Infrastructure comes of age in low returns environment

As cash-strapped governments around the world come under pressure to sell public assets, capital-intensive investors are searching for stable yielding investments, bringing the maturing infrastructure asset class back into the framework. Sam Riley looks at examples from around the world.

The infrastructure asset class has come full circle from its frothy pre-crisis days where some managers were spruiking the promise of private equity like returns on the back of high gearing and more risk.

Investors in North America, Europe and Australia share a renewed focus on the stable, yielding characteristics of infrastructure.

AustralianSuper is a 14-year veteran of the infrastructure asset class. The fund’s head of infrastructure Jason Peasley says that the conversation between institutional investors and their managers is again concentrating on long-term objectives.

“There are more conversations about long-term performance and a more conservative risk/return spectrum, particularly by institutions like AustralianSuper,” he says.

“Excess leverage is definitely a dirty word, disintermediation is also another aspect that people seem to be talking about in terms of going direct and having more co-investment, and avoiding the pooled-fund model. We don’t necessarily subscribe to that, as historically we have utilised managers and pooled vehicles, but definitely these are the types of conversations going on right now.”

The renewed focus on the stable, yielding characteristics of infrastructure is shared by investors on both sides of the Atlantic.

Universities Superannuation Scheme’s senior manager of alternatives Gavin Merchant says the aim of its infrastructure program is to invest in long-term, inflation-linked assets which provide cashflow that match the scheme’s long-term liabilities.

Infrastructure represents about a fifth of the fund’s £5-billion ($7.8 billion) allocation to alternatives, while its alternative assets represent about 16 per cent of the total $55 billion portfolio.

Merchant says the fund plans to increase its commitment to infrastructure in the coming years, eventually taking its allocation to between 5 and 7 per cent of the overall portfolio.

The push to increase exposure to infrastructure is shared by CalSTRS which, like USS, is looking at stable, regulated assets that provide an inflation hedge and will match its long-term liabilities.

CalSTRS head of infrastructure Diloshini Seneviratne says the fund’s investment team took more than two years looking at opportunities globally before the $148-billion fund dipped its toe in last year.

The first mandate it awarded was to First Reserve’s debut fund, which has an energy focus and Seneviratne says that it is looking to increase its allocation over time to $3.5 billion or 2.5 per cent of CalSTRS’ portfolio.

Infrastructure will eventually make up half of CalSTRS inflation sensitive-asset bucket, which also includes Treasury Inflation Protected Securities.

Industry Funds Management (IFM) recently landed an up to $500-million mandate from CalSTRS to invest in global infrastructure.

IFM chief executive Brett Himbury says institutional investors are looking to increase their exposure to infrastructure, with core, mature assets in developed markets in particular demand.

IFM manages more than $10 billion in infrastructure investments in an open-ended fund.

Himbury says that while there is an increasing amount of capital flowing into the sector, there is a shortage of deals, with a growing amount of money chasing quality assets.

“We are seeing our clients increasing their allocations to infrastructure and we are seeing that globally,” he says.

“So, while we are seeing an increase in the deal supply, we are also seeing an increase in the capital available. I would still say we have more capital than we have deals; there is a lot of appetite out there,” Himbury says.


Growing market

An OECD working paper looking at the investment in the asset class by pension funds estimated that the global market size spanned somewhere between $10 trillion and $20 trillion.

Alternative-assets researcher Preqin puts the number of infrastructure investors at 1352 globally and says the mean current allocation to the asset class is 4 per cent.

In its 2011 Infrastructure Fundraising and Deals report released in January, Preqin found that funds are typically looking to increase their allocations, with a mean target allocation of 5.3 per cent.

Himbury says that with more global investors looking to increase their infrastructure exposures, particularly to these high quality developed-market assets, there is a risk that prices will be pushed higher.

“In many parts of the world the risk-free rates are very low and you combine that with a high level of capital flowing towards infrastructure assets and there is clearly a risk that prices may be bid up,” he says.

“We think that we are seeing an increase in the demand for open-ended funds because in an environment where prices may be bid up, you don’t want to have the pressure to deploy the capital in a short amount of time if you are running a closed-end fund.”

The Preqin report found that more than a third of infrastructure investors were public or private pension funds, with the majority located in the US, UK, Australia and Canada.

It also found that investors still overwhelmingly prefer unlisted funds, with 81 per cent of investors surveyed expressing a preference to invest in unlisted funds, followed by 31 per cent who say they favoured direct investing.


Direct Investing

For AustralianSuper, this preference for pooled investments may be starting to change, according to Peasley.

The fund has been able to alleviate some of the drawbacks of open-ended funds – in particular where different investors in a fund have contrasting objectives and time horizons – through the ownership structure of IFM.

IFM is owned by AustralianSuper and 31 other industry superannuation funds, encouraging a closer alignment of interest between owners and management, as well as ensuring that investors are all long-term in their outlook.

Peasley says that the fund has a target allocation of 11 per cent of the total fund for infrastructure and is looking to double this in five years as the total size of the fund is also projected to double over this time period.

To increase its exposure to infrastructure AustralianSuper will need to move beyond pooled funds and invest directly, particularly in Australia, where it is looking to increase its exposure to core infrastructure.

