Q: With over A$12.9 billion ($9.7 billion; €9.1 billion) in funds under management, what are the hallmarks of Hastings’ portfolio construction?
KL: Considering infrastructure is relatively new compared to other asset classes, the market has been relying on two metrics – the discount rate and cash yield – which are not sufficient to support an investment decision.
Since infrastructure markets provide so little data and low transparency, some fund managers construct portfolios using a qualitative approach, based on sectors and geographic considerations. However, we prefer a quantitative approach, placing equal emphasis on risk, as well as the discount rate and yield, when it comes to constructing an infrastructure investment portfolio. The three metrics allow us to have a deep quantitative understanding of portfolio construction asset-by-asset.
Building a portfolio based simply on the pre-assigned percentage of exposure to certain markets and sectors won’t work. However, these factors do contribute to the risk profile at the asset level. Our ultimate goal is to build a portfolio which can provide low volatility through the ups and downs of economic cycles. We don’t make bets on what’s coming in the markets.
Q: What are the first steps you take in building your portfolio?
KL: It begins with understanding your existing portfolio – how each individual asset contributes to your risk profile and reacts to the economic cycle. Then you are in a position to strategically construct the portfolio to deliver the outcome investors are hoping to achieve.
The assessment on prospective assets is an ‘institutionalised’ process here at Hastings. During the post-valuation period, we update the risk-adjusted return profile of the funds every six months and conduct a deep-dive analysis of the individual risks of each asset, which we forecast by conducting a review of each asset on an annual basis separate from the valuation process. Then, when looking at new investment opportunities, you build a base case on the asset during due diligence and run a portfolio analysis on the impacts the asset is likely to have.
Each investor would have their unique risk profile based on their unique base case. You need to be strategic and thoughtful to be able to measure and manage the risks associated with the assets.
Q: How do you define risk?
KL: Infrastructure is traditionally considered as low risk but it could be riskier than you might think. Building a base case provides a forecast of the asset’s cashflow, so my definition of risk would be a forecast error. It takes a deep understanding of individual assumptions and the forecast that underpin each and every asset evaluation. How likely would these assumptions go wrong? What would cause them to go wrong?
Also, you should start to see what common assumptions these assets have and therefore determine the risk concentration in your portfolio. And that’s where you start to get a better understanding of whether an asset is complementary to the portfolio or not. Again, it is a portfolio-by-portfolio, asset-by-asset situation.
From Hastings’ perspective, we measure the risk associated with our base case and we take a look at whether the estimated risk and return impact of the new asset in the portfolio is a key part of the due diligence process that Hastings Equity Investment considers when making decisions.
Infrastructure does vary from the base case, substantially. But risks are measureable given you have constructed a base case for comparison – you will just have to do the hard work.
Q: Two of Hastings’ Australian primary funds are open-ended. Does that structure make more sense?
KL: Yes, and the principle is universal, not just for the Australian market. Open-ended funds are particularly attractive in the market, as they offer the unique advantage of allowing portfolio construction to occur through time.
When there are pressures on asset valuation, a rational way to mitigate the risk, in my opinion, is to be consistently committed to the market through time and open-ended vehicles are perfect to build that foundation. For example, our Utilities Trust of Australia, which is now 22 years old, allows investors to get access to the portfolio over many different economic cycles.
There is nothing wrong with closed-ended funds, but they pose a risk that fund managers have to exit from the assets in a shorter period of time.
Q: How do you fit large-scale infrastructure assets, like TransGrid, into the portfolio?
KL: TransGrid is one of those assets which you simply cannot find in the market. It was the first privatised electricity transmission network in the state [of New South Wales], fully regulated, scarce and monopolistic.
Hastings (on behalf of the Utilities Trust of Australia) bought a 20 percent stake in TransGrid, which represents slightly less than 20 percent of the portfolio. In addition to considerations on the projected growth of the fund, availability of quality assets in the market and potential benefits the asset could bring, TransGrid provided a very reasonable risk profile and attractive risk-adjusted return compared to other assets in the portfolio. In this case, we were also looking for some buffering against an interest rate rise, and the asset was a solid fit.
Q: As demand for infrastructure assets increases, partly driven by the low interest rate environment, how do you avoid overpaying?
KL: There are certainly increased pricing pressures and the infrastructure asset class has seen a significant growth in allocations and demand globally. One would be naive to suggest otherwise. Interest rate is one of many macroeconomic factors to be addressed and prepared for during portfolio construction.
One example of a pricing pressure point we have observed during our due diligence processes concerns the mismatch between the useful life of an asset and the contracted cashflows that are in place for that asset. The greater the mismatch, the more likely risk is to rise with that asset as forecasts of future contracts are highly uncertain.
As an investor, when you measure and manage the risks, you are in the position of making decisions on risk-return trade-offs. The measurement of risks and understanding of your opportunity cost of capital are the keys to determine whether you are overvaluing or undervaluing an asset.
EBITDA multiples are a poor tool to measure whether an asset is overvalued. It gives no indication of asset volatility or risk presented to an investor. It’s not fair to compare EBITDA multiples even in the same sector.
Q: After the landmark acquisition of TransGrid, what types of assets would complement your portfolio?
KL: We now have over two-thirds of Hastings’ portfolio invested in the Australian market. At the moment, we enjoy looking at volume-type assets, outside of Australia. The US market, as an example, presents attractive underlying economic dynamics, where the economic drivers are different from those in the Australian market.