THE GLOBAL INFRASTRUCTURE investment market is at an intriguing stage for institutional investors. Investors all over the world are increasingly becoming attracted to the stable, yield-dominated returns that this long-term investment can provide. Although it is only emerging in Europe and North America, infrastructure is well established in Australia. Over the last decade, Australia’s infrastructure investment market has reached a level of maturity where many institutional investors make separate equity allocations to this asset class. But before any institution considers investing in infrastructure for the first time needs, it needs to understand what it is, what its investment characteristics are, the role it can fulfil in a broadly diversified portfolio and how to gain exposure to this asset class. WHAT IS INFRASTRUCTURE? Infrastructure assets are the physical structures and networks used to provide essential services to society, which can include railroads, bridges and dams, among others. Because basic infrastructure is a pre-condition to sustainable economic, and industrial development, it is often provided by the public sector. However, in many developed economies, a change in regulations is allowing private sector investment in these businesses. Investing in infrastructure involves purchasing a direct or indirect equity stake in a business that owns and/or operates an infrastructure asset. Returns are mostly comprised of a larger proportion of the overall return of infrastructure investments. At a broad level, infrastructure investments can be split into two categories: 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 hands or by constructing and subsequently operating the asset. These businesses can be subject to varying degrees of regulatory control and market risk. Social infrastructure investments typically consist 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 maintains the physical assets and facilities. These arrangements are usually described as public/private partnerships (PPPs)or private finance initiatives(PFIs)and are generally employed in sectors such as affordable housing, schools, public transport and hospitals. At the heart of the infrastructure investment is a fundamental imbalance in demand and supply. User demand for infrastructure services is typically strong. For example, as households purchase more electric heaters or air conditioners to improve their levels of comfort, demand for electricity generation and for electricity network capacity increases. However, traditional public sector supply of infrastructure services is constrained by the combination of limited fiscal resources, the scale of required new infrastructure and the costs of replacing ageing assets. With no short-term solutions in sight, the fundamental imbalance will persist and this is fuelling the pressure to make use of private sector finance to develop and manage such infrastructure assets. This global trend is evident in the decline in public sector spending on infrastructure as a percentage of GDP. Moreover, governments are realizing that in many cases it is unnecessary for the public sector to own infrastructure assets and that projects can often be delivered in a more timely and cost-effective manner by the private sector. INVESTMENT CHARACTERISTICS Long asset life: a typical 10-year minimum lifespan of the underlying asset gives any related investments a long duration. These distinctive characteristics combined with the imbalance between demand and supply make infrastructure assets an attractive investment, particularly to long-term institutional invertors seeking predictable, high-yield returns. There is, however, a distinction between different types of infrastructure. For example, development-stage infrastructure assets face a relatively high level of business risk which may include construction risk, uncertain demand growth and early year post-privatization risk. Over time, business risks reduce as operating conditions and business performance become more predictable. For development projects, total return consists mostly of capital growth with a premium for associated risk factors. Investment in the construction phase of a toll road is one example of a development-stage infrastructure asset, with initial investors taking construction and possibly traffic-demand risk. Later-stage infrastructure assets, like an established toll road, are established businesses with a history of consistent, robust cash flows. Investment returns at this stage consist mainly of a stable income flow with modest capital growth linked to economic growth and/or inflation. Institutional investors seeking predictable cash flows and low volatility of returns may be best served by investing predominantly in later-stage infrastructure businesses as opposed to development-stage businesses due to the relative reliability of cash flow from these businesses. However, some exposure to development-stage infrastructure businesses may be helpful in order to generate long-term total returns. HOW DOES INFRASTRUCTURE PERFORM? Like any investment, the returns generated by investing in infrastructure are directly related to the risk exposure of the underlying assets. This implies that expected returns can be protected and even enhanced by understanding and actively managing the risks involved. This active management, combined with the characteristics of the asset, can provide distinctive risk and return profiles for investors. Single asset concessions (eg. toll roads, tunnels and bridges). These projects generally utilize private capital on a build-own-operate-transfer(BOOT) or own-operate-transfer(OOT)basis. This means that the government will typically sell the concession to build and/or own/operate the road/bridge/tunnel to a private consortium and collect tolls paid by consumers for a fixed period of time. At the end of the concession period, which may be about 35 years, the private operator(investor)will return all operating responsibilities and its ability to collect toll revenues to the government. As a result, unless the government decides to extend a concession for the asset during the life of the first concession, the value of the concession will ultimately decline to zero, to the point at which operating responsibilities and the asset must be returned to the government. There can be several