Publications

How to Invest in Infrastructure
- December 1, 2017: Vol. 4, Number 12

How to Invest in Infrastructure

by Keith Black

Infrastructure offers a unique category of investment opportunities that can share characteristics of private equity, public equity and real estate investments. Most of the investment opportunity in economic infrastructure focuses on transportation and utility infrastructure assets, including existing brownfield assets and the development of new greenfield projects. Transport assets include toll roads, airports, sea ports, railroads and parking lots. Utility infrastructure includes gas and electric utilities, oil and gas pipelines, solar farms, cell towers, and related assets. There are seven elements that describe infrastructure investments:

  1. Assets used by a large portion of the population and viewed as vital for everyday economic activity
  2. Assets that are relatively free from competition, often built in a highly regulated or natural monopoly environment
  3. Assets that are often developed, managed or regulated by governments
  4. Essential goods and services that have stable cash flows that may be able to rise with inflation
  5. Assets that charge fees for services
  6. Assets that may be operated under private management
  7. Capital-intensive, long-lived assets

Many of these assets are used daily by hundreds of millions of consumers worldwide, with consumers viewing these as ongoing, nondiscretionary expenditures that are part of their budget regardless of their employment status or economic outlook. As you can see from these unique characteristics, especially the vital nature of the assets, low cyclicality of cash flows and the ability to increase user fees at or above the rate of inflation, these assets can serve an attractive role in a portfolio, with a lower risk, higher yield profile.

There are a large number of publicly traded pipelines (MLPs) and utilities (electricity, gas and water) that are listed in both U.S. and global markets. These high-yield stocks have attracted great interest in recent years, as investors have sought to increase yield in a world of low, and even negative, interest rates. As bond yields are expected to rise, high dividend stocks may have some downside risk as high income becomes easier to find in the bond market. Electric utilities and pipelines have come under pressure in recent years for their potential impact on climate change as well as the risk of obsolescence or cleanup costs as the world becomes increasingly focused on cleaner, renewable forms of energy. Electricity generated through natural gas is considered cleaner and less risky than that generated through coal.

The U.S. market, though, has very limited availability of publicly traded investments in the categories of parking, airports and toll roads. Many funds invest globally, as the availability of airport and toll road stocks is greater overseas than in the United States.

Infrastructure assets can be accessed through both passive ETFs and actively managed mutual funds as well as through funds offered in a long-term private equity structure. The publicly traded funds tend to have a larger weight on utility assets and a lower weight on transportation assets, while the private equity funds tend to be more diversified. Fees on ETFs may be 0.50 percent or less, while active funds can have fees of 1 percent and higher.

Publicly traded ETFs and active funds have lower beta, 0.5 to 0.75, and higher yield, 2.5 percent to 4.0 percent, than public stock market indices. Drawdowns of 35 percent to 45 percent in the 2007–2008 financial crisis were lower than that of stocks, 55 percent, and REITs, 68 percent. Infrastructure ETFs have historically experienced only two-thirds the risk of REITs, as real estate assets tend to have more competition than infrastructure assets with the characteristics of natural monopolies. Because there is less competition for the infrastructure necessities of life, many operators can regularly raise prices, making infrastructure potentially a good inflation hedge. Public funds and indices can hold assets listed only in the United States, but most funds tend to diversify broadly, offering funds with investments in global, emerging markets and developed international markets. Funds are available in global form, which retain the currency risk of investments in foreign equity markets, or in currency-hedged form, which hedges all currency risk relative to the U.S. dollar. Lower risk assets include existing assets with a cash flow history in developed markets, while higher risk projects are those in emerging markets or the development of new infrastructure assets.

Closed-end or private equity infrastructure funds can differ substantially from publicly traded funds. Private equity funds tend to have long lives, perhaps a stated life of eight to 12 years. These funds tend to be more concentrated, often investing in 10 or fewer assets in a single fund. Private infrastructure funds can deploy substantial leverage, as the stable cash flows of the assets are viewed as having the ability to support substantial debt loads. However, several infrastructure assets have declared bankruptcy when large debt loads were added to assets where revenue projections did not hold up, so investors are encouraged to understand the leverage structure of each private equity partnership. Fees on private infrastructure funds are similar to those of private equity, perhaps with a management fee of 1.5 percent or more in addition to a carried interest of 10 percent to 20 percent of profits at the exit of each investment in excess of the investor’s preferred return of 8 percent.

A specialty of private equity funds are privatizations or public-private partnerships. In these investments, the private equity fund takes control over an asset, such as an airport, which was previously owned and/or operated by a governmental entity. The private equity fund may choose to purchase the entire asset or a majority stake in the asset. Some funds will participate in a long-term concession, leasing the asset from the government for a period of 30 to 100 years, earning the right to earn all cash flows from the asset for the stated period, but ultimately returning ownership of the asset back to governmental control. While funds invested in publicly traded assets have little control over the underlying business, private equity infrastructure funds can be intimately involved in the business, seeking to improve profitability through revenue growth and operating efficiencies. Key skills of a private equity infrastructure team include knowing how to efficiently run and grow operating businesses as well as the ability to negotiate with government entities to be able to privatize or lease government-owned properties. This latter task might appear easy, given the global need for infrastructure improvements and investments as well as governmental budget deficits, but these projects are often subject to a popular vote of a public skeptical of the price increases that often accompany privatizations.

Some larger and sophisticated investors may choose to invest outside of a public equity or private equity structure. Direct investment involves the purchase and operation of an asset by an investor, such as when a pension fund purchases all or a majority stake in a local water utility. Other investors may participate in development syndicates, where investors and property developers jointly build a greenfield project. The risks of development syndicates are greater, but the rewards can also be commensurately larger. Special attention should be paid to revenue projections, as some of the largest failures in infrastructure projects have come from overestimating traffic, especially for newly built toll roads. Finally, some investors prefer to invest in infrastructure debt rather than taking an equity stake in an infrastructure asset.

Other investors may define a category of investment in social infrastructure, which owns facilities such as schools, hospitals and prisons. However, most publicly traded infrastructure funds focus on economic infrastructure and do not hold much or any of the assets in social assets.

 

Keith Black is managing director of curriculum and exams at the Chartered Alternative Investment Analyst Association.

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