The point of low return

In times of economic downturn, people tighten their purse. They postpone far-flung holidays, spend more evenings at home and fill their fridges with basic foods. Yet they carry on drinking water, heating their homes and switching the lights on; and the long-term contracts governing the supply of such essential services, in most cases, continue to be honoured. If you happen to be among the companies providing these amenities, your revenues should to a large extent be recession-proof. And if you are among the lucky institutions backing them, so should your returns.

That’s the basic scenario driving investment in infrastructure. At a time when the developed world’s central banks have pushed interest rates down to rock-bottom levels – and further depressed yields through massive bond-buying programmes – it’s easy to see why the asset class, as a relatively low-risk, yet profitable alternative to mainstream securities, should gain in popularity.

At least that’s the theory. “Expectations are that infrastructure represents a stable, long-term investment in an equity class that will generate equity returns but at a lower level of volatility than listed equities,” says Jason Peasley, head of infrastructure at superannuation fund AustralianSuper. “It’s about having determined returns,” adds Susan Martin, chief executive of the London Pensions Fund Authority. “We’ll have people in our scheme that will retain pensions in the next century. So it’s really important to understand where your cash flows are going to come from.”

Given the emphasis placed by most investors on the stable, yet higher returns promised by infrastructure, it is surprising that so few attempts have been made to assess whether the asset class has indeed behaved according to this narrative. This may be partly linked to epistemological problems. For one, there is incomplete information out there on how past infrastructure investments have so far performed.

“There’s an asymmetry here,” says Robert Bain, an industry consultant focused on the transport and PPP sectors. “We know when some projects go disastrously wrong, but when they don’t – that is, when they don’t become distressed or default – we still don’t know whether the hurdle IRR has been reached.”

A second issue is that investors have widely varying expectations of what constitutes good performance, notes Philippe Taillardat, co-head of infrastructure investment management at fund manager First State Investments. Depending on the sub-sectors, geographies and structures they intend to focus on, he says, expected returns can range from seven to almost 20 percent – making it especially hard to judge the asset class as a whole.

So performance will in most cases be relative, and tied to whatever objectives investors are trying to achieve. “Different pension funds are at different stages and have different requirements. So naturally they may seek different things,” observes Joanne Segars, chief executive of the UK’s National Association of Pension Funds.


Still, while no straightforward answer can be found, there are several ways to infer whether the asset class has by and large achieved its mandate. The first one is to look at the evolution of investor allocations: given infrastructure’s young but growing track record, common sense would argue that appetite for it would rise in correlation with its perceived performance. The asset class’s current popularity suggests it has indeed performed well. “If people weren’t happy they wouldn’t continue to do this,” says Bain.

A more quantitative approach consists in looking at performance figures publicly available on the websites of the world’s largest infrastructure investors. That again seems to indicate the asset class has performed relatively well over the last couple of years. For example, Borealis Infrastructure, the infrastructure arm of Ontario Municipal Employees Retirement System (OMERS), posted a return 3.44 percent above its 9.0 percent benchmark for the whole of 2013; while fellow Canadian pension Canada Pension Plan Investment Board (CPPIB) saw its portfolio returns jump to 16.6 percent in the 12 months to end March 2014.

Yet neither of these insights provides us with a completely satisfying picture. The first obviously lacks nuance while the second only allows for a selective, short-term vision of the market. A more useful approach would assess the asset class’s performance on a longer timeframe. In particular, it would test its resilience under conditions of economic stress – such as the period that followed the Global Financial Crisis (GFC).

And that’s where our initial 50,000-feet view masks significant bumps on the road. “Certainly in my world, the world of transportation, there continue to be horror stories,” says Bain. “And it is not difficult to understand what happened: many of these forecasts date back to the pre-Lehman days. But then the world changed – in some cases dramatically.” Whether the financial crisis has increased the absolute number of distressed situations – or just made the distressed ones even more distressed – remains unclear, but there’s no disputing the impact.

Alain Carrier, head of Europe and former head of infrastructure at CPPIB, also singles out assets directly tied to GDP growth, such as certain toll roads and airports, as being the most exposed to the economic downturn that followed the GFC. He reckons that the period of exuberance that preceded it made some of the bad cases worse. But he points out, too, that other assets have not been immune.

“The crisis has led governments and regulators to take a closer look at the returns being offered to investors. There has been pressure to limit tariff increases, for example, even when these were due. So it would be naïve to claim that regulated assets have gone through the Crisis fully unscathed.” Regulated rates of return, he adds, have also been pushed down significantly as a result of the low interest rate environment.


Yet most investors think the asset class has resisted the downturn comparatively well. Importantly, they note that looking at investments made before the GFC generally provides reason to cheer.

“Our PPP assets have outperformed sector targets, and long-run returns from our general infrastructure portfolios are comfortably in excess of typical infrastructure hurdles,” says Paul Newfield, head of investment strategy at Morrison & Co, which invests on behalf of a number of large pensions and sovereigns including the New Zealand Superannuation Fund. Infratil, a New Zealand – and Australia-listed vehicle it set up in 1994, has posted annual post-tax returns of more than 17 percent since inception.

