Building exposure to infrastructure – difficulties, options and a story of undeployed funds
April 2019 | SPECIAL REPORT: INFRASTRUCTURE & PROJECT FINANCE
Financier Worldwide Magazine
April 2019 Issue
Infrastructure maintenance, upgrades and developments are a high-order priority for federal governments worldwide. More specifically, this means investments in critical economic infrastructure, such as roads, railways, bridges, sea ports, airports, utilities such as power and water, energy transportation and telecom infrastructure. Estimates for the scale of what is required vary, but the numbers remain eye-watering. Moreover, the gap between capital needed and predicted levels of investment is alarming.
McKinsey estimates US$69 trillion is required in infrastructure investment to support the world’s economic needs by 2035. The world needs to invest an average of US$3.7 trillion in infrastructure assets every year through 2035 in order to keep pace with projected GDP growth. McKinsey also states that needs could increase further by up to US$1 trillion annually in order to meet the United Nations’ sustainable development goals. The bottom line is that they estimate a US$5.5 trillion spending or investment gap globally between now and 2035.
Similarly, the Global Infrastructure Hub, a G20-sponsored organisation, estimates that US$94 trillion is required by 2040. It estimates at current investment levels only US$79 trillion will be invested, an infrastructure funding gap of US$15 trillion. It is the goal of that organisation to help encourage the policy conditions to unlock trillions of dollars in private investment to fund much-needed essential infrastructure. Whether using McKinsey or GI Hub estimates, it is clear that massive funding challenges lie ahead.
Put simply, governments around the world stand to greatly benefit from capital provided by private investors to help fill the infrastructure funding gap. Unfortunately, in contrast, some countries are going in the opposite direction, towards nationalisation of some privately held infrastructure assets. Such actions would lead to increased tax burden or enormous government borrowing, to fund not only the repurchase of existing infrastructure assets, but also the funding of new developments. Neither of these outcomes would seem to benefit the citizens of those countries.
Over the past 10 years, infrastructure investment has gained momentum among institutional investors like pension funds, insurance companies and sovereign wealth funds, but to a certain extent, infrastructure investment has hit a crossroads. From one side, the global economy is crying out for more infrastructure investment but governments still own much of their economic infrastructure directly, and are struggling to grow the pipeline of investable infrastructure assets. On the other side, a large and growing number of institutional investors are competing for exposure to a relatively small pool of non-government owned core infrastructure assets. This has seen transaction multiples increase strongly over the past 10 years. There is a clear supply and demand imbalance.
Infrastructure investment trends
Institutional investors typically allocate funds to infrastructure on the basis of its defensive characteristics and inflation-linked cash flows.
Strong performance and attractive investment features have led to significant funds flowing into the asset class over the past 10 years. This trend shows no sign of abating, with 71 percent of public pension funds believed to be allocating more money to infrastructure within the next 12 months.
Increasing allocations and fundraising combined with a limited availability of assets means that asset managers have found it increasingly difficult to deploy capital. The latest Preqin figures estimate that $173bn of dry powder, or unspent capital commitments, is waiting on the sidelines to invest in unlisted or private infrastructure. Exacerbating this capital backlog is scarcity of core infrastructure assets in the direct market and high multiples. Not unsurprisingly, given the strong flow of investment, a recent survey undertaken by Preqin found that 59 percent of unlisted infrastructure fund managers see high valuations as the major challenge to capital deployment, while 52 percent of managers believe that infrastructure assets are currently overvalued. Furthermore, 81 percent of managers are seeing more competition for assets relative to 12 months ago.
All this points to a market in which it will become increasingly difficult to deploy capital and equally difficult to acquire fairly valued assets. Surely something has got to give?
Given the attributes of the unlisted infrastructure market noted above, we would expect that any current allocations to infrastructure are likely to take some time to be deployed (assuming the asset manager displays a level of discipline, in terms of both pricing and infrastructure asset type). In the period during which allocated capital is not invested (directly, or through managers) in the desired infrastructure assets, it will be invested elsewhere in an institution’s liquid assets portfolio, most likely in a combination of equities, cash and bonds.
We make the case in this article that the $2.3 trillion listed infrastructure market provides investors with an alternative investment opportunity which we believe could provide a significantly better fit to their desired infrastructure exposure than the alternative places to park capital.
It may be hard to accurately determine exactly where capital is invested while it is awaiting deployment in an unlisted infrastructure allocation, given pension funds mostly manage their portfolio exposures as a whole. However, it would be fair to assume that the investment‐in‐waiting would roughly approximate the existing liquid portion of an institution’s portfolio.
To the extent that an institution has explicitly considered its alternatives, we would expect that the main investment criterion would be to balance return-seeking attributes while having some downside protection.
