Infrastructure on the Rise
Largely due to the current low interest rate environment, institutional investors such as insurers and pension funds are increasingly moving toward allocation into longer-term illiquid assets, in particular into infrastructure as an asset class. Global infrastructure assets under management have seen a 300 percent increase over the past seven years.
There is clear evidence that insurers and pension funds with long maturity liabilities are increasing their asset allocation to infrastructure as an asset class. Other categories of investors are larger family offices and sovereign wealth funds. The investment case is that infrastructure projects or businesses offer long-term yields that are theoretically fairly stable and normally can provide inflation protection. Typically, investors are taking a seven-to ten-year view on the risk / reward of investing in infrastructure assets, but frequently the time horizons can be considerably longer. According to Preqin, global infrastructure assets under management in unlisted funds are at a record high of 282 billion dollars, having increased threefold since 2007. Of the investors surveyed by Preqin, 25 percent plan to invest over 400 million dollars each over the next year in infrastructure, and 90 percent plan to invest at least 50 million dollars.
Typical infrastructure investment vehicles
In an unlisted fund, it is normal for the general partners to manage the infrastructure assets and to appoint management teams as relevant to the day-to-day management of individual assets or projects. Limited partners will have made an initial capital commitment, and capital will be called as and when funds are invested. There is typically an initial investment period, and if the general partner has not invested funds prior to the maturity of this investment period, then capital commitments are waived or the limited partners can vote on granting an extension. There will be clear guidelines on the fund's turnover, on investment concentration, leverage, planned repayments to limited partners, and how, if necessary, the limited partners can vote on a change in asset manager or general partner. Leverage has to be carefully monitored since funding can be at the fund level or more normally embedded in the actual projects or assets being invested in. Leverage levels will typically be higher than what is normally found in the private equity industry on the assumption that cash flows have a lower degree of volatility than that in private equity. Sources of performance will be cash flows from projects, the improvement or upgrading in infrastructure assets with new management, leverage and over the long term the disposal of assets to new investors.
Investor demand: Existing assets versus greenfield projects
The infrastructure industry is dominated by investment in existing infrastructure with a focus by general partners to improve the cash flows from existing assets, to improve the financing structures, to upgrade assets and to sell on what were originally purchased as undervalued assets. In some cases, publicly listed infrastructure companies will be taken private with a view that management change can be more easily effected in a private structure. One key problem is that although 70 percent of infrastructure requirements are estimated to be in greenfield projects, investor demand is primarily for existing assets. The rationale for this reluctance lies in the fact that investors do not want to carry the initial construction period risk where cash flows will be negative, and where investors have limited direct control over issues such as cost overruns, construction failures, environmental risks, supplier failures, etc. Greenfield project risks are typically carried out by companies with a long history of involvement in the construction of infrastructure, and they may be supported by government, bank or supranational institution guarantees. In emerging economies, many projects have only taken place backed by, for example, guarantees from the Asian Development or the Inter-American Development Bank. In Europe, the European Investment Bank has played a key role, not just in financing projects, but by providing guarantees.
Financing can be divided into a variety of constituent elements – including equity – typically with pension funds and insurance companies acting as limited partners in unlisted funds, companies involved in the infrastructure sectors providing equity, bank financing, the developing infrastructure bond market and the provision of guarantees from banks, governments or supranational institutions. Given the long-term and illiquid nature of the assets, it is generally agreed that it is inappropriate to have infrastructure assets in mutual funds where short-term liquidity is provided to investors. If retail investors want to access the infrastructure industry, the most appropriate route is to purchase the equity or bonds of infrastructure construction and maintenance companies.
Apart from equity investing on the part of long-term investors, there is a clear recognition among investors that the infrastructure bond market requires further development. With banks deleveraging and reducing maturity mismatch risk by focusing on floating-rate rather than fixed-rate assets and reducing proprietary positions, bank financing for infrastructure will decrease on trend, and therefore lead to greater reliance on access to funding from investors and the bond markets. Since investors are reluctant to act as equity providers in greenfield projects, they likewise will not be providers of longer-term financing for new projects. They will, however, be active participants in bond issues made by existing infrastructure management companies such as train operators, pipeline managers, etc., while they will also purchase bonds where there are credit guarantees either by government, supranational institutions or banks.
While the current low interest rate environment encourages increased allocation into longer-term illiquid assets such as infrastructure, it is important to focus on the risk factors in the industry. For new projects, the obvious key risk is that projects are either not completed or have serious delays and / or cost overruns. Political risk has to be carefully assessed; there have been a number of instances, notably in mining projects in higher-risk emerging markets, where a change of government has led to contracts / concessions being cancelled and assets sequestered. A number of alternative energy projects and wind farms have faced deteriorating economics as government subsidies have been withdrawn, and likewise social infrastructure projects, which might be in the form of a public / private partnership, can suffer from reduced government funding. Environmental issues are critical, notably in the transport, energy and waste management sectors. Examples of problems have been the imposition of environmental fines on projects and infrastructure assets and projected cash flows being delayed because of disputes over environmental issues. Another risk is the threat from new technology. For example, in telecommunications, the future viability of mobile masts has to be questioned, while initially the excessive installation of fiber-optic cabling led to major losses. Market price movements can change the economic viability of infrastructure. At present, the sharp decline in oil prices is challenging a number of alternative energies, and investment in oil and gas fracking is becoming less attractive. Financial risks involve the threat of higher interest rates and / or wider credit spreads. The final risk is that, in "easy" markets backed by quantitative easing, valuations may become stretched.
In the recent G20 communiques, the G20 stated "we are working to facilitate long-term financing from institutional investors and to encourage market sources of finance, including transparent securitization particularly for small and medium enterprises and we endorse the multiyear program to lift quality public and private infrastructure investment." It is obvious that at the level of individual governments and also the IMF, OECD and EU, accelerating infrastructure projects is a clear macropolicy objective. S & P has estimated that infrastructure financing needs worldwide could total 3.4 trillion dollars annually until 2030. For governments, infrastructure investment is clearly attractive given the initial positive impact on employment and the longer-term multiplier effect on the economy.
There are a number of clear trends in the infrastructure sector. First, new investment from investors such as pension funds that need long-term assets and do not need liquidity will increase significantly. Second, investment in infrastructure will have the support of governments and supranational institutions given the strong economic multiplier effects. Third, the environment for investing in greenfield projects / start-ups will remain challenging and will require project and credit support. Fourth, investors will focus on areas where there is inflation protection, minimal systemic risk, and where leverage and financial risk is intelligently managed. Finally, the flow of equity capital will be matched by the development of the infrastructure bond market as an alternative to bank financing.
This article originally appeared in Credit Suisse's Global Investor