Infrastructure is an integral part of our daily lives. We need it to light and heat our homes and to take us to and from work – and wherever else we need to go. In the same way that we own our homes as investments, we should similarly own infrastructure as well. It is effectively a hedge against increases in our cost of living, in that an increase in the cost of infrastructure services would be offset by an increase in the value of our investment.
The “Great Recession” of 2008 to 2009 caused a significant drop in government tax revenues and resulted in some of the highest government deficits since World War II. At the same time, a large proportion of infrastructure in developed countries is now at the end of its useful life and should be replaced. However, large government debt levels and deficits mean that government spending on infrastructure is not likely to increase faster than historical rates, which is what is needed.
Furthermore, emerging markets have a substantial infrastructure deficit, both in terms of capital and technical expertise. The Chinese government alone has invested RMB4 trillion ($586 billion) into infrastructure over the last few years, while India is estimated to need to double its infrastructure spending to $1 trillion over the next five years to 2016 to 2017 in order to achieve its intended 10 percent annual growth rate.
The increasing need for private investment into infrastructure has transformed the asset class into a sizeable and established sector which investors should include in their portfolios. The sector provides an attractive option for investors, especially in the current low interest rate environment, because operational assets often generate a high and stable cash yield compared with other asset classes, and revenues often have some linkage to the rate of inflation.
Infrastructure returns should generally fall between those of private equity buyout and tradable debt investments. Lower risk projects should generate stable cash yields like bonds but with some associated risk premia, while higher risk projects take on more equity risk (and, with the amount of leverage they use and their liquidity, become more akin to private equity in their risk/return profile). Infrastructure projects are in many ways like real estate; they are assessed substantially on the value of the physical assets and the cash yield generated. The assets are illiquid but are viewed to be relatively stable in value, and the yields on contracts often have linkage to the rate of inflation. Both real estate and infrastructure have also benefited from financial innovation, especially in the last decade, through the development of investment vehicles which allow both retail and institutional investors alike to invest in such illiquid assets on a larger scale. As the accompanying chart shows (p43), infrastructure has performed well relative to other asset classes.
The sector has been a significant beneficiary of falls in interest rates over the past 25 years and of the growth in debt securitisation, which has dramatically increased the pool of potential financiers. Such significant outperformance in infrastructure returns may not be sustainable, especially after the recent financial crisis, which highlighted the risks of increased levels of debt. However, the high demand for private infrastructure investment which is needed to sustain global GDP growth and the generally stable performance of many operational infrastructure assets should allow infrastructure to continue to provide an attractive level of return over the medium term.
In addition, both infrastructure and real estate are considered strategic assets, as they are needed in peoples’ everyday lives. This provides support for the valuations of these assets as well as opportunities for appreciation in asset values based on changes in demographics, lifestyle, and local resources. The saying goes that real estate is all about ‘location, location, location’; the same is also true for infrastructure, as high density usage of infrastructure dramatically increases the value of the asset. Similarly, changes in consumer demand towards more green energy increasingly make wind and solar projects attractive. In addition, locations near sources of cheaper, of cheaper, long-term cost inputs or higher production capacities are also beneficial to asset values. For example, developing and owning assets in the most productive locations for wind and solar power generation increases the value of these projects.
But where does infrastructure fit within an investor’s portfolio? It depends on the risk/return profile of the investor, which can be defined broadly in two categories: 1) income-seeking investors and 2) opportunistic investors.
1. Most infrastructure investments, such as PFI/PPP and core assets like transport and utilities, generate income and dividends, so they fall within an investor’s income portfolio. These assets share many of the same risks (illiquid assets, regulatory uncertainties, and construction and operational risks). In addition, the returns to investors from these investments come from the equity portion of the capital structure, though the stability of regulated tariffs reduces the risk substantially below what would normally be associated with equities. In this way, PFI/PPP and core assets are substantially less risky than equity, but more risky than government bonds (UK 20-year and 30-year government bonds currently trade at 4.12 percent and 4.19 percent yields, respectively ) and corporate bonds (currently 4.41 percent ).
Investors should expect returns closer to that of junior or high yield debt (currently 7.12 percent ) and be willing to accept greater risk than that of government and senior investment grade corporate bonds. This is commensurate with the types of returns indicated by PFI/PPP and core asset managers, roughly 6-9 percent per annum (with 5-7 percent often paid out as dividends) at the current level of interest rates. In addition, while these types of infrastructure assets have similar return expectations to those of junior and high-yield debt, the infrastructure returns come from different sources, principally a combination of operating income, some indexation to the inflation rate, and some capital gains.
This means that adding these types of infrastructure investments can diversify investors’ income portfolios.
2. Opportunistic investors focus on the capital gains growth of infrastructure investments. Opportunistic infrastructure assets, such as development projects and unregulated assets, require more management time and expertise as they are essentially functioning businesses. Since infrastructure assets are illiquid and employ leverage, they are comparable to private equity portfolio companies, though again, the stability of physical operating assets reduces the risk substantially. Such opportunistic investments generate mid-to-high teen returns, slotting in between growth stocks and lower-risk private equity. This also means that opportunistic infrastructure assets should be categorised in investors’ growth stock portfolios, or, if they are more institutionalised, in their alternative asset/private equity portfolios.
However, it can be difficult for the average person to invest in infrastructure investments given the average size of each asset. Whereas the average person’s primary wealth is concentrated in their home, they cannot make the same type of commitment to infrastructure, which are larger transactions, so they have to invest via commingled investment vehicles. The same holds true for all but the largest institutional investors; it is difficult to gain exposure to a diversified portfolio of infrastructure investments unless one is willing and able to invest a substantial amount of capital.
In addition, infrastructure assets are illiquid, long-term holdings, so they are not easily tradable; it is difficult to locate appropriate buyers quickly, and the assets incur substantial transaction-related costs. It makes more sense for investment vehicles to be structured so that they can hold infrastructure assets for long durations as well as provide investors with liquidity so that they are able to enter and exit from the vehicles. This is difficult in a mutual fund structure, because the fund cannot easily buy or sell illiquid assets to match investors’ subscriptions or redemptions.
Listed investment vehicles, with tradable shares on the stock market, provide a viable alternative for investors to access infrastructure investments. The listed market for other infrastructure vehicles has been growing steadily, and investors should recognise the value of these potential investments as portfolio diversifiers and as attractive alternatives to traditional utilities.
Roy Kuo is head of research at Dexion Capital, the London-based alternative investments group