By Reyno Norval, Senior Associate at Altius Associates
Due to the long term/international nature of private infrastructure investing there are a number of challenges within the infrastructure market facing investors today.
One challenge that faces the sector is rising asset prices, especially for core brownfield assets. This sector of the marketÂ is being seen as a “safe haven,” and the promised yield is viewed as an attractive replacement for low-yielding fixed income securities – though the truth here, to quote Oscar Wilde, is rarely pure and never simple. As a result we have seen capital rushing into the space, bidding up asset prices and likely reducing future returns.
A second challenge is the divergence inÂ expectations of returns that core brownfield infrastructure will provide to a portfolio.Â Some managers, often unrealistically, project mid-teen IRRs and yields of 5%, while more conservative managers target an 8-10% IRR with a similar yield.Â We believe that investors entering the asset class with an expectation of the higher return profile are likely to be disappointed.
Thirdly, regulatory risk is also alive and well in the sector.Â Â A recent example is Norway’s proposal to cut tariffs for future Gassled gas transportation contracts by 90%. Gassled isÂ aÂ true regulated monopoly located in oil rich Norway and transporting about one-sixth of the gas consumed in the European Union.Â Â Gassled seemed like aÂ "safe" investment with a risk profile that one major firm said "can best be described as a Norwegian government bond."Â The firmÂ in question was expected to provide its investors withÂ a 7% pre-tax inflation-linked return.Â Today, however, the risk/return profile has changed dramatically. Combine this risk with the rising assets prices and one is left with very little downside protection should regulation negatively impact on a project’s revenue stream.
This brings us nicely to the next challenge: determining which geographies provide the optimum risk/return profile for an infrastructure allocation. With few exceptions, emerging markets have not produced returns commensurate with the additional risks involved. Therefore what should be the allocation to these markets? Should there be one at all? Will we miss out on the upswing if we don’t invest in these markets right away? These are all questions being asked and creating uncertainty for investors. Or consider Europe, the so called ‘more developed’ economy, and the uncertainty it has created for investors over the past few years. For example will Greece leave the Euro? What is happening politically in Italy and Spain, which for so long looked like a great place to deploy capital in renewable energy generation projects? If the decision is taken by investors to stay away from these regions, the logical thing to happen will be that more capital is deployed to other ‘safer’ economies, pushing up prices and reducing returns, which in turn changes these risk/return profiles.
Another challenge is that infrastructure, excluding energy, is an emerging asset class. Therefore there is limited historical return series to analyse which, in turn, makes it much more difficult to evaluate managers because of limited operating history and short track records. In addition there have been very few clean exits or fully realised funds to date. Therefore, sourcing, analysing, and selecting the best managers requires as much judgment as analysis, and requires more time, effort, and expertise than normal.
Selecting a benchmark for private infrastructure investments is yet another challenge. There are no widely-accepted industry standards. Given that real assets are expected to hedge against inflation, one benchmark that might be appropriate is a premium over an inflation Index. A benchmark of CPI + 6% or so would require the Fund to earn a return of 9%, which is between those expected from fixed income and equities, during periods of average inflation (3% historically). Another potential benchmark is simply the investor’s absolute expected return target. If a 12% return is expected, this figure could serve as the fund’s benchmark. There are also a few publicly-traded indices designed to track real assets such as infrastructure. However these indices are heavily weighted towards publicly-traded electric, gas and water utility companies, which is not representative of the infrastructure sector in general. We favour absolute return targets and the CPI + premium benchmark, as it requires the Fund to earn higher returns in times of higher inflation. Of course any benchmarks for private infrastructure funds are only valid over the very long term and will not provide useful information on a quarterly basis or prior to coming out of the J curve.
Environmental and social impact could cause a challenge for certain types of investors, especially regarding headline risk. Infrastructure projects planned on greenfield sites could cause environmental degradation, the clearing of forests, or diversion of water flows from their natural path, to mention but a few. The impact on a society can be equally damaging as some residents may be relocated or neighbourhoods disrupted. The uproar in the UK by certain constituencies in relation to the building of high speed rail 2 is one example of this. Objections to infrastructure projects on environmental and social grounds can block or delay matters indefinitely.
Finally, for investors exploring direct investment into infrastructure assets or projects, a key challenge is acquiring and retaining the necessary resources and expertise to properly assess the investment opportunities, as well as to maintain/monitor them over a long life.Â The two most prominent attractions for investing directly are reduced fees and more operational control. Many investors underestimate the time, cost, and experience required to build the internal capabilities necessary for both of these attractions to add any value. For example, in order to create a diversified portfolio of infrastructure assets, a team of top experts in a variety of sectors with a variety of skills needs to be hired. This cost may offset the fees paid to the fund manager but the investor may actually have access to less experience and expertise than with the fund manager. In addition, more operational control only adds value if you have the right expertise internally to take advantage of this ‘benefit.’ Direct investing takes time and costs money to be executed properly and should rarely be the starting point for an infrastructure investor.
We have highlighted the challenges, but we believe there are many advantages to investing in infrastructure. These include attractive risk/return characteristics, inflation hedging, diversification from modest correlation with other asset classes, the cash yield component, and a good duration match for pension/insurance liabilities. However, these are long term, capital-intensive projects that have risks associated with them that must be addressed. The best managers and advisors understand these underlying assets and have the necessary expertise to construct an infrastructure allocation with the optimal risk/return profile.
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