Infrastructure provides stable long-term returns with an element of inflation linking
In many ways infrastructure looks like the perfect asset class for UK schemes. Investing in utilities, transport assets, and social infrastructure can provide stable, long-term, inflation-linked returns for schemes looking to match their liabilities.
On the downside, infrastructure is generally illiquid, comes with high governance requirements, and investors need to either be very big or access infrastructure through pooled funds.
Overseas giants have long recognised that the potential benefits outweigh the drawbacks. The biggest Canadian, US and Australian funds have made significant investments into infrastructure in the UK and around the world.
But UK schemes are behind the curve. Most lack the scale to invest directly in projects, and the average allocation is around 1%. But with yields on traditional matching assets coming under increasing pressure, are British funds missing a trick?
WHAT IS INFRASTRUCTURE?
The class covers a broad range of structures and facilities that underpin daily life – transport assets such as roads, bridges, airports and ports; utilities like energy and water distribution and waste water management; and social facilities like hospitals, schools, universities and prisons.
These assets have a number of attractive characteristics for pension schemes. Long-term returns are good compared to other ‘low-risk assets’. Hermes’ head of infrastructure Peter Hofbauer says returns for a low-risk investment are typically in the high single digits, while more adventurous strategies target double digit returns.
Cash flows are also stable, because demand is generally stable. Infrastructure assets like power distribution grids are effectively monopolies and provide essential services, so returns will not fluctuate too much over the economic cycle. While people are unlikely to splurge on extra hospital visits when stock markets rally, they are equally unlikely cut back on these when the economy hits a downturn.
The diversification provided by infrastructure is also a positive for schemes. The fact that demand for many services provided by infrastructure projects is stable means that returns don’t tend to correlate with the assets that typically make up the bulk of a scheme’s investments.
What is the risk relative to returns from an infrastructure investment and over what time frame?
How will this help diversification if I already have commercial property in my portfolio?
Many infrastructure assets also provide a measure of inflation protection, which is key for UK schemes as they mature and are increasingly keen on finding assets that match their liabilities. Pricing agreements are often long term, regulated and linked to inflation.
RISK V RETURN
Different infrastructure assets mix these characteristics in different ways. The risk/return profile is determined by what stage the project is at, how users pay for the services provided, and what the ownership structure is.
Some assets like toll roads are paid for directly by users, and include an element of patronage risk (the danger that drivers will go elsewhere), others are funded by the taxpayer and therefore have a more secure income. Many infrastructure assets sit somewhere between the two: monopoly-like assets often have their prices regulated, giving a substantial element of predictability and stability of income.
Typically, taxpayer-funded enterprises like hospitals and schools sit at the lowest risk end of the spectrum, followed by regulated utilities, followed by toll roads and bridges, with assets with the highest patronage risk, like airports, carrying the greatest risk and bringing the greatest returns.
Schemes can invest in infrastructure assets before construction, known as greenfield investments or, once a project is up and running, known as brownfield. Greenfield investments are typically higher risk because there is a large element of construction risk and higher patronage risk (the possible the asset will be under-used, leading to lower returns).
Greenfield returns will be higher than brownfield but delayed until the project is operational. Brownfield assets are already generating cash and are therefore lower risk and lower yield.
But perhaps the most significant factor in the risk/return profile of an investment is the stage of a project that investors get on board. Pension funds are typically wary of investing in the earliest stages – so called greenfield projects – because, although this is where the greatest returns can be had, the risks are high. Schemes are more keen on brownfield investments – projects that have been up and running for some time, and are already throwing off cash flows.
Again, there is a middle option that can be attractive to pension funds. ‘Development projects’ are existing structures that are going through some form of upgrade. These investments offer some of the extra upside of a new build, but with less of the uncertainty.
HOW TO ACCESS INFRASTRUCTURE
The first question for schemes looking to get into infrastructure is whether they want to be equity investors or debt investors.
Equity holders receive the greatest share of the upside, are typically in it for the long term (perhaps 30 years) and, if they have the resources, can become involved in managing the asset.
But most schemes prefer to invest in debt. This role was traditionally played almost entirely by the banks, but many have pulled back since 2008. Infrastructure debt has lower returns and less risk and typically has a maturity of less than 10 years. Bonds don’t necessarily have the same inflation linking, although many projects to do issue inflation-linked bonds.
The next big question is how schemes want to access the asset class. Very few UK funds have the scale to invest directly in the way the big overseas schemes do, but the very biggest have moved into this area. Directly holding the asset can drive down the cost of investing, but comes with high governance requirements and, given the scale of infrastructure projects, results in a concentration of risk.
Traditionally most infrastructure investments have been made in the form of equity – the investors have bought a stake in the project. This gives active investors a chance to influence how the asset is managed, and increase returns. But it is generally a very illiquid investment.
Infrastructure debt is a more liquid, less volatile asset and gives investors a more secure position in the capital structure, although returns are capped.
For all but a handful of schemes the answer will be to invest in a pooled vehicle. Pooled funds – typically limited partnership vehicles – allow schemes to diversify their risk in infrastructure investments just as they diversify risk in other asset classes.
Diversified infrastructure funds are attractive to trustees and typically mix greenfield and brownfield projects as well as different types of infrastructure projects. Therefore pooled funds can provide an appropriate aggregation of risk while retaining the potential for growth.
So the market is developing, and trustees have a growing range of options of accessing the diversification, stable returns, and liability-matching properties of infrastructure.
But there is still a long way to go before we see allocations on anything like the scale of Canadian or Australian funds.