In recent years, infrastructure has emerged as an attractive asset class for Canadian pension plans and endowment funds looking for long-term, stable investments with strong risk-adjusted return characteristics.
Large pension plans have developed into global leaders in infrastructure investing, as they have built teams of experienced investment professionals and committed billions to the asset class. However, infrastructure investing is also a good fit for most any size of pension plan.
What is infrastructure?
Infrastructure generally refers to the permanent assets that a society requires to facilitate the orderly operation of its economy. Most definitions of infrastructure include assets characterized by physical bricks-and-mortar features; high and sustainable barriers to entry (monopolistic characteristics); inelastic demand attributes; relatively stable rates of return; and strong correlation with local economic drivers, including GDP, population and employment growth.
Investing in infrastructure involves purchasing a direct or indirect equity or debt interest in a company that owns or operates an infrastructure asset. These investments typically offer annuity-like cash flow streams with real return characteristics and the potential for long hold periods—sometimes as long as 30 years.
As an asset class, infrastructure can be captured in four subcategories.
1. Regulated assets include electricity transmission and distribution (T&D) networks, gas T&D networks, and water distribution, collection and treatment networks. These assets are generally natural monopolies with high barriers to entry, stable demand characteristics and revenues based on an allowed rate of return as determined by a government-affiliated body.
2. Transportation assets include toll roads, tunnels and seaports. These assets have revenues based on use or availability. For example, a usage- or patronage-based toll road collects tolls from vehicles as they enter or exit the highway, while an availability-based toll road collects pre-arranged payments from a government body if certain availability or performance targets are met.
3. Contracted assets include electricity generation, midstream gas and communications networks. With contracted assets, the underlying assets may operate in a competitive environment and are subject to fluctuating market prices and volumes. However, returns on these assets are stabilized through long-term contracted rates and volumes.
4. Social infrastructure assets include physical assets associated with providing social goods, such as schools, hospitals and prisons. Revenues are contracted through the government and are based on availability or performance standards.
What are the risks and opportunities?
Infrastructure investing has become increasingly popular for a variety of reasons. According to the Pension Investment Association of Canada, the amount of capital invested in infrastructure by Canadian pension plans has doubled over the past five years to $42.1 billion (as at Dec. 31, 2010). Most notably, infrastructure assets have reliable and predictable cash flow streams based on regulated or contracted revenues and exhibit monopolistic characteristics, including a captive market and high barriers to entry, with low substitution risk (limited competition).
Consequently, infrastructure investing can provide attractive risk-adjusted returns, as well as lower volatility and risk of loss compared with other asset classes. From a portfolio construction perspective, infrastructure assets have low correlation with other asset classes, including global equities and government bonds. The long-term nature of infrastructure investments is a good fit for institutions with long-term liabilities and limited liquidity requirements, such as pension plans. And the real return nature of these investments may provide a hedge against long-term inflation.
Given the benefits of investing in the asset class and the desire to limit portfolio volatility, most institutional investors have allocated or increased their allocation to infrastructure investments (typically to 10%–15%). Consequently, there has been a flood of capital to the asset class, as more and more investors attempt to get in the game.
At the same time, there has also been a significant increase in the supply of infrastructure investment opportunities. Driving this increase are trends such as pressure on governments to trim debts and budget deficits; government attempts to create jobs and stimulate stagnating economies; existing infrastructure reaching the end of its useful life; and governments’ desire to transfer risks (design, construction, operations) to investors in the private sector.
The result of these confluent trends is upward pricing pressure and lower rates of investment returns. Developing a thorough understanding of the risks associated with infrastructure investing is critical in selecting the right investments or managers for your organization.