As governments throughout the world become increasingly unwilling and unable to fund trillions of dollars of needed infrastructure investment, the private sector has been stepping in to fill the gap. In the process, they are pioneering a broad and burgeoning investment asset class, one which has been providing attractive rates of return with low volatility. Assets include:

• Electric power generation and transmission
• Telecommunications and water facilities
• Toll roads
• Railways
• Airports and seaports
• Schools and hospitals

Earlier this year, Toronto CFA Society, Financial Executives Institute (FEI), Canadian Institute of Chartered Business Valuators (CICBV) and Canadian Venture Capital & Private Equity Association (CVCA) jointly hosted a symposium on investing in infrastructure. Topics included an overview of infrastructure investment, a review and analysis of private-public partnerships (i.e., PPP or 3P) and discussions of direct investing and fund investing. Expert speakers came from institutions that invest directly in assets and indirectly through funds, as well as from general partners of infrastructure funds, advisors and consultants: The following is a summary of the key points from the symposium, as well as an additional post-event Q&A with some of the industry experts that presented.

SYMPOSIUM SUMMARY

Main reasons for investing in infrastructure:

1. Yield enhancement (relatively high risk-adjusted and absolute returns)
2. Low correlation to traditional asset classes, along with the related diversification benefits
3. Protection from inflation (usually through long-term government price contracts that contain escalation clauses)
4. Asset liability matching (underlying longer-term capital assets provide a match for long duration liabilities of pension plans)
5. Low volatility asset class (product return profile relatively predictable – “monopolistic” type assets tend to offer lower volatility in returns)

Institutional investors can either invest directly in infrastructure assets or indirectly through funds. Direct investments can be done alone or with other partners through co-investments. If the investor participates through a consortium, the other partners may or may not have the same requirements or competencies.

Most investors are targeting low double-digit net returns (i.e., 10-12 percent) with a 6 percent to 8 percent volatility for stabilized assets in OECD countries, typically referred to as “brownfield“ assets. These are assets that currently exist and have a stable cashflow history associated with them. However some investors are targeting “greenfield” (or developmental) investments in more politically risky areas with the expectation that these may provide a greater return premium comparable to traditional private equity expectations (i.e., 20 percent plus).

Social versus economic: infrastructure challenges in partnerships with governments

There are two sectors or categories of infrastructure investments: economic or demand based assets (such as energy, transportation, utilities, etc…) and social (i.e., hospitals, courthouses, educational institutions, etc…). Economic infrastructure supports economic activity and can be developed by both government and private sector initiatives, and often results in user-pays, demand-based revenue. Social infrastructure investments are in facilities that provide social services to the community and are almost always developed through PPPs. These involve the government putting projects out for tender to consortiums to bid on to design, build, finance and maintain a specific facility. The successful consortium is awarded by governments with project mandates to build and operate long-term concessions in return for availability payments from the government entity. Figure 1 shows the typical structure of a PPP project.

Larger pension plans are generally more interested in investing in economic infrastructure assets because social infrastructure often does not provide inflation protection and typically requires relatively small equity investments to complete the project.

Fund investing and direct investing funds: Most suitable approach for smaller investors

In the case of smaller institutions, often the only feasible way to invest in infrastructure is through funds.

Advantages:

1. Diversification by category and geography of underlying assets
2. Ability to leverage fund managers’ expertise, relationships and resources – a smaller internal team can manage these investments compared to the resources required for direct investing
3. Potential to source co-investment opportunities at lower fees

Challenges:

1. Fees (fee structure for more opportunistic strategies are management fees of 1.5 to 2 percent per annum and up to 20 percent incentive fee)
2. Lack of control and decision making as to the timing of assets being acquired and/or divested
3. Finding managers who can exhibit long-term consistent benchmark outperformance

Direct investing: best for investors with large capital resources and expertise

Direct investing is possible for investors with substantial investment capital and large internal teams that have the expertise to source and execute deals and manage the underlying assets.

