What is infrastructure?

In one of its typically robust and incisive pieces of research, Swiss private asset manager Partners Group reveals what it considers to be the vital building blocks in the construction of an infrastructure portfolio. Such construction is no simple task. 

The report starts out with the acknowledgement that some of the early investors in infrastructure have not received due reward for their pioneering spirit. Many have found that infrastructure has not delivered the consistent, non-cyclical returns they had hoped for. There again, some may be partially responsible for their own plight if they have been guilty of what Partners Group delicately terms “sub-optimal portfolio construction”.

Don’t oversimplify 

One example of where portfolio construction may become “sub-optimal” is in the assumption that infrastructure offers inflation linkage per se. This would, in the view of Partners Group, be to risk simplifying a linkage which, in reality, varies from asset to asset.

For example, infrastructure boasts regulated monopoly-type assets, such as toll road concessions, where the link to inflation is about as explicit as it can be, since revenues rise in line with a specific inflation indexation formula.

It also includes assets with allowed rates of return, such as US utilities, where the allowed rates are adjusted to reflect changes in inflation but where the adjustment does not take immediate effect (hence, there is a negative short-term effect in the event of a sudden, unanticipated rise in inflation).

And then, for less regulated assets, there is a need to evaluate the ability of the asset in question to pass on price increases to customers. Given the characteristics of many infrastructure assets, such as high barriers to entry, they may have strong pricing power and the ability to protect returns in the face of rising inflation. But a careful assessment of the specific asset is necessary.

Partners Group divides infrastructure assets into three “buckets” based on the different ways inflation impacts their returns: “correlated”, which accounts for 57 percent of the assets in Partners’ 2009 global infrastructure programme; “contractual” (29 percent); and nominal (14 percent).

Into the “correlated” category fall assets such as Newcastle Coal Infrastructure Group, an operator and developer of a large coal export terminal in Australia, where there is a “strong but not direct linkage” of revenues to changes in inflation. In the “contractual” category is, for example, a French wind joint venture with Italian energy company Sorgenia where inflation adjustments are “effectively guaranteed and enforced” via a contractual obligation. And, in the “nominal” bucket, you will find the likes of Porterbrook Leasing, the UK rail rolling stock leasing firm, where various factors such as high barriers to entry “compensate the investor for the limited inflation linkage”.    

The study comes on the back of several conversations Infrastructure Investor has had with LPs recently in which they have claimed infrastructure has not delivered on the fundamental characteristics with which it is readily associated. For example, the ‘stable, predictable cash flow’ element has been brought into question by such things as the volatility of demand risk when the economic cycle turns; and by the occasionally unpredictable actions of regulators.

These are valid criticisms only if you assume that broad generalisations can be applied to all types of infrastructure asset – which in reality they can’t.

One other infrastructure trait said to appeal greatly to LPs is as a portfolio diversification tool. Partners Group is doing investors a favour by shedding light on the kind of granular analysis required to achieve that diversification – one which acknowledges the complexity of the assets that fall under the infrastructure banner.