Given the obvious issues associated with holding cash (cash drag), we reviewed four return-seeking portfolio options, comparing these portfolios to a listed infrastructure performance benchmark. Those four portfolios are: (i) 100 percent equities; (ii) 50 percent bonds and 50 percent equities (50/50 portfolio); (iii) 33 percent bonds, 33 percent equities and 33 percent hedge funds (33/33/33 portfolio); and (iv) 100 percent hedge funds – often seen as a defensive but return-seeking asset class.
From our observations, equities, hedge funds, a 50/50 portfolio and a 33/33/33 portfolio all have remarkably similar returns over time. In contrast, listed infrastructure has outperformed these investment options by a very large margin, despite showing similar risk characteristics.
Finally, we observed that in the final quarter of 2018, listed infrastructure displayed significantly better resilience than hedge funds, or alternative portfolios. This re-emphasises the defensive nature of listed infrastructure even against asset classes traditionally considered to be defensive or countercyclical.
Drawdown and risk analysis
One often‐quoted concern with listed infrastructure is that it has a high correlation with listed equities. However, correlation is simply a measure of the consistency of directionality of short-term measurements, rather than a true measure of diversification or risk management. The correlation of listed infrastructure to equities is approximately 75 percent over a 10‐year period and may be higher during periods of short-term market volatility, but this is significantly lower than the correlation of a 50/50 equities and bonds portfolio, which demonstrates a correlation of 96 percent over the same period.
Instead, we would suggest that capital loss (and speed of recovery) are a significantly more useful measure of short- to medium-term risk. During the financial crisis, listed infrastructure experienced a very similar drawdown profile to a 50/50 bonds/equities portfolio and to the hedge fund index. Furthermore, the listed infrastructure index and the 50/50 portfolio recovered their value at almost the same pace – approximately three years from peak to recovery. In contrast, the listed equity market showed a 54 percent drawdown at its peak and experienced a materially slower recovery, taking almost six years to recover its losses.
In a paper entitled ‘Implications of Dry Powder for Listed Infrastructure’, by ATLAS Infrastructure, the case is made that the listed infrastructure market should be even more resilient in the current environment given the significant volume of dry powder currently sitting in unlisted infrastructure funds, which may provide support for asset prices in a material market correction. This support was not a feature of the market in the 2008-09 period, and may help to explain the particularly strong performance of listed infrastructure through the most recent pull-back.
The paper found that listed infrastructure had achieved comparable and often superior returns to general equities with materially lower downside risk. Furthermore, it has shown a very similar risk profile to 50/50 equities and bonds portfolio, while delivering 300 basis points per annum in excess returns. In either case, it provides a significantly better risk/return outcome. The paper also noted that listed infrastructure has delivered very similar long-term returns to unlisted infrastructure, using the Preqin index.
It should be noted, while this article makes the case for a broadly diversified listed infrastructure portfolio using the FTSE Developed Core Infrastructure index, active stock selection offered by the specialist global listed infrastructure managers have historically and will continue to be a significant contributor to excess returns in the asset class.
The fallacy of the discrete, ring-fenced funding source
In discussions with investors, some have mentioned that using listed infrastructure as a funding source for an unlisted infrastructure commitment may imply that should the listed infrastructure market lose ground, it may be left with insufficient capital to fund its unlisted commitments. The only answer to this concern is to hold all unallocated commitments in cash, or other very low risk/low return assets, but face the consequences described earlier.
In reality, the unspent commitment is unlikely to have been held in cash and instead is more likely to have been invested in a mix of equities, cash and bonds. As we demonstrated above, this would have very similar drawdown characteristics to listed infrastructure while offering, in aggregate, substantially lower returns (plus offering no, or very little, infrastructure underlying exposure).
In practice, holding undeployed allocations in cash, or across a general portfolio, undermines the intent of a given portfolio allocation to infrastructure and weakens the risk-return profile of that portfolio.
One potential option to overcome the issue of undeployed allocations may be for institutions to include a listed infrastructure component in the infrastructure team’s benchmark, which is equivalent to any undeployed allocation. The infrastructure team would then be held accountable for the entire infrastructure allocation and be able to make more conscious decisions as to the deployment of that capital.
This article provides evidence that listed infrastructure can provide superior long‐term risk/return characteristics relative to a variety of alternatives.
Ultimately, a carefully defined listed infrastructure market is made up of a large number of high-quality infrastructure assets, covering regulated utilities, energy transportation, transportation and communication infrastructure. These assets are mission critical to the needs of the global economy. Most institutions would gladly include these assets within their direct infrastructure portfolios if they were available in unlisted form. Accordingly, we firmly believe that the $2.3 trillion listed infrastructure market has demonstrated desirable investment characteristics over many years and can and should play a valuable long-term strategic and tactical role within an institution’s broader infrastructure allocation.
Fraser Hughes is CEO at GLIO and David Bentley is a partner at ATLAS Infrastructure. Mr Hughes can be contacted on +32 2 767 1888 or by email: email@example.com. Mr Bentley can be contacted by email: firstname.lastname@example.org.
© Financier Worldwide