Infrastructure can be seen as a subset of the real asset universe. Perhaps the defining characteristic of real assets is that they are “hard” or “tangible”, providing ownership of a store of value compared to financial assets where earnings power is more derivative.
Real asset investments typically focus on cash flow generation and may provide inflation linkage for inflation-sensitive investors. In a portfolio with traditional asset classes, real assets should provide for return diversification and stabilisation, achieving comparable returns to more traditional financial risk assets with lower risk.
Infrastructure can offer a range of specific roles in a portfolio not ordinarily accessed by investing in other real assets. Cash flows can be more stable, transparent and with enhanced inflation linkage compared with other real assets. Infrastructure investments can provide access to a different set of earnings drivers than traditional financial risk assets.
High levels of uncertainty surround many traditional financial risk assets, while investors also face emerging inflation concerns and overbidding on traditional sources of protection from such risks (most notably sovereign bonds in “safe” jurisdictions, and inflation linked in particular).
Many investors are therefore focused on the relative merits of infrastructure investment. However, current market conditions pose challenges and effective portfolio construction is essential in order to be successful.
The demand side
Stable, transparent and potentially inflation-linked cash flows form a natural match to investors’ corresponding liabilities. In today’s low-yield environment, investors new to the asset class often view infrastructure as a substitute for traditional low-risk assets like fixed income; offering the lure of cash flows with relative stability and visibility, but with higher yields. This appears to be driving elevated demand for lower-risk core infrastructure assets.
The market has also seen a surge of new investor entrants in recent years, both by region and investor type (see below).
Investors considering infrastructure investing, by type & region (2012)
This has included a notable increase in interest in co-investment and direct-style investing among some larger investors.
The supply side
Overall transaction volumes are below the peak in 2006-07 due to:
– Continued scarcity of long-term debt finance, which was central to the last market boom;
– Reluctance by existing asset owners to sell assets acquired in the last boom at a capital loss;
– Corporate indecision. Many larger asset owners which might be sellers are dealing with other challenges.
Regional Deal Flow
Source: First State Investments
Against this, pressures on many existing asset owners to sell assets are intensifying. Capital adequacy requirements and other regulatory pressures are being imposed on financial institutions. Balance sheet pressures on both financial and corporate owners of assets also remain significant.
Plus, financing challenges face many major Western governments needing to balance fiscal and borrowing constraints against the delivery of projects to address cumulative public infrastructure under-spend and to support growth and population pressures.
Major structural shifts in demographics and energy supply are also giving rise to new infrastructure financing requirements, for example the “shale revolution” in North America.
Demand for core infrastructure assets is rising but in some sub-sectors this has not been matched by the volume of transactions coming to market. Taken collectively, supply and demand dynamics have resulted in emerging pricing pressures in some areas:
– Developed airports (e.g., the UK and Portugal). Considerable activity over recent years has spanned both hub and non-hub airports (each have their own economic sensitivities, but both can be seen as “core” in nature);
– Developed utilities (e.g., the UK) are being aggressively pursued in perceived “safe” regulatory jurisdictions;
– A similar scenario involves some of the world’s developed economy ports.
These market pressures, in turn, appear to be translating into some pre-Lehman pricing observations across some sub-sectors.
Fiscal pressures facing many developed governments are elevating regulatory risk in some jurisdictions. In February 2013, Spain announced what amounted to retroactive reductions to tariffs for projects installed between 2009 and 2011.
In Norway, the Ministry of Petroleum and Energy proposed a 90 percent cut to tariffs on new contracts to ship gas through the privately owned Gassled natural gas pipeline network. Similar experiences have been reported in other jurisdictions previously considered “safe”, including the German solar sector, and, at least on some measures, water and utilities in the UK.
However, governments around the world accept that private finance needs to form a central component of their future project delivery plans. They are heavily focused on mobilising pensions and other long-term investors to support this cause.
Effective investing in a challenging market
End investors need to maximise their effectiveness in the face of these challenges. Key to this is disciplined investing, which spans a number of elements:
1) Pricing discipline. Entry price is the single most important component to returns, and the one aspect of an investment that cannot be adjusted afterwards. It should be a central focus for managers and investors considering direct investments. We encourage limited partners to press managers to provide evidence in portfolio updates and reporting;
2) Awareness of the macroeconomic (cyclical) risk being taken, and the effective regulatory risk exposures inherent in assets, and how these may interact. Risk awareness should be displayed at an individual asset level and on an overall investor portfolio level, via portfolio risk measurement techniques;
Effective portfolio construction also encompasses a range of other key elements. These include each of the following, across which effective controls are required:
A) Managers. There is a need for an awareness of agency and counterparty risks and controls to manage these. Some counterparty risks have increased with the rise in institutional failures and the pressure on some independent asset management platforms;
B) Strategy. Appropriate controls should also be in place around individual manager strategies and areas of manager competence. A mix of complementary strategies across portfolios which aligns with investor objectives should be the ultimate focus;
C) Geography. Understanding where imbedded geographic risks lie, beyond economic growth to fiscal distress and the associated uptick in regulatory risk this can bring;
D) Sector and investment stage. Awareness of, and a set of controls around, the effective investment risk exposures;
E) Vintage risk. Controls to ensure that exposure to a particular investment vintage is not excessive. This is to mitigate against the risk of systemic factors which may undermine a particular cohort of investments, and/or better opportunities presenting themselves in future. Perhaps now more than ever, this is a critical consideration for effective portfolio construction;
F) Revenue and common factor risks. There is the need for a meaningful look-through assessment of underlying economic revenue and common risk factor exposures. They should be understood, monitored and managed at an overall portfolio level.
Effective Diversification Considerations
The challenging wider economic and financial market conditions facing investors underline the case for an exposure to infrastructure. However, perhaps now more than ever, an effective approach to portfolio construction and imbedded risk management controls are critical to maximising the chances of success.