Long-term investors such as Dutch asset manager APG – which manages the investments of the $329 billion Dutch pension fund ABP – have also increasingly moved to club or co-investments in the last couple of years in an effort to avoid hefty management fees.

Being closer to its investments, as well as investing with like-minded investors has also allowed APG to look at defining standards for its infrastructure investments that include looking at improved environmental, social and governance factors and long-term performance benchmarks.

Moving away from a fund approach has also given APG more direct control over the correlations of its infrastructure holdings.

In the past the asset manager has found that assets like toll roads have seen as much as a 30 per cent drop in traffic because a decline in economic conditions led to less commercial traffic flows.

The direct move is one that USS is also looking to make, with the fund saying that it wants to get closer to its infrastructure investments, which have typically been in core utilities and transport assets.

“Going forward, we are employing a direct investment approach rather than investing through infrastructure funds,” Merchant says.

“We are a financial investor that takes its responsibilities very seriously, which generally includes a requirement for board representation. Our preferred approach is to work with like-minded investors (be they pension funds, infrastructure funds or strategics) who are aligned with us in how they think about the asset.”

Seneviratne says that direct investing is a long-term aspiration for CalSTRS, but that the fund is first looking to learn from established managers like IFM before taking that leap.


Return Targets and fees

CalSTRS has a benchmark of the consumer price index plus 5 per cent for its infrastructure investments.

AustralianSuper aims for equity-like returns with lower liability and less volatility.

IFM reports that since its inception it has achieved a 12.5 per cent return net of tax and fees.

Himbury says that pooled management does not necessarily have to lead to funds paying high fees.

IFM’s fees are 45 basis points but the OECD report into infrastructure funds has found fees were similar to private equity without necessarily achieving the same performance.

The OECD found that cost to the investor was typically a base management fee of 1 to 2 per cent and a performance fee of 10 to 20 per cent, usually with a hurdle rate of 8 to 12 per cent.

But funds that are looking to directly invest need to weigh fees paid to a manager up against the cost of building and maintaining in-house expertise, the ongoing cost of managing an infrastructure asset over the long-term, and the fees and costs associated with the transaction itself.

While investors can mitigate these costs to a degree through co-investments, Himbury says that much of the alpha of an infrastructure investment is achieved through the ongoing management of an asset, which takes considerable capacity and experience.

Preqin also finds that the fees fund managers can demand has come under pressure particularly in light of the difficult fund raising environment faced in the last couple of years.

In 2011, the number of deals made by unlisted funds fell to its lowest level since the financial crisis, declining by 49 per cent to $31.8 billion, Preqin found.

“The balance of power between investors and fund managers when negotiating terms and conditions has shifted towards the investors somewhat in recent years,” the report’s author Iain Jones finds.

“This means fund managers will have to ensure that their terms, especially those relating to management fees and carry structure, satisfying investors if they are to be successful in this increasingly competitive fundraising market.”


Crisis and opportunity

While there is increasing capital looking to find infrastructure assets, the after-shocks of the global financial crisis are also leading to the potential for more assets to come on stream.

With both sovereigns and financial institutions looking to shed debt and sell assets, long-term investors are looking at what prime assets may be coming up for sale in both Europe and America.

Ireland is an early example of where sovereign wealth funds and private investors may co-ordinate to buy core assets.

The Irish government through its bailout deal with the International Monetary Fund and the European Union has committed to selling off $2.64 billion in assets over the next two years.

Ireland’s sovereign wealth fund, the National Pensions Reserve Fund (NPRF), has been tasked with providing seed capital for a group of funds looking to invest in infrastructure, venture capital and credit for small to medium businesses.

Eugene O’Callaghan, the director of NPRF, says that the fund has already committed $330.8 million to an infrastructure fund and has sought interest from investors in Asia and Australia to eventually reach a total of $1.32 billion.

He denies that the NPRF could ultimately be involved in a fire sale of government assets, saying that the government is, unlike other governments around the world, just starting down the path of privatisation.

“We are operating on the basis that there definitely won’t be a fire sale but there is a committed seller so the assets are likely to be available at reasonable prices,” he says.

Ireland is not the only cash-strapped government looking to the private sector to invest.

Britain’s Chancellor of the Exchequer George Osborne has recently called for British pension funds to invest more money in domestic infrastructure projects.

The conservative government has flagged an overhaul of the investment framework to encourage investors and has called for the industry’s views on what incentives are necessary.

In the US there are bills that have been introduced in both the Congress and the Senate for an infrastructure bank that would be funded with up to $30 billion.

The bank would look to partner with private investors to build nationally significant projects and sell long-term bonds of up to 50 years to support the institution’s ongoing operations.

But while governments are looking to incentivise investors, Himbury says that the real problem is not “sweetening” the deal, but the number of deals.

He notes that the old private equity-type investment model soured the politics around public-private partnerships, with unrealistic returns objectives breeding public suspicion.

“Our view is not about making the deals sweeter but making the deals available, and we would like to see more available deals around the globe not necessarily incentivising through tax or other structures,” he says.

“We are not short of capital, we are not short of expertise or interest in the sector, notwithstanding a bit of a flurry of activity recently, we are short of deals globally.”