer plenty of opportunities. Bank of America Merrill Lynch expects that governments and private enterprise in emerging markets will spend more than $6trn on infrastructure over the next three years. Unfortunately, from ALM perspective, emerging market infrastructure makes little sense.
"If you want asset liability matching and inflation hedging, there is probably going to be a local/regional bias," says Danny Latham, European head of infrastructure at First State Investments. "The inflation characteristics of emerging markets tend to be less correlated with the inflation that is happening in your own jurisdiction."
His colleague, senior asset manager for infrastructure Jeffrey Altmann, says it is easy to get tripped up. "We've spoken to several US investors who say they are concerned about investing in European regional funds. Yet these LP's have invested in global US dollar denominated funds, many of which have a high concentration of European assets in their respective portfolios and hence have a similar kind of exposure. If you are concerned about currency and interest rate risk then you have to invest locally."
Pension funds also have to decide how much illiquidity they can handle. "Low-risk assets can be matched to inflation-linked liabilities, but there is also a big illiquidity and liquidity-mismatch issue to think about," says Howie. "This is a physical asset which you are expected to hold for 20-30 years."
Still, there is some consensus among managers that, as infrastructure grows more popular, with development of sub-sectors and an increasing range on the risk spectrum, the benefits will only get better. "If I had a crystal ball I would expect the infrastructure asset class may well rival the real estate sector over the course of the next 5-10 years," says Latham. "It comes back to fundamentals. From governments to corporates the supply of opportunities is enormous, and therefore by definition the capital will mobilise to meet that investment opportunity."