This analysis of the infrastructure sector by Infracapital, M&G’s Infrastructure Fund Management arm, outlines why the long-term nature of the investment, and its integration with core components of economics, makes the asset class so suitable for pension funds
Infrastructure by its nature has a long history, providing the backbone for an economy so that it can function efficiently. Despite this history, and a well-developed infrastructure system in Europe, the sector as an asset class is relatively young. Today however, against a backdrop of on-going volatility in the wider economy, the sector is becoming increasingly attractive.
Why are institutional investors allocating more money to the sector? There are two key trends. Firstly, the shift in the focus of pension funds to more closely align the risks of their assets and liabilities, and secondly, the desire to further diversify their investments. Investing in infrastructure provides a steady longterm income with a link to inflation – suiting funds that need to pay their scheme members an income over several decades. For other pension funds, their interest in the infrastructure sector is less about aligning their assets and liabilities, and more about diversifying their investments across a broader range of asset classes. Infrastructure’s appeal is that it is not particularly highly correlated with these other asset classes.
It would be a mistake, however, to think that infrastructure is a homogeneous sector. It isn’t. The type of investment available varies considerably from country to country, as do the investment styles of different funds. In the developed world, infrastructure tends to be well established and as such produces predictable cash flows. In the developing world, however, it is much more akin to equity investing with higher risks, and returns that are more volatile. Continual investment is required in existing infrastructure in the developed world to support economic and demographic growth.
There are different ways to approach infrastructure investing. At a basic level, an investor could simply buy shares in a quoted utility or transport company. However, the majority of infrastructure assets are no longer publicly listed and, while offering liquidity, this option still exposes investors to general market volatility. An alternative is investing in funds which directly invest in infrastructure assets. The exact nature of these funds can vary – being closed or open ended with different strategies, and can include investing in a portfolio of infrastructure funds as well as directly in the assets themselves. Infracapital, the fund management arm of M&G, operates a closed end structure, which we believe best allows for the close alignment of managements’ interests to those of investors. The skill of the manager in constructing a diverse portfolio is critical to ensuring investors enjoy both steady yield and moderate capital growth, with low correlation to the economic cycle.
One final avenue for investors is direct investment in infrastructure assets. However, this requires a team with broad experience in mergers and acquisitions, as infrastructure assets require very active management and dedicated personnel with commercial and industry experience, which is prohibitive for most institutional investors. For these reasons, coinvestment has become an attractive middle ground for investors, who can benefit from the expertise of the fund manager, but can enjoy great exposure and a lower average fee through coinvesting in portfolio companies alongside the fund in which they are invested.
Due to the relatively young nature of the infrastructure market, there is relatively little private market data available with respect to the performance of the asset class, and as such, it is difficult for investors to compare and contrast infrastructure assets or funds. However, research has shown that the underlying earnings of infrastructure cashflows demonstrate the attractive desired characteristics of materially lower volatility than, and low correlation to, equities. Therefore, adding infrastructure to investment portfolios should further diversify cashflows and provide protection against the economic cycles that impact broader markets.
Infracapital believes the current investment opportunity in European infrastructure is particularly compelling, and has identified a significant number of potential investments driven by several key themes including utility and other corporate non-core disposal programmes. Many of these programmes are due to regulatory initiatives and capital structure issues, refinancing pressures, privatisation of publicly-held infrastructure, and renewable (“green”) energy targets requiring significant capital. The unparalleled demand for private sector investment in infrastructure, and the breadth and depth of opportunities in the market place are expected to translate into a very attractive period for investing in the sector.
What is infrastructure investing?
Infrastructure refers to assets that are associated with the provision of public goods and services, and provide the backbone of an economy to ensure both social and industrial productivity. In the past, most of these structures were built and financed by national governments. However, over the past few decades that has changed, with more private capital now involved. Private investors are interested in providing the capital for these investments because the characteristics fit well with the requirements of many institutional investors.
Attractive characteristics of infrastructure
For institutional investors, one of the most appealing aspects of investing in infrastructure is that the income stream from these assets rises in line with inflation. This is important for pension funds, whose liabilities are also linked to inflation, and over a very long period. There is a very real risk that inflation can seriously erode the value of their assets if it is not managed correctly.
The sensitivity of an asset to inflation will vary across infrastructure assets. However, infrastructure assets will often have revenue streams that are linked to inflation through specific regulation or concessions, with pricing adjustment mechanisms that are linked to an inflation index. Typically, regulated energy and water utility companies are linked to inflation through such mechanisms. Understanding these underlying drivers and the impact of these drivers on assets in a portfolio will determine the inflation protection provided. In addition to inflation-linked growth, the inclusion of assets with correlation to the economy, such as those in the transport sector, also offer long-term GDP-linked growth.
Infrastructure assets and businesses tend to be key to the provision of services that are essential to society and to the economy. As such, the demand for such services is fairly inelastic and ensures relative resilience during market downturns.
Infrastructure assets typically have longer investment hold periods than traditional private equity investments. Their longer lives are often supported by long-term contracts for services, also reflecting the longevity of the assets. Infrastructure assets generally have limited technical obsolescence risk, which provides downside protection and supports such longevity. With longer hold periods, dedicated asset management teams, such as Infracapital’s, have increased opportunities to enhance the business’ performance.
Infrastructure businesses often operate in natural or regulated monopolies. In many cases, the relevant business may be the sole provider of its service to the local economy. When there is competition from other companies, typically this competition is limited or regulated. In general, the capital intensive nature of infrastructure investments, combined with substantial replacement costs, lessens the threat of competition.
The characteristics of infrastructure offer stable, predictable operating cash flows. These are derived from longterm contracted revenue streams, inelastic demand, lower operating costs and extensive operating track records. This allows for stable yield through the life of the investment, contrary to private equity or venture capital investments which are focused on capital growth in order to deliver investor returns.
Low correlation to other assets
Infrastructure cashflows are typically not highly correlated with other asset classes. Studies show that subsectors within infrastructure can have low correlation, offering diversification potential within the asset class. The monopolistic nature of many services makes them immune to economic gyrations, while the contractual nature of the services they provide also protects the revenue.
Low volatility relative to other asset classes
Inelastic demand and stable revenues, combined with a low level of on-going capital expenditure result in relatively consistent returns, with lower volatility than many other asset classes. Unlisted infrastructure vehicles are further protected from the general market volatility affecting listed funds due to their more stable, long-term capital bases. This characteristic reinforces the suitability of holding infrastructure investments – which are a long-term asset class – in a closed fund structure rather than a listed fund which, by its nature, will be susceptible to general market volatility.
Low risk of capital loss
Infrastructure business models are based on providing essential services. Once operational, these businesses are less likely to suffer from significant permanent declines in value relative to other industries. When the correct capital structure is put in place, infrastructure businesses should be suitably robust in order to withstand downturns in the economy. Typically, the regulatory frameworks are transparent and protect cash flows.
Funding the future
Demand for infrastructure is expected to increase significantly with global economic growth, technological progress, climate change and urbanisation. Average annual global infrastructure spending totals more than $2.5 trillion and is projected to increase substantially. In addition, it is estimated that between €1.5 trillion and €2 trillion of capital will be needed for European infrastructure assets over the next decade. Facing budget deficits and funding pressures, governments are unable to meet this investment need and, therefore, the private sector is seeing increasing investment opportunities in the sector.