Geography clearly matters, however. AustralianSuper’s Australian portfolio, suggests Peasley, has probably met or exceeded expectations by out-performing broad equity markets since inception. Yet he admits the performance of its global portfolio is more mixed, mainly due to the impact on some assets of the GFC – though he says investments made since then have performed well.

Good opportunities are not limited to developed markets. “We operate in countries which for the most part don’t have an investment grade, but our non-performing loan ratio is less than one percent,” says Thomas Maier, managing director for infrastructure at the European Bank for Reconstruction and Development. “It does show that even in these higher-risk markets you do find transactions that can be done profitably.” He adds that Meridiam Infrastructure and Macquarie, the bank’s equity partners in Eastern Europe, Central Asia and Russia, have been “quite successful” in these markets too.

Then again, more granularity is needed to assess performance at the sector level. “At different points of the market cycle, we’ve been rewarded for different sorts of investments,” says Newfield. He notes that while renewable energy brought good dividends in the early 1990s, Morrison’s funds then generated outsized returns by investing heavily in airports through to the late 2000s – a window probably now closed. “Do I expect you’ll be able to earn 20 percent-plus target returns investing in many developed market capital city airports today? I certainly don’t.”

Taillardat carves the market into four broad sub-asset classes, each with its own dynamics and expected targets. He thinks the first – social infrastructure PPPs – has performed well. But, at 10 percent on average, returns there are low – as part of the risk is transferred to public counterparties – and currently being dragged down. Renewable energy follows a similar story, displaying good but diminishing returns as subsidy regimes fade out.

A third category includes strategies closer to private equity, when a manager hopes to post sizeable capital gains by taking an infrastructure company to the next level of maturity. Here, Taillardat reckons performance will be easier to gauge after a few more years, when funds raised in the mid-2000s start monetising assets. Others suggest the track record has so far been mixed, with both notable failures and outstanding successes.

Then there’s the last strategy: that of core infrastructure. “It certainly ranks among the most dynamic sectors,” says Taillardat. “It has largely performed in line with expectations, although that depends on the ability of investors to properly manage the assets to successfully generate the cash yield.” He dismisses fears of overheating in the sector, arguing that this is mainly true for very large, trophy assets. He quotes internal and competitors’ research to illustrate how competition below the €600 million deal mark remains reasonable.


But not everyone is so sanguine. Carrier says the increase in appetite for infrastructure has made assets “very expensive”. Newfield thinks “it will be much harder to get the sort of returns we’ve seen over the last 20 years in the next 20 years”. A lot of this has to do with increased competition, agrees Peasley. “Our return expectations are probably a bit lower than what they were historically. Investors are bidding away the inefficiencies that perhaps existed when it was somewhat a new asset class that wasn’t completely understood by the broader institutional investor community.”

Bain thinks greenfield concessions are not immune to the trend of diminishing returns. For one, he thinks they are often being awarded to the highest bidder rather than the most capable contender. In addition, he remarks, the public sector has become smarter at structuring transactions. “When a private investor has invested in infrastructure and does very well, the public sector seems to see it as not right. They forget that the private investor had complete exposure to risk throughout construction and start-up operations, and in some cases – with 20:20 hindsight – they want to claw back some of the profit.”

Encouragingly, few observers expect recent mega-deals to blow up. Newfield consequently thinks long-term investors should remain calm in the face of what may be the top of a cycle. “One of the risks that the sector is going through right now is that for a lot of people this is their first cycle of infrastructure investment.” More specifically, Carrier notes that growing appetite for infrastructure is a response to the current level of interest rates; as and when these do start to rise, it is possible that competition for assets will abate somewhat.

He adds, however, that infrastructure has now developed into an asset class in its own right – and that it is likely to command an allocation of some kind from most significant pools of capital in the future. And no matter whether competition eventually eases, investors still have to invest – while paying prices that will allow future returns to match their targets. “The challenge for people like us is to remain ahead of the curve,” says Newfield.

He reckons excess returns are still available in greenfield projects including availability-based PPPs and renewable generation assets. Carrier says it’s also about the way you bid – outside auction processes, through partnerships with corporates, or by carving out more complex transactions that remain outside the public eye.

For those able to invest directly, this new reality means either accepting lower returns for the foreseeable future or working harder to try and match targets. But those currently exposed to infrastructure via third parties will have to make choices, says Newfield. Management fees and time-bound horizons threaten to eat away already reduced returns while also, potentially, putting managers at a cost-of-capital disadvantage during auctions. Yet sourcing and executing one’s own direct deals requires resources many investors don’t have.

“If I was a pension fund I would probably still be using a manager. But I would push for a fund in which assets could be held for a long time and with a fee structure clearly aligned to performance.”