Spanning out

Infrastructure offers opportunities for investors seeking to diversify. Its investment characteristics put it between bonds and equities on the scale of risk and return. Cherry Reynard assesses this burgeoning asset class.

Infrastructure investing has been in the headlines. Macquarie’s takeover of Thames Water and the controversy surrounding BAA has shown how powerful and far-reaching private involvement in infrastructure assets has become.

Infrastructure has attracted institutional investors with its long-term, predictable income streams and as such has seemed like a haven for beleaguered equity and bond investors. But S&P warned at the start of the year that leverage and lax operational covenants were threatening the stability of the sector.

Companies like HSBC and Macquarie have made funds available to retail investors. The providers suggest that infrastructure is a separate asset class sitting somewhere between bonds and equities on the risk/return scale. With the volatility in bond and equity markets, can infrastructure help balance and diversify an investor’s portfolio? Or should investors heed S&P’s warning?

The term infrastructure covers many investment types. Andy Williams, head of global infrastructure at Alliance & Leicester, says infrastructure can include those financed under the private finance initiative (PFI) in combination with governments or the increasingly important non-government related infrastructure development. The former would include schools, hospitals, defence, prisons, police stations, fire stations and similar projects.

In return for a stable long-term income stream, investors have to ensure that the service they provide is up to scratch. The terms of this service are set out in standard contracts. Non-government related infrastructure development would cover things like power stations, renewable energy or toll roads. Companies use external financing so they do not have to take the risk if a project fails. These have similar investment characteristics, but the risks are slightly different.

Infrastructure investing startedin earnest in the 1980s. In Britain, Margaret Thatcher started to encourage private sector financing of public businesses as part of her drive for limited government. There were several important privatisations. Australia took a similar route in the mid-1990s, though with even greater enthusiasm. The breadth of public/private partnerships (PPPs) expanded and governments round the world started to think whether public businesses could be better and more efficiently managed by the private sector.

Jonathan Fitch, manager of the Macquarie Global Infrastructure Securities fund, says: “Governments started asking themselves whether assets should be financed by the private sector and what provided the best model. Do they believe businesses can be more efficiently run? What can they afford? Around the world this began to happen at different levels of government, from local to national.”

The advantage for governments of seeking private financing for infrastructure projects is that they do not have to find a chunk of cash every time a road or power station needs rebuilding. These assets are not on its balance sheet. Tony Roper, director of infrastructure investment at HSBC, says this became a particular issue in the last years of the Conservative government when the reduction in infrastructure spending from 3-4% to 1-2% of British GDP started to bite and the need for investment mounted.

In Australia the sector also received a boost from the superannuation schemes. Roper says: “In Australia, there was this new, growing wall of money. Australian pension schemes began investing all over the world. They took a liking to infrastructure as an asset class, particularly in Britain and Europe. It was a way of securing debt against long term cash flow streams.”

The sector is now diverse with many different types of schemes operating in many different countries. It has ceased to become contentious with governments of all hues embracing the concept of financing infrastructure building through the private sector. The Labour government in Britain has extended the public-private partnership concept further than any previous government (with variable results, some might argue, as the recent Metronet debacle has demonstrated).

Stephen Vineburg, head of global infrastructure at First State, says: “All Western democracies need the involvement of the private sector in infrastructure. Fiscal resources are scarce and there remains a question over whether it makes sense for governments to maintain, say, roads and airports. It has moved beyond ideology. It is self-evident that the pool of capital is here to stay and the requirement for that capital is here to stay.”

So what is the appeal of infrastructure investing? There are two main ways of accessing infrastructure: through the listed market and direct. Each will have slightly different risk and return characteristics over the shorter term, though over the longer term they may converge.

Roper says: “Because of the contractual nature of many infrastructure projects, they tend to be protected against a downturn. These revenues streams continue regardless of what is happening in the wider economy. The risks and rewards differ with different projects. The risks may be with the construction of a project. Or they may be with how much of the revenue is at risk from a toll road, for example. With a ferry operator, investors would take patronage risk, whereas with a regulated water utility, investors would take regulation risk.”

Both direct and listed infrastructure investments tend to share several investment characteristics. Institutional investors have typically been attracted by its consistent long-term income stream, which helps them with their asset-liability matching. Outside Britain – especially in Australia – similar qualities have appealed to retail investors. Many of these contracts will run for 20-25 years. Fitch says that investors are likely to get an ‘annuity-like’ income stream, above that of bonds, with a higher risk, though below the risk in equities.