Advantages:

1. No fund management or incentive fees to pay
2. Select investments more closely tied to an investment strategy
3. Tailor investments to meet an investor’s needs (i.e. an institution who requires cash to pay its obligations today will be able to select investments that generate yield from the beginning versus another investor who has longer dated liabilities who may want more capital gains)
4. Ability to exert influence over management
5. Control over length of time an asset is held and then the exit strategy

Challenges:

1. Lack of asset diversification
2. Compensation required to attract and retain investment professionals
3. Large budget required for due diligence costs to evaluate potential investments
4. Assumption of pursuit costs on deals that do not close (broken deal costs)
5. Greater volatility due to limited number of underlying assets

Key prerequisites:

1. Ability to source transactions, which requires a team that has deep global relationships
2. Ability to execute internally (there is a lot of competition for prized assets in this sector – prospective investors must balance wanting to win the bid with not overpaying for an asset)
3. Ability to manage and operate the asset once it has been acquired, which requires a diverse and skilled team with operating expertise that is willing to stay to manage the long-term asset
4. Ability to manage risks specific to an individual asset or industry sector

Important considerations before either type of investing:

Whether looking at investing directly in an asset or indirectly through a fund, panellists noted some important points to consider before investing in infrastructure:

1. Size of allocation relative to overall portfolio (unlike private equity, if an infrastructure investment is too large and there is a significant loss, it is very difficult for a portfolio to recover)
2. Whether the investment is direct or through a fund, most infrastructure assets are subject to greater governmental, political and regulatory risk than other investments
3. Conflicts of interest between the manager and any of its other funds or with its other divisions or affiliates, such as an investment bank sponsored fund (and if so, what is the process to resolve these situations)
4. If investing through a fund, ensuring appropriate compensation structures are in place for key team members to ensure a proper alignment of interests (including “skin in the game”) are in place that align the general partners’ interests with those of the investors

Investment opportunities abound in emerging markets; OECD countries present more challenges

Panellists specifically identified Asia and other emerging markets as locations expected to provide key opportunity for the next number of years. For example, India has 1 billion people but currently uses only a quarter of the energy that the U.S. does; this is anticipated to grow significantly over time. By comparison, OECD countries are likely to experience relatively slow growth in the next decade due to de-leveraging and aging demographics. The challenge of securing attractive infrastructure returns in many OECD countries is that potential inflation levels are running at 3-4 percent per year and economic growth at only 2 percent.

Shale gas opportunities present one of the bright spots in North America. Some panellists predicted that 15-20 percent of north-eastern coal plants will be shut down in the next 10 years due to environmental concerns and identified that shale gas will be needed to fill this gap. Accordingly, panellists were also positive on renewable forms of energy such as wind and solar, and particularly the need for new transmission assets. Potential return projections made on various types of assets were:

1. Transmission: 12 to 14 percent
2. Asian assets: 20 to 25 percent (which is similar to private equity return targets)
3. Regulated utilities: 9 to 11 percent
4. Transportation:15 to 19 percent

The symposium closed on the note that the structure of pension fund liabilities associated with aging populations in the developed world will increase investment demand for the asset class of infrastructure. Pension plan managers and others are expected to increase their allocation to these less volatile assets due to their attractive risk-adjusted return characteristics.

FOLLOW ON Q&A

After the event, The Analyst (TA) put some additional questions to the experts participating.

TA: It has been suggested in the U.S. that a REIT or income trust-type investment vehicle could be used to channel money into infrastructure investments, benefitting both investors and cash-strapped governments. Can you comment on the feasibility of this in the U.S., Canada or elsewhere?

Experts’ response: Theoretically, the concept of a REIT or income trust investment vehicle investing in infrastructure assets could present some appeal. However, practically speaking, establishing these types of investment vehicles would be extremely difficult and complex from both tax and legal perspectives. By investing in public shares or exchange-traded funds (ETFs), the individual investor can efficiently access the infrastructure space in ways other than through an infrastructure REIT/income trust. Given the benefits of diversification, it can be argued further that building a portfolio of high-quality stocks or ETFs may be less risky than direct investment in a single REIT/trust-type investment vehicle that may have a specific sector focus or geographic concentration due to its small size. While ultimately a REIT/trust-type vehicle could achieve appropriate diversification, in light of the significant level of competition that exists for high quality infrastructure assets, it would likely take a long period of time to do so.

