Long time readers of this blog may have been doing a bit of head scratching lately over my sudden predilection to write about infrastructure investments. Well, I think the following headline from this morning’s IPE explains my interest and motivation pretty nicely: “Sovereign wealth funds flock to infrastructure.” In short, SWFs are increasingly keen on this asset class, which means I am too.
Accordingly, I thought I’d offer a quick primer; tell you what sort of returns and risks SWFs are exposing themselves to with infrastructure. In order to make my job easier, however, I’m just going to crib from George Inderst of the OECD. He has a new paper entitled “Public and private financing of infrastructure: Evolution and economics of private infrastructure finance.” It offers a useful framework for understanding all of the considerations of a commercial infrastructure investment.
First, here are the things that separate infrastructure assets from other assets:
- High barriers to entry;
- Economies of scale (e.g., high fixed, low variable costs);
- Inelastic demand for services (giving pricing power);
- Low operating cost and high target operating margins; and
- Long duration (e.g., concessions of 25 years, leases of 99 years).
Second, here is the value proposition:
- Attractive returns;
- Low sensitivity to swings in the economy and markets;
- Low correlation of returns with other asset classes;
- Long-term, stable and predictable cash flows;
- Good inflation hedge;
- Low default rates; and
- Socially responsible investing.
Finally, here are the many risks that need to be managed:
- Construction risk;
- Operational and management risk;
- Business risk (demand, supply factors);
- Leverage, interest rate risk;
- Refinancing risk;
- Legal and ownership risk;
- Regulatory risk (fees, concessions);
- Environmental risks;
- Political and taxation risks; and
- Social risks (e.g., opposition from pressure groups, corruption);
- Concentration or cluster risk (small number of similar assets in portfolio);
- Illiquidity risk (immature secondary market);
- Pricing risk (valuation basis);
- Risks related to the governance of investment vehicles (e.g., conflicts of interests, opacity); and
- Reputation risk.
The risks will undoubtedly vary according to how the fund accesses infrastructure. The risks facing a fund investing through a listed product will be far different than the risks for a direct investor. Anyway, there you have it: SWFs & Infrastructure 101. Class dismissed.
This post originally appeared on the Oxford SWF Project website.