Infrastructure Research: What I have learned so far
I have had “Infrastructure Research” spelled out on my business card for more than a decade now. During this time I witnessed what started as a credit crunch to become the Great Recession, first missed then embraced the shale revolution,sided with the Anglo-Saxon economists on the demise of the euro, analysed a very wide range of–sometimes conflicting–announcements on utility regulations every so often coming from the same regulator, fully embraced the solar revolution from the start, wrote multiple internal memos at different times calling the trough on the cost of debt, took credit for adding the word“forecastable” into the English language, fought relentlessly against inflation correlations based on high frequency data, advocated scenario analyses instead of sensitivities in investment analysis. Also during this time, institutional investors started to follow the footsteps of the Australian and Canadian institutions; infrastructure emerged and proved itself as an asset class globally.
Today, infrastructure asset prices are at all time highs and many valuation metrics are at or above their pre-recession levels. Needless to say that is true for almost all asset classes even with the flat equity markets in 2018, given the amount of liquidity central banks pumped into the system in the aftermath of the Great Recession – everything is expensive. There is a secular trend in infrastructure that further pushes the asset prices up though. Target allocations to our young asset class increase across the spectrum globally, so there is an additional pressure on asset prices. Observations on relevant past transactions, to the extent they exist, do not help as valuation discount rates rapidly move down because of these two trends. Investors need an approach that require discipline and can put money into work in an efficient way.
As a result, the second phase of infrastructure investing is taking off globally: Investors are, quite appropriately, focusing more on direct investments that better suit their liabilities and portfolio construction procedures. In this juncture, here are some thoughts from the research desk.
There are no benchmarks. Data aggregation in infrastructure is challenging, and it will remain to be challenging: It is a truly wide asset class both across sectors and jurisdictions, but the assets are large, and many of them are unique so the transactions database is as shallow as it gets. Any benchmark proxy then, either relies on the limited set of transactions data or is set up on an overly simplistic formula, say a nominal or inflation plus a margin number, has strong arguments going against it. As assessing their investments and asset managers is a requirement for investors, one available and appropriate option is to compare each investment’s performance to its own underwriting assumptions. It is a time-consuming option and requires a certain level of expertise, but much better than using high level artificial proxies for benchmarking needs.
Yield often includes return of capital. Except in utilities, infrastructure investments are rarely perpetual, i.e. the exit value approaches to zero at some point in the investment horizon. Transportation sectors are dominated by concession agreements, which are simply long-term leases, so the exit value at the end of the concession term is by design zero. Contracted power investments, including the fast-growing renewables also have finite economic lives; the lives of turbines and related machinery can be extended by proper maintenance only up to a point, and more importantly the repowering aspect, which includes land lease extensions and transmission connection enhancements should be considered in the opportunistic side of the investment strategy not in the forecastable core side. As a result, the reported yield from many such depreciating infrastructure investments is not easily comparable to yield from perpetual investments such as real estate. The yield from a regulated utility (perpetual investment) and an airport or a wind farm (depreciating investments) should not be liberally aggregated in investor reports without considering the return of capital aspect.
Nominal return targets lead to scope creep. Because of the lack of benchmarks, many investors rely on nominal or inflation-plus return targets, which are perfectly fine in the short term or for individual investments. In a commingled fund setting or in the long term, as the cost of debt and equity risk premium for infrastructure change, nominal targets get outdated. Especially when manager remuneration depends on the performance versus the targets, any trend in market return expectations lead to managers pushing the boundaries. In today’s market environment for instance, labelling investments as “infrastructure” or better “core infrastructure” lead to asset price increases. Investment discipline is essential and aligning GP and LP interests is not trivial in the long term when it actually matters.
Illiquidity premium is not in return but in volatility. Estimating illiquidity premium for privately held infrastructure was my very first task when I became an infrastructure researcher. After so many years and multiple reporting lines, it remains a work-in-progress. The main challenge is that, more so than other private investments, infrastructure valuation is an art rather than science. The cash flow forecasts for core infrastructure assets tend not to change too frequently, but the margin of error in valuation discount rate estimation can be quite high. Cash flows to equity, which are easily observable, can be quite smooth for core infrastructure. That cash flow stability does not necessarily imply the stability of returns, if the discount rate, which is not observable without an actual transaction, is volatile. As a corollary to the lack of healthy transactions data, valuators tend to be cautious, so periodic asset valuations have significant auto-correlation; the return series tend to be artificially smooth. A private infrastructure investment cannot steadily provide higher returns than a similar but publicly listed one in the long term. The return series of the private one, however, will have a significantly lower volatility.
Beware of Infrastructure investment plans named after politicians. There is a fundamental mismatch between the needs of institutional investors and policy-makers. Investors value stable and cash flow producing assets, while policy-makers need new assets and capacity enhancements – the dichotomy between brownfield and greenfield investments. When politicians announce infrastructure plans, and most do at some point in their careers, their focus is, rightfully, on the greenfield side. But such investments come with development risk including the licensing and permitting risks, and of course the notorious demand forecasting issues. I have not come across a sizeable greenfield transportation project that had forecasted traffic close to the actual levels, though I am told they exist. Institutional investors seeking stability and forecastable cash flows stay away from such investments. Schemes such as availability payments or minimum traffic guarantees alleviate such concerns for investors, but they may be politically costly, so they are not widely implemented.
Except energy, US infrastructure is in a state of communism. US infrastructure financing is traditionally done through tax-exempt municipal revenue bonds. Private investor involvement breaks the tax exemption and so raises the cost of capital. There are of course other incentives for the local politicians to control these assets as well. There have been much more condemnations, that is the municipality taking over the asset, than privatisations in the US infrastructure space, and there is no reason in the capital markets for that situation to change. The implication is that truly diversified exposure to the US infrastructure space is impossible. On the transportation side there are only a handful of investable core assets; there is no sizeable airport in the US under a concession agreement for instance. There are only a few terminals in the airports and seaports that are privately operated. Most toll roads are owned and operated by local governments as well, so the investable space is rather small. US water utility sector is very fragmented, majority of the systems owned by municipalities or even neighbourhood associations. Even in energy related infrastructure, around a quarter of the population is served by government owned utilities and cooperatives. The one-sidedness of the investable US infrastructure space lowers the diversification benefits of our asset class even for global investors.
As our asset class gets more established in the mainstream, we infrastructure researchers will lead the way in defining the strategies and analysing how infrastructure investments interact with other asset classes in portfolios. In that regard, more to come from the infrastructure desks – this one, and the others. Stay tuned.