Moreover, direct investment in infrastructure assets requires a unique investment perspective. Infrastructure assets are illiquid, tend to be capital intensive, can initially have low cash yields, and require a long-term investment horizon. These characteristics tend not to fit well with investors looking for high yields (income trust/REIT investors) or with publicly-traded entities that are required to report financial results on a quarterly basis.

From the government perspective, establishment of a REIT/trust-type vehicle could create additional access to capital, but given the large amounts of assets under management by infrastructure investors there would appear to be already sufficient capital available. The issue is more one of inexperienced PPP markets, especially in the United States. Greater government focus on improving the quality and process of future PPPs would likely yield greater access to capital than the establishment of a REIT or income-trust vehicle.

One jurisdiction that has used a listed infrastructure model is Australia but aggressive sponsors over-levered the structures and took advantage of retail investors’ desire for cash yield by using financial leverage and return of capital to pay dividends. Many of the regulated assets within these structures now require significant reinvestment of free cash flow to expand their regulatory rate bases and their pricing has been hurt by the diminishing yield, despite the value of reinvesting in their assets at a zero premium (i.e. a dollar paid for a dollar of rate base).

TA: In light of the public interest in the running of infrastructure assets and operations at the lowest possible price, is not the risk of government regulation and hence the investment risk very difficult to assess, particularly with respect to such infrastructure as roads, airports, railway lines and social infrastructure? How can investors protect themselves?

Experts’ response: The key is to invest in countries that have a clearly established regulatory framework, as well as a significant history of regulatory stability and contractual change-in-law protection. While there is always the risk of regulatory changes occurring, investors can take some comfort if local governments have a history of supportive regulatory environments. It is also helpful if there exists a commercial rationale (required need to develop, improve or, reinvest in infrastructure assets) such that the regulatory authorities have an incentive to maintain and encourage continued investor confidence in the sector. It’s also possible for investors to try and protect themselves through the use of specific contract terms, concessions or other legal means.

In jurisdictions where the investor is less familiar with the regulatory environment, or concerned with the potential for punitive regulatory change, a partnering strategy can be employed to help mitigate regulatory concerns. Partnering with a strong corporate entity that operates within the country in question can bring expert knowledge of the local environment; provide clarity and understanding of regulatory policies; assist with due diligence efforts; and, may have some degree of potential influence with the regulatory agencies.

Private sector contracts to own and manage infrastructure assets over long periods also include lifecycle maintenance obligations, which the public sector usually minimizes due to budget constraints. This whole life costing is critical in comparing value for money to the government in a private sector procurement arrangement.

TA: There is no active market for many infrastructure assets, which tend to be large and unique (unlike, for example, commercial real estate for which there is an active property market). Should not this illiquidity be accompanied by a premium return to compensate for it?

Experts’ response: The issue of an illiquidity premium is really a question of expectations. Infrastructure assets are unique investments and are suitable for investors with a particular set of investment criteria. Typically, successful investing in the infrastructure asset space requires the investor to have a long-term investment horizon: 15, 20, even 25 years would not be uncommon. If there is a potential for an asset sale to occur quickly, then the infrastructure asset class is not likely appropriate for an investor with this requirement.

Theoretically, as the investment horizon of the investor increase the need for additional compensation for illiquidity becomes less important. In the extreme, where the investor holds the asset for its useful life, or majority thereof, the illiquidity premium would be zero.

A final point on the question of receiving compensation for perceived illiquidity is that the market competition for infrastructure assets continues to be highly competitive and has exerted downward pressure on expected rates of return. Under most scenarios it is unlikely that investors requiring an illiquidity premium on top of their cost of equity capital would be successful in acquiring high quality infrastructure assets.