Low yields drive hunger for infrastructure

In today’s low yield environment, real assets such infrastructure are particularly sought after, thanks to their ability to provide inflation-linked, relatively attractive risk-adjusted returns, low correlation to the economic cycle, and, in some cases, income.

For investors that can afford to lock up capital for up to 25 years, infrastructure assets can operate as stores of value for future generations, and access to those, often large, projects is made easier by specialist debt or private equity funds.

Research studies report increased allocation to infrastructure by institutional investors over the past few years, while asset managers praise the unique features and growth potential of investments in this space.

In developed countries, refurbishments and replacement of crumbling infrastructure are the key growth drivers, whereas new systems and networks are needed in emerging economies to keep pace with population and economic expansion, middle class growth and urbanisation.

But private banks have mixed views. “The longer-term case for infrastructure investments in private client portfolios remains intact,” states Daniel Kuehne, head Investment Solutions Group and Markets UK at Bank Julius Baer. “This is largely due to the attractive cash flow and income yield property of these investments, as well as to the fact that project pricing and shareholder returns are highly linked to inflation,” he says. This may offer private clients a hedge against rising price levels in the medium term.

Desire for liquidity and income drives private investors towards listed funds, and vehicles investing in globally diversified projects offer the most attractive way to implement the infrastructure theme, according to Julius Baer.

Other institutions are more sceptical. The CIO of a major European private bank, who prefers to be quoted only in relation to high conviction calls, points to a scarcity of suitable vehicles for private investors.

The dream of the Eurotunnel, which finally opened in 1994, caught the imagination of the French, he says, who poured lots of money into the project, but they are only now starting to make money. “Infrastructure projects have a very long-term timeframe, whereas individuals need to get returns over a relatively short-term.”

Illiquidity, lack of income and a strong correlation to the economic cycle remain key issues, he states, with individual stocks or mutual funds investing in infrastructure companies providing only a “diluted exposure” to the theme. A toll road or an airport company generates revenues from existing roads or airports in their portfolio, whose drivers are different from those underlying the construction of new infrastructure. These assets should be considered as equity investments and as such assessed within an equity asset allocation strategy, he says.

Other concerns relate to emerging markets growth and doubts about the ability of developed markets’ debt-ridden governments to allocate capital to infrastructure projects.

“Infrastructure is not one of our key themes for 2014,” explains Lars Kalbreier, global head of mutual funds and ETFs at Credit Suisse, explaining that the bank’s clients invest in this space mainly via private equity.

“Many infrastructure funds have a quite wide exposure to developing economies, but with the increasing economic divergence between emerging markets, investors need to be much more selective.”

In developed countries there might be urgent need to replace ageing infrastructure, but “when government spending needs to be reined in, that does not bode well for infrastructure investments,” believes Mr Kalbreier.

Core vs economic

However, it is crucial to distinguish between core and non core, or ‘economic’, infrastructure.

The most basic distinction is based on how investors get returns, explains Giles Frost, founding director at Amber Infrastructure, an international London-based sponsor, fund and asset manager of social and economic infrastructure projects.

In ‘economic’ infrastructure, including toll roads, airports or ports, assets are mainly paid for by users, or at least revenues are linked to user demand. These assets are therefore strongly correlated to GDP growth and the major risk for investors relates to the change in demand level.

In ‘core’ infrastructure, such as schools or hospitals, revenues do not depend on the use of facilities. “Investing in core infrastructure is ultimately reliant on the credit quality of the governments in the countries where infrastructure is located,” says Mr Frost, emphasising the capital preservation characteristics of assets in developed economies, such as the UK, Western Europe, North America and potentially Australia. Payment obligation on these infrastructure assets are backed by governments themselves and their returns, which are inflation-linked, are 3 to 4 per cent higher than government bond yields.

The cost of core infrastructure is born by the government but is spread over the life of the assets, which helps make the investments affordable. Also, most infrastructure projects are developed through public-private partnerships. And the majority of governments currently have plans for new major infrastructure works, seen as a way of stimulating their economies.

When investing in this space, it is important to focus on assets that come with the desired characteristics of infrastructure, says Markus Pimpl, head of listed funds at Partners Group, the Switzerland-based firm with €31bn in assets under management, which is focused primarily on private markets and investments.

These characteristics include lower sensitivity to the economic cycle, growth potential, stable dividends and inflation protection. Suitable companies are found in the transport, communication, social and utilities sectors.

“We invest in satellite operators or telecommunication towers, for instance, but not in telecommunication companies, often included in infrastructure funds, because they are not monopolists and do not have the attributes of core infrastructure,” says Mr Pimpl. “As monopolists, these companies usually provide us with a contractual inflation link or protection.” With this approach, competition, the main risk in public equity investment, is avoided, he says.

Also, private companies listed on the stock exchange that win concessions to operate infrastructure assets, such as water grids, toll roads, or airports have better access than
government to credit. With concessions already in place, there is transparency of cash flows and Ebitda (earnings before interest, taxes, depreciation, and amortization) likely to be generated in the future, he states.

Core infrastructure firms are able to increase their Ebitda on a very consistent basis, which enables them to distribute stable dividends. In a low yield environment, this is particularly appreciated by investors who can diversify their equity allocation with what is considered a rather defensive investment.

The major risks of investing in core infrastructure are mainly linked to political developments and regulatory changes.

“Investing in infrastructure is about understanding political risk and the regulation of these assets,” says Mr Pimpl. In-depth sector know-how is paramount to forecast future developments, as when new regulation comes into force it is often too late.

In core infrastructure, the risks are about making sure that “you got the costs right,” says Amber’s Mr Frost.

“When developing infrastructure, you are promising to deliver the assets, whereas a school, a hospital or a road, for a fixed price. Therefore the biggest risk is around the construction of those assets and then operating them during their life for the cost projected.”

Sharply rising interest rates are a risk investors should be aware of when considering investing in infrastructure, warns Julius Baer’s Mr Kuehne, explaining however this is not the bank’s base case scenario for 2014. “As investors’ interest and capital flows into the infrastructure sector remain significant, we expect that any gradual rises in core government bond yields on infrastructure discount rates and capital growth should be offset by investor flows.”  

Filling the funding gap

According to a recent report from consultant McKinsey & Co, an estimated $57tn (€41.7tn) will be needed to finance infrastructure development around the world until 2030, but the gap between investment needs and available public funds could be around $500bn annually, according to S&P’s analysis.

With budgetary constraints burdening government globally, and banks’ long-term lending restricted by regulatory requirements, non-traditional lenders such as insurers and pension funds are expected to take a larger share of the infrastructure investment pie. 

Alternative investments as well as mini-bonds, ie direct loans to small or medium enterprises, will also contribute to fill the funding gap, explains Giordano Lombardo, group CIO of Pioneer Investments.

Efama, the European Fund and Asset Management Association, is pushing for a more efficient regulatory framework and a better-designed structure of European Long Term Investment Funds (ELTIFs), under which investors will be able to put money into companies and projects that need long-term capital.

These vehicles could be an important source of economic growth in the EU in the future. In Europe, 80 per cent of debt financing to the economy is provided by banks, in contrast to the US where bank-financing is as low as 20 per cent.

 “Mutual fund providers today have an historical opportunity to become a relevant alternative channel of long term financing to stimulate economic growth,” says Mr Giordano. But this will take time, as fund managers will have to acquire structures, skills, resources and achieve economies of scale.