In a recent conversation with a market source, the importance of a benchmark for the infrastructure asset class was impressed upon us at Infrastructure Investor. The source related a conversation with a representative of a sovereign wealth fund that was considering parking “billions of dollars” in infrastructure debt. The fund representative apparently had one pressing question at the front of his mind: “What is the benchmark?”
You might think that an answer to that question would be fairly straightforward. The Investopedia website appears to confirm this, with its definition of a benchmark as “a standard against which the performance of a security, mutual fund or investment manager can be measured. Generally, broad market and market-segment stock and bond indexes are used for this purpose”.
But even those only moderately acquainted with the infrastructure asset class will instantly spot the flaw. “Infrastructure”, far from being a homogenous entity, is in fact a very broad grouping of different assets with different risk and return profiles. If you can’t say what infrastructure is, how can you compare it with something else? (And that’s before you even begin to engage with what the “something else” should be).
Problems such as these sometimes occupy the mind of Stephen McCourt, who in June was appointed head of the new London office opened by Meketa Investment Group, the Boston, Massachusetts-based consulting firm that provides private market advisory services to institutional investors.
“There is a lot of complexity around the peer universe that you use to do your benchmarking,” he says. In other words, while with one infrastructure fund you might consider a rate of return of 20 percent to be acceptable, with another it might be 8 percent. Both may be pursuing perfectly sensible strategies, but they are different strategies designed to suit investors’ varying risk appetites.
McCourt says that many of Meketa’s clients set an infrastructure benchmark of Consumer Price Index (CPI) plus between 400 and 450 basis points. “It speaks to the distinctiveness of infrastructure, which is protection against inflation,” he says, acknowledging that changes in CPI are used as an inflation measure. “It seems like a reasonable return over inflation, given the risks of core infrastructure.”
However, McCourt questions whether this measurement is representative. “Over the last few years it has been easy to hit as inflation has been so low, and interest rates low and steady,” he points out. In addition, it is a benchmark that tends to be adopted by those investors with a bias to core infrastructure and may not be appropriate for those seeking a risk/return at the higher end of the spectrum.
For those with an appetite for greater risk/return, various benchmarks have been used. Public or private equity have been referenced as direct comparators for infrastructure. Meanwhile, some sophisticated investors – especially those that have migrated increasingly to infrastructure as a bond substitute – have begun benchmarking around target cash yields.
One of the biggest infrastructure benchmarking exercises has been undertaken by the Singapore-based EDHEC-Risk Institute (EDHEC), which produced a recent paper entitled “Benchmarking long-term investment in infrastructure”. Interestingly, the EDHEC approach involves using project finance as its benchmarking “reference”.
In its paper, EDHEC identifies three reasons why project finance can be used in this representative way. Namely: “It is the most significant form of investable, stand-alone infrastructure project by size; it benefits from an internationally recognised and uncontroversial definition; it can be expected to have a unique risk/return profile and thus to contribute positively to long-term investors’ portfolio choices”.
Frédéric Blanc-Brude, author of the paper and research director at EDHEC, expounds on the usefulness of project finance as a reference point in conversation with Infrastructure Investor: “Project finance companies only do one thing,” he says. “They don’t have charismatic chief executives that can change their business plans; instead they are all about one pre-defined project. So with project finance, we can better predict how the firm is supposed to behave over the next 25 years, with a model of its cash flows. That helps a lot in terms of the limited amount of data that’s available: we use this data to calibrate a generic cash flow model spanning the next two decades.”
The benchmarking methodology put forward by EDHEC appears to be gaining traction, having been discussed at a meeting of the Group of 20 major economies (G20) Investment and Infrastructure Working Group in June this year. In a section on “Creating a public good”, the paper makes the point that an adequate benchmark should benefit infrastructure not just from an investment but also from a regulatory viewpoint.
To quote from the paper: “The same need to create new knowledge on the risks of long-term investment is also patent on the regulatory side: it is widely acknowledged that the current prudential regulatory framework is ill-suited to long-term investment especially in the case of infrastructure.”
In other words, if the actual rather than perceived risks of infrastructure can be measured and made widely available, it could help the asset class in its dealings with regulators and maybe avoid the kind of restrictions on long-term investment that appeared to arise from the European Union’s Solvency II Directive, for example.
‘DIALOGUE WITH REGULATORS’
This regulatory angle is also viewed as important by Daniel Schmidt, a partner at Munich-based research organisation CEPRES. In December last year, CEPRES launched a new infrastructure platform with the BAI (German Association of Alternative Investments). Schmidt says that CEPRES will cooperate with BAI in order to provide the demanded aggregated statistics so that “they can start a dialogue with regulators in order to try and reduce capital requirements”.
CEPRES’ initiative is based on data going back to a time when there was no infrastructure asset class as such, but infrastructure deals were sometimes done by private equity firms. This means that the database now has details of some 2,000 infrastructure transactions. “CEPRES is the first to be able to create an infrastructure benchmark by taking information on infrastructure from before infrastructure was its own asset class,” Schmidt claims.
He adds: “If you just look at the infrastructure asset class over the last five years it’s not a big data set and it doesn’t show what happens if the market crashes. We can measure all the way back to the 1970s.”
Schmidt reaches for a parallel with the development of a benchmark for mezzanine investment. “In 2003 we reached out to mezzanine funds when insurers were thinking about investing but didn’t have the information they needed. It led many limited partners to invest in that asset class and that’s the way we want to go with infrastructure as well.”
It’s still early days but, thanks to the pioneering work of organisations such as EDHEC and CEPRES, it may be that before long a convincing answer can be given to the sovereign wealth investor mentioned at the outset – as well as to all other investors who are attracted to infrastructure but confused about its relative merits.