Infrastructure will also provide a hedge against inflation. Vineburg says: “A lot of funds have thought about what has similar characteristics to the index linked bond market. Infrastructure offers some protection against inflation.” The cash flows from infrastructure investments will usually rise in line with inflation and this will be provided for in the contracts at the start of any infrastructure project.

Of course, these investments are also illiquid. They are capital intensive and require high upfront investment. The income stream is secured by contract and the assets have to be managed in a certain way. Once capital is committed, it is difficult to get it out. Vineburg says all of these assets have an inefficiency premium. Investment in a fund will get round this, but it does explain why the majority of infrastructure funds are structured as closed-ended funds so liquidity can be better managed.

Many of the risks are in the early stages of investment. As Vineburg says, “If you buy poorly it is hard to recover.” How do infrastructure managers go about making the initial investment, and then managing that investment?

Roper identifies two main type of approach by infrastructure manager: Those who buy and hold; and those who aim to buy and sell quickly. The former will have a lower risk profile and as such a lower yield. The latter can make 12-20% a year, but with a greater degree of risk as they will be more involved with the construction process rather than just gathering the long-term income stream. The market is also divided into those managers who invest directly in infrastructure assets and those who only invest through listed companies. Those who invest directly have a more significant duty of care and will have to take a moreactive role in the ongoing management of assets.

Vineburg says that when looking to make direct investments First State will start by looking for a stable cash flow over time. He says: “We want stable and forecastable levels of revenue. We also want a stable regulatory framework.” He highlights Anglian Water group as an investment fulfilling much of the group’s criteria: many people need water; Britain has a stable regulatory regime and the group is comfortable with the terms under which the cash flows were set. Vineburg says this would be an archetypal asset for an infrastructure investor.

Vineburg emphasises this is often a two-way process. He says: “We have long-term investors. For things like airports we understand the need for capital expenditure. This is one of the reasons governments like our involvement. We offer long-term, stable stewardship of the asset.” However, there have been plenty of examples in the past of the sponsors of infrastructure investment (governments or corporates) being insufficiently choosy about the long-term stewards of their assets. BAA has been an extremely controversial case in point, where the infrastructure investors have happily collected revenue streams while ignoring the need for ongoing investment, bringing a vital service to a halt.

Purchasing on the right terms is key. These are long-term assets and the terms under which the capital is provided and the income stream granted are crucial. Vineburg says: “Purchasing on the right terms has the largest impact on performance. We do performance attribution that has shown the importance of these entry terms. Shareholder management has become very important – how we work with regulators, governments and the operation of the assets.”

Fitch has a different approach when he looks at limited companies for the Macquarie Global Infrastructure Securities fund. He says: “We are tracking a database of about 700 companies around the world. We have a bottom-up investment process based on the fundamentals. We are looking for businesses that have unique features and proven essential services. We want definite usage patterns – for example, toll roads or airports. These have strategic positions and tariff structures.”

The businesses are capital intensive and tend to be project-based with long-term cash flow. Fitch says he does not prioritise things like the price to earnings ratio, saying: “An airport, for example, may need £5 billion in investment two years out to build a new terminal. This will fundamentally change the proposition so it doesn’t make much sense to look at price to earnings.” He also aims to ensure his portfolio has a diverse spread of companies and a reasonable geographic spread.

Fitch adds: “The infrastructure universe today is worth about $4 trillion. It is increasingly competitive. Our preference is always for regulated businesses such as water, which are granted on long-term concessions. The user demand is set and if you don’t get traffic the owner-operator pays the risk.

HSBC focus on core infrastructure in their funds. Roper says the definition of infrastructure has been stretched to include service stations and ferries, but the group focuses on regulated utilities, toll roads, electricity and social infrastructure. He looks at the long-term yield potential.

‘Limited recourse financing’ requires slightly different assessment criteria. These projects are linked to a company, but are ring-fenced so that if they go wrong there are few implications for the company. Alliance & Leicester’s Williams says: “This is a way of companies diversifying risk. If a project goes wrong, the banks take over. It is an alternative to obtaining long-term debt in the credit markets. There might be a private finance initiative project to build a £60m school. Half would be sold down and re-invested, so the £30m is spread across two projects. There is quite a lot of trading in deal syndication. They sell debt to the other banks and get a more diverse portfolio.” However, it is this area that has generated problems with infrastructure financing as the banks have struggled to pass on loans from infrastructure financing as credit markets have shut down in the turmoil.

