Open to playing a longer game with open-end infra vehicles

What is driving some investors to allocate to longer duration open-end infrastructure vehicles?

Investors received a reminder of what volatility looked like in 2020 as the economic impact of covid-19 prompted sharp sell-offs in public markets and a bleak investment outlook.

The global economy now appears to be on the path to recovery and the markets have returned to pre-pandemic levels. Yet although the vaccine rollouts have boosted confidence, memories of the coronavirus and its impact on economies around the world are likely to linger.

The conditions that predominated during the decade that followed the global financial crisis remain in place. Interest rates on government and corporate fixed-income securities are at record lows. Government support packages, such as quantitative easing, look set to remain a feature for years to come while economies cannot stand on their own.

Meanwhile, inflated valuations in multiple sectors and the widespread disruption of industries, creating clear winners and losers, have made investing in equity markets less attractive.

As such, the appeal of reliable income streams from infrastructure investment is growing – particularly as governments throw their support behind infrastructure programmes to fuel economic growth after the pandemic, such as the US’s $1 trillion bipartisan infrastructure bill, which is currently going through the legislative process.

Increasing exposures

Infrastructure was one of the more popular sectors among respondents to Natixis’s 2021 Global Institutional Investor Outlook. Some 42 percent plan to increase exposure this year, making infrastructure the most sought-after asset class after private debt.

Percentage of respondents to Natixis’s 2021 Global Institutional Investor Outlook worried about the liquidity risks posed by long lock-up periods

The longer-term horizons of institutional investors also speak to the opportunity set, with many of the infrastructure programmes announced likely to take many years to come to fruition.

Longer-term, inflation-proof income streams are an attractive quality for institutional investors looking towards the eventual return of inflation to the markets.

“Certain investors, particularly institutional investors such as pension funds and sovereign wealth funds, have considered long-term infrastructure and other funds to be increasingly attractive,” says Edward Tran, a partner at Katten Muchin Rosenman. “The ability of long-term funds to invest on an extended durational basis has been welcomed by these investors, given the investors’ own extended timeframes for harvesting investment returns.

“A pension fund or sovereign wealth fund is interested in ensuring that it has long-dated assets, as this better enables these investors to match investment assets with long-term liabilities.”

Competitive advantage

Although institutional investors may have traditionally sought infra exposure via closed-ended funds and strategies, more recently there have been signs of greater appetite for more open-end structures with longer investment horizons.

The open-end structure is often used by asset managers for longer-dated assets because it has no specified term end.

In a recent blog, UK law firm Torys outlined other benefits that were drawing investors and asset managers to the open-end structure. These included a greater ability to continuously reinvest income, and more flexibility on how performance fees are structured.

“There is a growing realisation that long-term funds offer a niche strategy whose appeal has started from a small base but is clearly growing”

Edward Tran
Katten Muchin Rosenman

Typically, open-end funds will invest in core or core-plus assets that generate most of their returns from yield. The funds also hold some advantages over their closed-end counterparts, such as remaining open to investors wishing to top up their allocations.

The recent focus on liquidity by some regulators, such as the UK’s Financial Conduct Authority, is another positive attribute for open-end structures that are able to redeem more easily.

“Conventional wisdom suggests that open-end infrastructure funds will almost certainly benefit from this trend,” says Tran. “A long-term fund’s ability to invest beyond the typical
10-year timeframe will likely be viewed as a competitive advantage, which distinguishes some funds in the eyes of long-term investors.

“These investors will perceive that a long-term fund will be able to hold more illiquid assets, taking advantage of opportunities that would otherwise be unavailable to funds constrained by a 10-year investment and exit period.”

FCA proposal

In May, the FCA launched a consultation on proposals for a new fund structure designed to “invest efficiently in long-term, illiquid assets”. The proposed long-term asset fund will include “longer redemption periods, high levels of disclosure, and specific liquidity management and governance features”, the regulator said.

In a statement by the FCA, its chief executive Nikhil Rathi specifically cited defined contribution pensions as a target investor group for the new structure.

Rapidly growing UK DC funds have traditionally struggled to allocate to infrastructure and similar illiquid assets because of daily liquidity rules.

“It is important for overall economic growth that the financial system supports investment that may take time to deliver a return,” Rathi said. “This is in addition to the potential benefit to investors themselves. We think our proposals would enable the establishment of authorised funds that are appropriate for both professional investors and sophisticated retail investors that want this type of investment risk and opportunity.

“This new type of fund may also be more attractive to DC pension schemes that have long investment horizons and who, under current fund structures, find it difficult to invest in these types of assets. Nevertheless, it is important that the LTAF commands the confidence of target investor groups and can meet their needs.”

There have been several high-profile open-end fund launches more recently, with considerable sums raised.

Private equity firm KKR has raised at least $3 billion for its open-end KKR Diversified Core Infrastructure Fund. This featured significant commitments from several US institutional investors, including $500 million from the Los Angeles County Employees Retirement Association.

As reported by Infrastructure Investor this year, BlackRock Real Assets is mulling the launch of a sustainable infrastructure strategy within its open-end range – its first foray into the area. Jim Barry, the firm’s global head of real assets, said it would be a “lower-risk, lower-return and more open-end structure, akin to what you might find in real estate”.

“As we think about these offerings, we’re clearly thinking about them in the context of making them as client-friendly and responsive as possible,” he added, explaining that the world’s largest asset manager had previously been taking a “walk before you run” approach to open-end infra funds.

Blackstone Infrastructure Partners is also considering reopening its own open-end vehicles.

Locking up longer

Longer-term closed-end vehicles are also seeing increased interest from institutional investors.

A renewed focus on long-term returns after the volatile market conditions of the pandemic is likely to have fuelled the appetite for ultra-long-dated investments.

“We see a trend towards long-term investments mainly driven by institutional investors such as pension funds and insurers,” says Eduardo Illitsch, head of international sales at Swiss Life Asset Managers. “This trend does not only lead to open-end structures, but we also see more long-term closed-end structures.”

Illitsch says that as well as having launched an open-end vehicle for Swiss pension funds, Swiss Life Asset Managers has launched several closed-end core infrastructure funds with durations of more than 25 years.

Institutional investors are also becoming more comfortable with tying up their capital for longer in the pursuit of more stable returns. Less than half (44 percent) of respondents to the Natixis institutional investor survey were worried about the liquidity risk presented by long lock-up periods.

Closed option

The appetite for long-term infrastructure exposure may fuel demand for core and core-plus strategies.

However, investors looking for more nuanced types of strategies – such as region- and country-specific – or other higher-returning strategies, such as opportunistic or value-add, may have to consider closed-end funds instead. In addition, the demand for shorter, time-limited infrastructure strategies is unlikely to dissipate immediately.

“At this stage, there is a growing realisation that long-term funds offer a niche strategy whose appeal has started from a small base but is clearly growing,” says Katten Muchin Rosenman’s Tran.

“Investors have positively embraced several of the new long-term funds, and it is expected that the long-term funds will continue to play a small but growing role in the investment strategies of institutional investors.”

Swiss Life Asset Managers’ Illitsch adds: “Both investment solutions – long-dated closed-end and open-end funds – have their respective advantages and drawbacks.

It is important that prospective investors understand those advantages and drawbacks and factor them into their investment decisions.”

Increased demand for longer-term strategies and assets should benefit open-end infrastructure funds and the larger asset managers that specialise in them.

Yet the number of open-end funds remains limited, and the majority of institutional allocations are likely to continue to be to closed-end vehicles.