Getting real with infrastructure

Institutional investors are looking for asset classes with long-term, stable cash flows that hedge inflation and help match liabilities. One option is investing in real assets like bridges and pipelines.

Cutbacks in federal funding—to the tune of $68 billion between 1990 and 2002, according to Infrastructure Canada—have left Canada facing an infrastructure deficit in the tens of billions of dollars. And with this funding gap increasing(see “Infrastructure Backlog,”), governments are searching for new ways to develop capital projects. As a result, industries such as utilities, transportation and healthcare that have historically been government territory, are allowing private capital access to build, own and operate projects. These trends have created an opportunity for private investors to find infrastructure investments with attractive returns and acceptable risk profiles.

Public-private partnership is in its infancy here in Canada, with sporadic investments since the late 1980s and becoming increasingly prevalent in the past few years. Countries like the U.K. and Australia have been leading the way in this sector for over 20 years, with arguably well-developed policies, regulations and networks. But with an increasing number of the largest pension funds in Canada turning their attention to this growing asset class, investment in infrastructure is becoming a more frequent topic of conversation within the investment community.

WHAT IS INFRASTRUCTURE?
The term infrastructure refers to long-term capital facilities, which provide services that are central to all economic activity. These include toll roads, bridges, railways and airports, among others(see “Infrastructure assets”). Good infrastructure delivers key economic services efficiently, improves the economy’s competitiveness, generates high productivity and supports strong economic growth.

Infrastructure assets are conventionally segmented by sector: transportation, essential services and social infrastructure. Infrastructure assets are generally large-scale projects that require a significant capital outlay and time to build. However, after the initial outlay and start-up period, these assets offer the potential for strong, longterm returns. They tend to enjoy a monopoly-like status as a result of the essential services they provide, have natural barriers to entry and little or no competition; this means cash flows can be predicted with a considerable degree of certainty. Operating costs are generally low and the assets have a long operational life, generating strong cash flows, thereby providing a stable yield for equity owners.

WHAT ARE THE BENEFITS TO PENSION FUNDS?
With over $700 billion in capital, according to the 2004 Canadian Pension Fund Directory(a sister publication to BENEFITS CANADA), and with the majority of them near the foreign property limit, many Canadian pension funds are under increasing pressure to find opportunities to deploy their capital. As well, the average age of pension fund beneficiaries is increasing; it is projected 41.4% of the population will be over 40 by 2011, according to Social Development Canada. And Canada’s population will age at an unprecedented rate, with the proportion of people over 65 more than doubling over the next 30 years.

This will require pension fund managers to invest more heavily in secure, income-yielding investments. Returns on traditional investments are also declining, making this relatively under-funded asset class an attractive option, especially in light of its large growth potential.

Infrastructure investments are, by nature, illiquid and require long-term capital, making pension funds natural partners. They typically have a 20- to 25-year investment horizon, a match with pension liabilities that have a 20- year duration.

Diversification is another key benefit for pension fund investors. Infrastructure has a low to inverse correlation to movements in other asset classes—meaning infrastructure assets tend to be immune to economic cycles as they provide essential services and are not affected by fluctuations in the stock market—and it operates on a different cycle. For example, while most investments respond negatively to inflation, infrastructure assets typically benefit from increases in inflation as a result of increased demand for the services these assets provide, acting as a hedge.

In addition to the attractive stable returns, liability matching benefits and diversification, these investments also contribute to overall economic growth, including the creation of new jobs, thereby generating even more resources for the pension funds and contributing towards the capital needs of current and future beneficiaries, as a result of these new people paying into the pension plan.

WHAT ARE THE RISKS?
Infrastructure assets typically have a predictable useful life. The bulk of the risks(and therefore potential rewards)arise from two main categories: project risk and political and policy risk, of which the latter is the more difficult to both measure and mitigate. However, the ability to predict and manage risks increases the opportunity to provide superior returns to investors.

Project risks are the typical risks involved in developing any business or asset. The risks of capital cost overruns, a longer than estimated project completion period, or higher-than-expected operating or maintenance costs are inherent in any project. But, having a partner experienced in building and operating these types of assets can mitigate much of this risk. Patronage ramp-up—the risk that there will not be enough people using the facility to sustain the asset, or that usage will be slower than forecasted— and demand risk can be reduced by the proper demographic, economic and sensitivity analysis.

In the initial stages of the investment, political and policy risk consists primarily of delay and cancellation risk. Political pressure can cause a government to delay a project for months, or even years, or the government may determine that the project is not in the public interest. This type of risk can be largely affected by the type of infrastructure asset, as some are inherently more politically challenging than others.

Once the project is developed and operating, political and policy risk can impose both increased costs and reduced revenue on the asset. Changes in regulations or policies that necessitate changes to the project might impose costs or reduce the need for the project, which could affect the assets return on investment.

HOW DOES PRIVATE INVESTMENT CREATE VALUE?
The private sector has traditionally had greater accountability than government in regards to delivering quality assets on time and on budget. This means improved service delivery, with capital projects coming online sooner, and improved cost effectiveness. Governments may be able to finance projects more cheaply, but this is often offset by the increased costs of government- managed projects. And because of the guaranteed nature of revenue streams, lenders generally require a lower risk premium, making debt financing relatively inexpensive in the private sector as well.

Private investors also have better access to technology, expertise, capital and commercial networks, especially if they have previous experience in implementing similar projects. In addition, the assets are generally better managed, and better management reduces costs. All of this translates into better service for the end-user and an increased return on invest- ment for the asset, which translates into a superior return for the investor.

The pressure on plan sponsors to deliver better riskadjusted returns has resulted in many pension funds increasing their allocation in alternative investments. With similar characteristics to real estate and resource assets, infrastructure is a natural fit in this asset class. Long-term, stable cash flows generated by these assets facilitate liability matching for plan sponsors. Low correlation to traditional asset classes provides significant diversification benefits, reducing the overall risk of the portfolio. And with an experienced partner, investors can reduce the risk of investing in infrastructure and achieve attractive returns.

Bruce Robertson is the president of Brascan Asset Management in Toronto. Krista Horsman is a vice-president with Brascan Asset Management in Toronto. khorsman@brascanam.com; brobertson@ brascanam.com