Blended infrastructure – a winning approach

April 2021  | SPECIAL REPORT: INFRASTRUCTURE & PROJECT FINANCE

Financier Worldwide Magazine

April 2021 Issue

Blending listed and unlisted infrastructure offers a host of benefits, but many investors still view them separately. We would argue that to harness the full potential of an infrastructure allocation, they need to adapt their thinking.

For a rational investor, listed infrastructure should be considered equally alongside unlisted when considering an allocation. Inherent in this approach are several factors: fees, liquidity and portfolio rebalancing requirements, risk exposures, diversification, cash flows, opportunity sets and, perhaps most importantly, risk-adjusted valuations, as opposed to splitting the asset class by the method of accessing equity.

We consider infrastructure a homogenous asset class and, as such, the optimal allocation between listed and unlisted infrastructure is driven by individual investor circumstances. The single asset class premise is based on a number of long-term observations, including the views that: (i) assets owned by listed and unlisted infrastructure are the same; (ii) regulators of infrastructure businesses are the same; and (iii) management expertise is comparable between listed and unlisted, but it is also asset specific.

Infrastructure assets

We see the physical characteristics of assets owned by listed and unlisted investors as similar, if not the same. Given the inherent similarities in the types and physical characteristics of both listed and unlisted infrastructure assets, it is difficult to differentiate on the basis of ownership. As such, the immaterial difference between the physical nature and characteristics of the assets owned by listed and unlisted investors suggest they are somewhat homogenous, as opposed to distinctly different by nature.

Regulation

The regulators of infrastructure businesses are the same, regardless of who owns them. As monopoly providers of essential services, infrastructure businesses are regulated to guarantee certain outcomes, such as the provision of fair and transparent pricing, as well as adherence to rules around service quality, capital expenditure, maintenance and upkeep. Regulators rarely pay attention to the ownership of the asset, except for some focus on capital structures which have some bearing on returns.

Management expertise

Some argue that unlisted infrastructure investors have better control because they have direct ownership and management of assets, understanding that it is akin to buying private equity. However, it must be pointed out that it is difficult for unlisted infrastructure to outperform on purchase price or general market moves alone. Unlisted valuations generally trade at substantial premiums to the listed market, and unlisted buyers must assume this ‘control premium’ when they compete for new assets.

Listed companies have a long history of being listed and are without government interference or material government ownership. Indeed, compared with the private sector, listed infrastructure companies are arguably more aligned to investors as management remuneration is typically tied not only to financial and operational performance indicators, but also total return measures such as share price performance and dividends distributions.

Infrastructure sectors were not made equal

Total investment in infrastructure represents over $5 trillion of assets. We find the types of infrastructure assets owned by listed and unlisted investors vary between sectors, with some either under-owned or not owned at all by unlisted investors.

For example, many large regulated utilities, such as city gas or electricity distribution networks or long-distance pipeline infrastructure, are more difficult for an unlisted investor to access. This is not to say it is impossible, but evidence suggests that there is only a finite amount of capital that unlisted investors – whether individually or by consortium – can and will commit to single infrastructure investments, and so ownership of these larger assets becomes more difficult.

In addition to this, there appears to be a quality bias in favour of the listed market as the largest assets, more often than not, need to be listed. Looking around the world, we find some of the largest airports, distribution and transmission networks, pipeline networks and water utilities are typically owned in listed markets.

Many industries offer similar-sized opportunities across either listed or unlisted investment routes, including airports and communications infrastructure assets. Notably, electric utilities, particularly in North America, offer significant opportunities for listed investors. For instance, of the 45 investor-owned regulated electric utility parent companies in the US, 40 are listed. These companies alone have a combined market capitalisation of $905bn, and the top 15 each have a market cap greater than $25bn. This is particularly important given North American regulated utilities represent approximately 40 percent of the GLIO Infrastructure Index.

We also recognise that the vast majority, if not all, of infrastructure owned in the unlisted space is owned by infrastructure investors. This compares to the listed space where there is approximately $115bn under management by dedicated listed infrastructure managers, representing around 3 percent of listed infrastructure assets, while the remainder is largely owned by generalist investors across global equity portfolios.

With close to $215bn in dry powder, perhaps this in itself highlights the underpenetrated nature of the listed infrastructure universe for existing unlisted infrastructure investors.

Long-term returns both mirror and complement those of listed infrastructure

There are several information and valuation asymmetries, which mean that comparing the returns and volatility of listed and unlisted infrastructure is not a clear-sighted approach. Listed infrastructure is valued daily and is therefore influenced by market sentiment, resulting in short-term volatility. Unlisted infrastructure values, however, are based on periodic valuations of underlying assets, which typically occur on a quarterly basis.

We use two unlisted infrastructure benchmarks to compare performance versus our Index: the EDHECinfra Broad Market Index (BMI), which covers a market size of approximately $245bn, and the Preqin Infrastructure Index, which covers a market size of approximately $640bn. In coverage terms, both are considerably smaller than the $3 trillion market capitalisation of the GLIO Index, and we recognise this caveat in the analysis.

We have compared the quarterly performance of these indices, examining a full 17 years between Q4 2003 to Q4 2020. To make results comparable, we unsmooth the Preqin Index by increasing the long-term volatility of Preqin to 11 percent from 7.8 percent per annum, transposing the volatility figure into a number more comparable with our Index and EDHECinfra BMI.