variations on this model, with some or all traffic risk taken by the government. Airports and unregulated utilities. These tend to be investments in existing businesses with established operating conditions. On privatization, significant capital growth can be generated for private investors as a result of private sector business practices, cost efficiencies and business strategy enhancement. Following the initial “growth spurt” of privatization, these businesses will generally offer opportunities to generate continued growth through implementation of business strategies that appropriately respond to, or anticipate changes in the broader economic and business environment, competitive pressures and customer trends. A key objective for the manager of the asset will be to maximize ongoing income delivered from the business, which should be sustainable during the life of the investment. Regulated utilities. Regulated utilities are typically existing regional monopolies and as a result, development opportunities are often limited. Regulated utilities offer few opportunities to generate significant operating efficiencies following the period immediately post-privatization. However, the regulated nature of the revenue stream and limited competition results in a reliable income stream throughout the life of the asset. Social infrastructure. Social infrastructure investments are generally structured in a highly-regulated way with specialist contractors operating the assets to fixed performance criteria. They are typically PPP or PFI projects as described earlier. The income stream is often provided directly by the government and is structured as a payment for making a facility(ie. a school or hospital)available to an agreed standard over a concession period. Provision of the underlying service, such as education or healthcare, generally remains the responsibility of the government and the private concession holder is not exposed to patronage risk. As a result, these investments exhibit characteristics of “structured finance” type transactions paying an income typically higher than government bonds for a fixed term. As the asset is normally transferred to the government at the end of the concession period, the capital value of the investment will decline towards the end of the term. Investment success relies on the financing strategy which typically features significant leverage to enhance equity returns. WHERE DOES INFRASTURCTURE FIT IN AND INSTITUTIONAL PORTFOLIO? There are several ways to view infrastructure investments in a portfolio context. Their long-term, relatively stable and predictable cash flows can be compared with fixed income returns while their relation to tangible assets begs a comparison with direct property investments. But while there are some similarities, there are also significant differences. For example, mature infrastructure returns are typically much less volatile than most private equity investments and the holding period is long term compared with the medium-term exit strategies required of most traditional private equity investors. Typical total post-fee returns of approximately 7% to 10% for a mature infrastructure portfolio compare with 15% to 25% for a diversified private equity portfolio. These differences offer diversification benefits from the inclusion of an investment class that can behave differently to traditional types of investment. Infrastructure investment returns show a low correlation with those of traditional asset classes. The important risk-return differences between infrastructure portfolios and traditional private equity, fixed income or direct property categories have led many investors in developed infrastructure investment markets to treat it as a separate asset class. The development of Australia and Canada’s infrastructure investment markets over the past decade has demonstrated this trend, with Australian pension funds, on average, allocating 5% of portfolio assets to the sector and larger funds committing more. Industry funds(ie. public sector funds with members specific to particular industries)which represent nearly one-tenth of the total pension fund assets in Australia, have committed over US$2.3 billion to infrastructure investments as at June 2004. Insurance companies have also invested substantial sums, although these are difficult to quantify due to limitations in their required reporting. Some large individual pension funds have made particularly sizable allocations to the sector. By way of example, some large superannuation funds in Australia have allocated 20% or more of plan assets to infrastructure. HOW TO INVEST IN INFRASTRUCURE There are three main ways for institutional investors to gain equity exposure to global infrastructure investments: Although direct investments provide more control to the investor over the underlying assets, this method of investment typically requires large capital outlays that could limit diversification opportunities. It is also likely to require specialist due diligence and management skills that may not be readily at hand within the investment team of a pension or insurance fund organization and may be time-consuming. The decision timeframe to invest in a deal is usually tight and inflexible and involves significant due diligence costs. Listed funds provide excellent access to small investors looking to gain exposure to the unique performance characteristics of infrastructure businesses. However, these funds are required to make public the details of the assets they manage and this may not be suitable for some institutional investors. Listed funds are also exposed to stock market volatility, which also may not suit some investors. Gaining an exposure to infrastructure businesses through an unlisted fund offers the possibility to share the cost of entry across a number of investors. But the due diligence process and active management should be left to a qualified investment team. All in all, infrastructure investments are an effective way to generate the stability and yield these investments can provide. This article has been reprinted with the permission of Deutsche Asset Management Canada Limited. Peter Hobbs is the global director of Real Estate and Infrastructure Research for RREEF Deutsche Bank Real Estate in London, U.K. peter.hobbs@db.com For a PDF version of this article, click here. |