Dialing up exposure

There are two primary ways for institutional investors to gain access to infrastructure assets: indirect investment and direct investment. 
Indirect investment can take two forms: investing in a listed infrastructure fund (or asset), or investing in an unlisted infrastructure fund. Investing in a listed fund is somewhat less than ideal since it exposes investors to stock market volatility, thus lessening the diversification benefit of the investment. Listed funds are also marketed primarily to smaller institutions and to retail investors who do not meet the higher minimum investment requirements of unlisted funds.

Unlisted funds are typically structured as limited partnerships, similar to most private equity vehicles.

Also similar to private equity, infrastructure partnerships generally have an investment term of 10 to 12 years. Exit strategies for closed-end funds include asset sales and/or the exchange-listing of assets or the entire partnership.

Direct investment can be implemented in two ways: by direct investment in an infrastructure transaction, or by co-investing with a manager of an unlisted fund. This approach is most appropriate for a larger institutional investor, as it requires significant expertise or a relationship with a consultant who can provide the appropriate level of due diligence.

Utilising a core-satellite approach, an institutional investor can develop a diversified infrastructure programme, while at the same time targeting the subsectors of infrastructure best positioned to benefit from policy priorities such as the Obama stimulus plan in the US, and potentially sidestepping the
subsectors less recession-resistant.This strategy combines “core,” or diversifying, asset class investments, in an unlisted infrastructure fund, with “satellites,” or direct investments, that seek outperformance. For our purpose in this article we will utilise co-investments. One advantage of a co-investment versus a direct investment is the additional layer of due diligence provided by the infrastructure manager. Co-investments are typically passive, non-controlling investments, as the private equity firm or firms involved will exercise control. Access to co-investments is typically provided to investors already invested in the closed-end private infrastructure fund.

Co-investments are not without risk in that participating in a particular investment choice can increase overall exposure to a specific transaction, infrastructure manager, or subsector. Having in place an appropriate investment policy and monitoring procedures will mitigate some of the risk.

This strategy creates a balance between a strong foundation based on diversified asset allocation and opportunities for risk-controlled, enhanced performance. The role of the core portion of the portfolio is to provide a diversified exposure to the asset class (brownfield, greenfield, emerging markets, and the Organisation for Economic Co-operation and Development (OECD)). The satellite or coinvestments provide for potential outperformance with regard to the benchmark by increasing exposure to attractive transactions and making investments with a higher return potential. In the chart on the following page, the core is at the center of the pie and the satellite or co-investments are in the outer ring. The co-investments provide for the flexibility of increased exposure to areas in infrastructure that the stimulus plan focuses on and areas that are more recession-resistant. Ancillary benefits of co-investments include little or no fees, or carried interest charged by the underlying manager.

Portfolio scenarios

Infrastructure investors can design a great variety of portfolios combining various percentages devoted to the core portfolio and to the satellite (co-investments). For illustration, we structure four unique portfolios combining differing amounts to the core and the satellite. The satellite is varied to provide differing amounts of exposure to sectors that are more recession-resistant. The portfolio scenarios are shown in Table 1 (above).
Portfolios A and B have a 100 percent allocation to core, but varying allocations to brownfield and greenfield investments. Portfolios C and D have a 60 percent allocation to Portfolio A (80 percent brownfield and 20 percent greenfield) and a 40 percent allocation to satellite investments. Portfolio C also assumes that the 40 percent satellite allocation is targeted to the more recession-resistant infrastructure subsectors (e.g., Utilities, PPPs, and Regulated Assets). Portfolio D assumes that the 40 percent satellite allocation is targeted to the less recession-resistant infrastructure subsectors (e.g., Airports, Rail, Social, and Toll Roads – greenfield).

The charts (below left) present the risk-return and yield-return relations of the four portfolio scenarios. As expected, the higher the degree of exposure to brownfield and more recession-resistant subsectors, the lower the net returns and volatility of returns. Interestingly, the yield for these hypothetical portfolios falls within a fairly narrow bandwidth; Portfolio B has the lowest yield, given the highest exposure to greenfield.

Conclusion

In today’s economic environment, investors need to be especially sensitive to both strategic and tactical methods in developing and managing fund assets. They need to develop a diversified program, and have a clear understanding of the long-term risk-adjusted returns, the cash flow characteristics, and the asset liability matching capability of each asset class in the programme. At the same time, given the deepening global recession, challenging debt and equity markets, rapid globalisation, and ever-changing macro issues, investors need to ensure they retain flexibility in their investments.
Institutional investors contemplating an allocation to infrastructure should consider a core-satellite approach that combines the desirable features of a strategic focus and tactical flexibility. The core part of the portfolio should provide for diversified exposure to the infrastructure asset class. The satellite part should allow for increased exposure to attractive transactions with higher return potential, and target the subsectors of infrastructure best positioned to benefit from announced stimulus plans, while potentially sidestepping the less recession-proof sectors.

Brett Nelson serves as the head of Global Private Equity at Chicago-based investment advisor Ennis Knupp + Associates. The Global Private Equity group provides non-discretionary and discretionary private equity and infrastructure asset management services and separate accounts to institutional investors worldwide.