Below are the key results of the analysis and with this insight we can see how listed and unlisted infrastructure are complementary, with annualised returns similar across infrastructure indices. There is a strong argument for blending allocations between listed and unlisted, given they indeed own the same types of assets.

The key findings for Q4 2003 to Q4 2020 are: (i) average annual returns for listed and unlisted infrastructure are similar (11.3 to 11.8 percent per annum); (ii) infrastructure outperformed global equities (10.3 percent-plus per annum); (iii) average volatility for infrastructure ranged from 11 (Preqin USI) to 15.6 percent (EDHECinfra BMI), with the GLIO Index falling almost exactly between the two unlisted indices; (iv) average volatility for equities was 17 percent, significantly higher than the GLIO Index (13.6 percent); (v) Sharpe ratios for infrastructure ranged from 0.66 to 0.91, significantly higher than equities (0.54); (vi) the GLIO Index more highly correlated with equities (0.86) than EDHEC and Preqin USI; (vii) the GLIO Index Beta is 0.69; (viii) EDHEC BMI is correlated (0.41) with the GLIO Index; (ix) our Index is correlated (0.34) with Preqin USI; and (x) Preqin USI correlated (0.33) with EDHEC BMI.

As a next step, we created efficient frontiers by blending the GLIO Index with both EDHEC BMI and Preqin USI using optimal infrastructure portfolio mixes based on the analysis above.

The blend between the GLIO Index and EDHEC BMI is optimal at 60/40. Conversely, our Index/Preqin USI is optimal at 40/60 percent. We even observe a ‘sweet spot’ between the two blended portfolios which would indicate a 50/50 split between the GLIO Index and unlisted infrastructure works well.

The blended GLIO/EDHECinfra returns 11.7 percent per annum with reduced 12.1 percent standard deviation. The blended GLIO/Preqin USI returns a very similar 11.5 percent per annum, with 200bps less standard deviation. The infrastructure blends have a correlation of 0.81 between them. The correlation between both infrastructure blends and equities is 0.67. The blends outperform equities on average 1.6 per annum, with an incredible 600bps lower risk or standard deviation on average.

Premiums and volatility

Private transactions have generally occurred at significant premiums to the multiples of listed infrastructure companies. The unlisted infrastructure universe has seen robust fundraising over the last sev­eral years, and this significant private investment demand is facing a competitive environment with relatively few assets available for sale, driving deal multiples and respective valuations upwards.

For instance, our analysis shows that private investors have been acquiring assets at multiples of 18 to 20 year-ahead cash flows, compared with a 10 to 12 average cash-flow multiple for listed transportation infrastructure companies. This demonstrates a distortion in the infrastructure investment universe whereby direct investors appear willing to pay a significant premium. The listed market, by comparison, is an easier and less expensive way to obtain simi­lar asset exposure.

Moreover, these transactions give us a much better idea of the true volatility (dispersion of transaction points in the figures) of unlisted infrastructure assets, rather than relying on smoothed returns from theoretical valuation models.

ESG – on everyone’s radar

While environmental, social and governance (ESG) factors are increasingly at the front of investors’ minds, we note two different stories in unlisted and listed infrastructure investing – the former opting for more impact-focused investing, and the latter integrating ESG factors into end-to-end investment processes. As investors increasingly embrace ESG as material to investment performance, it is likely these paths will merge as more products are developed in line with these changing client needs.

Listed infrastructure companies are typically more incentivised to produce comprehensive and transparent ESG reporting due to their broader and more liquid investor base, as well as higher levels of public scrutiny.

While unlisted infrastructure companies are also incentivised, the demands and requirements being placed on them by stakeholders are different to their listed counterparts. In this respect, we note different responses from companies across the infrastructure spectrum on ESG factors.

We see a true alignment between infrastructure investing and companies’ ESG credentials. We believe that it is beneficial to actively integrate ESG factors into the investment process, engage with companies on the issues that arise and align proxy voting decisions with shareholders’ interests. The recently launched ‘GLIO/GRESB ESG index’ is an important step in the right direction and a tangible ‘touch point’ for companies and investors alike.

Conclusion – a single asset class

Investors need insight into many factors highlighted in this article, which include the size of the opportunity set, diversification requirements, fees, liquidity and portfolio rebalancing requirements, and risk-adjusted valuations. Indeed, blending listed and unlisted infrastructure investments broadens the opportunity set while reducing asset portfolio volatility and maintaining attractive levels of return.

We believe that listed infrastructure provides a less expensive means of obtaining a broad and diversified exposure to infrastructure assets. When coupled with the significant gaps between transactions and listed trading multiples across many sectors, along with other potential benefits such as liquidity, this creates an attractive opportunity for investors looking to increase their infrastructure exposure.

We encourage investors to consider listed infrastructure as a long-term ‘hold’ investment opportunity versus a short-term mark-to-market risk.

 

Steven Kempler is a co-founder of Maple-Brown Abbott and Fraser Hughes is the founder and chief executive of the Global Listed Infrastructure Organisation (GLIO). Mr Kempler can be contacted by email: skempler@maple-brownabbott.com.au. Mr Hughes can be contacted by email: f.hughes@glio.org.

© Financier Worldwide

BY

Steven Kempler

Maple-Brown Abbott

Fraser Hughes

Global Listed Infrastructure Organisation (GLIO)

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