Infrastructure: crying out for greater definition

Right across the Western world and in many other parts of the globe, too, infrastructure is le mot du jour. Billions of dollars have already been raised for infrastructure funds over the past decade, and the asset class has the potential to grow far more significantly still over the coming decade as the transfer of assets from traditional owners to institutional investors gathers momentum and as governments seek stimuli for their economies.

However, infrastructure’s boon may yet prove its undoing too. The anticipated influx of capital would be hard to sustain even in a mature asset class. In an emerging asset class such as infrastructure, which remains ill-defined and poorly understood, it could ultimately prove catastrophic. At the heart of the issue is a stark difference in perspectives and objectives between investors and managers. Resolving this difference will be critical to the growth and sustainability of infrastructure as an institutional asset class.

A CONFUSION OF PERSPECTIVES

Infrastructure’s ‘false dawn’ of the mid-2000s, when newly minted managers pursued private equity-style transactions fuelled by a wave of cheap credit, has obscured for many the true nature of the asset class. The private equity model, despite its inappropriateness for a significant segment of infrastructure opportunities, still prevails. The situation has been exacerbated by certain managers who have, either intentionally or unintentionally, misrepresented aspects of their fund’s strategy, particularly in relation to risk and return. The result is confusion for many investors, who struggle to differentiate a high-risk strategy from a low risk one due to the uniformity of the offerings presented.

In conjunction with this, investors themselves are approaching the asset class with very different agendas. While some investors have created specific infrastructure allocations that are treated as a segregated part of their overall allocation strategy, many investors are participating in the asset class using capital that is being redirected from other allocations. In some cases, investors are diverting a fixed income allocation away from lacklustre bond portfolios, and others are looking to deploy under-utilised real estate allocations. At the other end of the spectrum, some investors are seeking to reduce risk and increase distributions in their private equity portfolio. This leads to confusion for managers as they seek to design products to suit an investor base.

As a result of these factors, perceptions of risk and return vary dramatically, as do perspectives on structure, term, incentivisation and organisational structure. While infrastructure offers a broad range of opportunities, the combination of high-risk and low-risk strategies within the same offering can create a dangerous cocktail that may result in investors taking more risk and receiving less return than they intended (while managers raise larger funds and charge higher fees than they ought to).

DISTILLATION FOR GROWTH

In order to achieve the next phase of growth, infrastructure needs to be unbundled and redefined. In the real estate space, which perhaps provides the most appropriate parallel for infrastructure, there is a clear delineation between core, value add and opportunistic strategies according the level of risk and return that is on offer to investors. Strategies fall into one, or at most span two, of these categories, allowing investors to make a clear election as to where they want to sit on the risk spectrum. Structures and terms vary substantially according to category, from listed Real Estate Investment Trusts (REITs) and open-ended funds at the core end to private equity-type structures for opportunistic and value add strategies.

Although real estate provides some interesting parallels, it does not unfortunately provide simple solutions. Real estate assets are fundamentally different from infrastructure assets in a number of critical ways. Infrastructure assets tend to be larger in size, more complex and technical in nature, require greater capital expenditure (capex) and management to maintain, and are less homogenous.  Infrastructure therefore needs to come up with its own definitions, or at least re-define assets according to its own set of risk and return parameters, in order to make sense of its landscape.

While the market may lack definition for now, it is possible to sketch out the book-ends of the infrastructure risk/return spectrum as follows: an opportunistic strategy might remain reasonably broad-based in focus by sector, geography and investment type. While there may be a yield component, it may take several years for yield to flow through to investors, and the total anticipated return will rely quite heavily on the manager’s ability to drive value from the portfolio, and the value achieved at exit. It will be structured like a private equity fund, have a shorter term, and the manager will be properly incentivised to create value. More often than not, the end goal will be to create ‘core’ infrastructure product. Investors will be primarily seeking capital gains, combined with a risk-adjusted total return.

By contrast, core strategies will necessarily become tightly bounded, and investors will be focused primarily on liability-matching assets that deliver stable long-term yield. Some of the features one might expect to see in a core fund may include:

• a strategy that focuses on downside protection rather than value creation;
• long-term contractual cash flows underpinned by strong covenants;
• a target return that reflects the importance of current yield to the investor, and which is based on an initial structured return that has a high degree of predictability rather than relying on value creation;
• limited exposure to macro-economic conditions, and to residual asset value risk;
• a long hold period to reflect the liability-matching characteristics of the investment;
• little or no currency risk, resulting in strategies that are naturally focused on a limited number of geographies;
• a conservative use of leverage;
• an economic package for the manager that is appropriate and delivers alignment of interests with the investors.

MOTIVATION FOR CHANGE

Unbundling infrastructure strategies will be complex, and require the close co-operation of both investors and managers to achieve it in an efficient and productive manner. Nevertheless, it is in the interests of all parties to achieve the next phase in the development of the infrastructure asset class.  Investors will obviously benefit, because they will be offered products that provide them with more defined parameters of risk and return. Additionally, it may become easier for them to identify best-in-class managers, since performance should become more transparent when measured against clear-cut investment objectives.

However, managers (and placement agents) are set to benefit too. By providing more appropriate solutions to investors, managers will be able to unlock far bigger pools of capital than have currently flowed into the space. Moreover, by unbundling strategies and creating segregated vehicles for different strategies, the manager will diversify its risk while offering it the potential to grow total assets under management beyond the level that it might otherwise have been able to.

IMPLEMENTING CHANGE

Everyone has a role to play in shaping and driving the next phase of infrastructure’s evolution.  Managers need to take a lead in defining their products, narrowing the focus to capture only those assets that sit well together within a single vehicle. Investors and their consultants need to hone their strategies, develop their capabilities and take an active role in guiding managers. Lawyers, placement agents and other advisors must support their clients in finding creative solutions.

One means to stimulating debate and bring about uniformity within the sector would be to establish an industry forum to provide leadership to the sector, set objectives, define strategies according to risk and return, and institutionalise the way that funds are marketed and evaluated. In real estate, Investors in Non-listed Real Estate Vehicles (INREV) provides such thought leadership and has been an important catalyst in professionalising the asset class in Europe. The Institutional Limited Partners Association (ILPA) provides something of a similar function in private equity, though the maturity of the asset class means that to some degree it is self-regulating. If such a forum is to be created, it is important that it be led by investors for the benefit of investors, in the same way that INREV and ILPA are.

CONCLUSION

Infrastructure has survived its first major downturn to become established as an asset class. If it can deal with the burgeoning interest in the sector then it may find itself propelled to the forefront of mainstream asset allocations. However, in order to achieve its full potential it must evolve to provide investors with the investment products they seek. Infrastructure is facing its toughest challenge yet: delivering on investors’ expectations.

Bruce Chapman is co-founder and partner of Threadmark LLP, a London-based placement agent focused on capital raising from European and Middle Eastern investors for alternative asset managers in the private equity, real assets and real estate sectors