Investing in Infrastructure

Economic infrastructure consists of services for which the user is prepared to pay, such as transport, utilities and communications. Investments may be sourced through government privatization processes, sales of businesses already in private (or public) hands or by constructing and subsequently operating the asset.

Social infrastructure covers entities such as hospitals, schools and housing and typically consists of partnerships between the public and private sectors under which the government continues to provide the core service while the private sector builds, owns, operates and/or maintains the physical assets and facilities.

The global infrastructure market is large and growing. Developed and developing economies are currently experiencing a period of increased infrastructure investment activity, undertaken by both governments and the private sector. Continental Europe, the United States and the emerging economies have lagged Australia, Canada and the United Kingdom, which have relied on private finance to undertake infrastructure projects since the 1980s.

Why invest in infrastructure?

Infrastructure’s appeal is several-fold, and varies depending on the sponsor’s objectives, but include:

• High income—Typically, a portfolio of infrastructure assets is anticipated to provide income that is in excess of the income level generated by fixed income securities.
• Relatively stable income—Most infrastructure assets tend to be less cyclical or exposed to demand risk than the average listed (or unlisted company).
• Potentially high risk-adjusted returns—Total returns of as much as 10% per annum may be achieved, net of all fees. Volatility is estimated to lie between that of equities and bonds.
• Long asset life—It is common for infrastructure projects to span at least 30 years. In addition, the infrastructure funds usually have at least a 10-year initial life, giving access to a long-term “bond-like” cash-flow stream.
• Diversification from other asset classes—Analysis completed on listed infrastructure companies suggests that infrastructure equity has a lower volatility than “broad market” quoted equities and some diversification benefits. One would expect a similar relationship for unlisted infrastructure.
• Inflation linkage—Many infrastructure assets have regulated price increase mechanisms that explicitly consider the rate of inflation. This results in infrastructure providing a potential hedge against inflation, a valuable characteristic for many defined benefit pension plans.

The risks associated with infrastructure

There are, however, several risks associated with the asset class. These include:

• Illiquidity (for unlisted closed-ended investments)—Investors should view any allocation to infrastructure as a long-term commitment with limited exit opportunities in the next six to eight years. In practice, we suspect that a limited partnership interest could probably be sold before that timeframe, although it is likely to be at a discount.
• Relatively new investment market—Most Canadian pension and endowment funds have not traditionally invested directly in infrastructure. There are limited performance histories for the the listed and unlisted funds and many of the managers are new to the asset class.
• Political/Regulatory risks—Political or regulatory driven changes can negatively impact the value of an asset. For example, governments could tax the use of cars more heavily, thus potentially reducing demand for toll roads. Alternatively, governing bodies could negatively impact the pricing for regulated utilities.
• Operational risks—There is a possibility that a selected investment manager might not be able to operate an asset(s) successfully and this may lead to penalties or loss of market share (i.e., adversely affect the returns of the investment).
• High investment management fees—These are typically in the range 1.25% to 2% (of committed funds) per annum, plus a 20% performance share above a net return of 8% per annum. In practice, the infrastructure managers often invest heavily in the funds themselves (e.g., 20% or more), so there is significant alignment of interest to achieve good returns after fees.
• Performance measurement may be more difficult—In particular, it may take a few years before any meaningful performance data becomes available (for unlisted infrastructure).
• More complex documentation—Most unlisted infrastructure funds are structured as limited partnerships. Negotiating these agreements is more complicated and time-consuming than standard investment management agreements.

Current status of the asset class

There are several emerging trends for the asset class. These are:

• Increased investment by U.S. plan sponsors, and into U.S. assets—In a widely noted decision late in 2007, CalPERS approved an allocation to inflation-linked assets, including US$2.5 billion into infrastructure. Many other U.S. pension plans took notice and have begun to consider, or implement, an investment into infrastructure. More recently, the Commonwealth of Pennsylvania named a Citigroup-led group consortium the preferred bidder for a 75-year lease of the Pennsylvania Turnpike, worth a reported $12.8 billion.
• Greater breadth of funds—Until five years ago, there were only a few investment vehicles for Canadian plan sponsors to invest in infrastructure. Now, the number has grown significantly, with most of the large, global financial institutions, and some investment managers, offering funds. Moreover, there is an increased variety of funds focusing on different segments on the infrastructure market.
• Concern over asset valuations—With any asset class that undergoes a groundswell of interest, there is the risk that asset valuations will become unreasonable. Given that infrastructure investing usually incorporates leverage, the recent credit “crisis” has only exacerbated this concern. Return expectations for infrastructure have moderated during this time but it remains to be seen if the supply and demand for infrastructure are “out of whack.”

As Canadian plan sponsors look to take advantage of the benefits of diversification, and to invest in assets that provide steady returns and act as a hedge against the plans’ liabilities, alternative assets—and infrastructure in particular—will likely prove to be attractive.

That said, these types of assets are not for every plan and require a considerable commitment of time and effort to gain the required knowledge and comfort for a plan to make such an investment. Many plans are expected to make this effort, however, and continue the trend of increased allocation to alternative assets.

For more about alternative investments such as infrastructure, click here to read A Trustee’s Guide to Alternative Investments.

Chris Kautzky leads Hewitt Associates’ investment consulting office in Vancouver. chris.kautzky@hewitt.com