Alternative asset classes: don’t wait too long

Real estate and infrastructure assets feature strongly in plan sponsors’ allocations given their income component and equity-like returns with lower than equity volatility, and the longer duration of many of the assets. As well, should an inflationary environment emerge, they are real assets and provide inflation protection.

While infrastructure projects have been around for many years, the ability of plan sponsors to invest in third-party funds is a relatively recent development. Infrastructure assets include regulated utilities, toll roads, schools, hospitals, ports, airports, and renewable energy projects. Much of the infrastructure built in developed economies (North America, Western Europe and Australia) is aging and in need of repair and/or replacement. With many of these governments in deficit, alternative forms of financing are required, including varying levels of private participation. In the emerging economies, too much infrastructure is financed by governments alone.

It is not surprising, then, that much money was raised to participate in the infrastructure opportunity, especially in 2006 and 2007. Many deals were also done with high levels of cheap debt—90% debt was not unusual for such assets as toll roads.

During the credit crisis, it was difficult to access debt, making deals difficult to finalize. This led to excess capital during 2008 and 2009, with the situation only improving in the second half of 2010 as deals were finalized, though the financing terms were nowhere near as attractive as in the boom years. The high-leverage levels led to financial difficulties, and in some cases distress, for some assets. For example, some assets had functioning and profitable operations, but debt-servicing levels totally negated any profit.

The natural question is whether now is the right time to invest in infrastructure. Many believe we are still in the early stages of deleveraging. The chart below shows the capital structure of infrastructure deals pre- and post-crisis. We can see the increased equity component post-crisis, which will require increased operational improvement and more disciplined purchasing to generate attractive returns to investors.

Not all is negative. The current environment may lead to opportunities for the providers of capital, including the following:

• There is significant fiscal pressure on governments to boost public expenditure. This could lead to monetizing of assets or new deal flow in infrastructure.
• Asset-backed debt holders may own foreclosed assets, but they lack the expertise and capital necessary to maximize recovery, providing opportunities for professional management.
• Some assets may need recapitalization, which could lead to public-to-private transactions and management buy-ins.
• Some assets are too weighed down by their debt load, leading to distressed sales of assets (rather than sales of distressed assets).
• We could see mergers and termination of funds.

With improved pricing, increased deal flow and more sensible capital structures, we are becoming more optimistic about the potential for infrastructure assets. As noted above, headwinds for the asset class exist and have to be carefully managed. However, waiting until these fully pass could result in a missed opportunity.