The amount of ongoing management for an infrastructure asset will depend on whether the group is investing through the listed market or direct. Day-to-day management of an infrastructure asset will be through an operating company. For direct investors, they will often have a board seat and will have some say in the running and ongoing performance of that operating company. Williams says of the direct market: “There are strict controls on how the operating company can behave. It will have to meet financial targets. This is where the strongest negotiations are in the early stages.” The level of allowable gearing will also be set at an early stage.

Different regions are developing at different paces. Britain and Australia are among the most developed markets. Of course, this also means returns are not as punchy. Vineburg says returns tend to be core/core-plus and it is difficult to get strong growth. In Western Europe he sees the Netherlandsand Germany as good prospective markets. French provincial airports are also providing opportunities. He has seen the sale of several ports in Spain, which has also thrown up some good investments.

Unusually it is America that remains the big untapped market. Vineburg says: “It is interesting. There is trillions of dollars of deficit on the US highway network. To the impartial observer the regulatory systems are inefficient because there are multiple regulators. However, it is pregnant with opportunity. At the moment it is like Gulliver being held down by the Lilliputians. At the local political level, it requires lots of sophisticated shareholder management. However, I believe it will resolve in time and then it will dwarf everything else.”

Recent disasters like the collapse of the road bridge over the Mississippi river in Minneapolis have highlighted the need for an improvement in America’s infrastructure. However, as Vineburg says, political issues remain. The privatisation of two American toll roads – the Chicago Skyway and the Indiana toll road – caused considerable controversy. At the same time, legislators in Texas have voted to block further privately financed road projects for the next two years.

What is the outlook for infrastructure over the medium term? The benchmarks are usually the Macquarie Global Infrastructure index, managed by FTSE, or the S&P Global Infrastructure index. Most commentators agree that the outlook for infrastructure remains buoyant in terms of deal flow and demand. Williams says: “The markets are still buoyant. People are waiting on the US and there are plenty of opportunities coming up in Canada and Eastern Europe. The UK has slowed on the PFI front, but China will probably go down that route over the longer term. It is still delivering good returns as an asset class.”

But the credit crunch has also exposed some of the dangers of infrastructure investing. The argument has always been that monopolistic cash flows enable large borrowings. It has been seen to blend the high leverage multiples of project finance with undemanding covenants of leveraged buy-outs, but in the recent ‘flight to quality’ leverage has been shunned and banks have struggled to offload their infrastructure financing.

There have also been failures. Metronet, a tube maintenance group, is Britain’s most recent example. It collapsed with a huge debt, forcing, among others, Balfour Beatty to write off its £103m investment. Generally deals will fall apart if there is too much leverage, or the revenue projections are wrong. Sydney’s cross city tunnel defaulted and had to be refinanced because the projections of passenger flow through the tunnel were wildly optimistic.

These are greater risks in the direct market. The limited company market has different characteristics and its risks are more transparent. In Britain, after a period of consolidation during which they became expensive, utilities are trading at below the market average – 12.9x versus a market average of 13.4x (source: Hemscott). They continue to pay good dividends – the sector average is about 4%. Balfour Beatty is a classic infrastructure stock and generates much of its revenues from PPP and PFI projects. Again, after the market rout, it does not look expensive, trading on 13.3x, despite reporting pre-tax profits up 35% for the first half of 2007.

Does it have a place in the retail investor’s portfolio? There are several funds on offer to the retail investor. First State brought its Global Listed Infrastructure fund to market in October. It will be managed by Peter Meany and Andrew Greenup. The Macquarie Global Infrastructure Securities fund is on many of the important platforms and has attracted interest from fund of funds managers. The HSBC Infrastructure Company is structured as an investment trust and listed on the Stock Exchange. This offers direct access to 17 infrastructure projects that have passed their initial development stage. Babcock and Brown and 3i offer similar closed-ended propositions. 3i targets higher growth, while HSBC and Babcock and Brown are seeking a steady yield.

Its long-term cash flows make it ideal for asset liability matching, as the pension funds have found. This means it is a solid Sipp investment. Macquarie has found it a suitable retail product in Australia. It has a relatively low correlation with traditional assets – 0.55 correlation with equities and just 0.06 correlation with global bonds. This means it is an effective diversifier.

Infrastructure’s long-term income stream can seem like a dream come true for investors seeking inflation-linked, annuity type returns. Its promise of protecting assets in a downturn is also likely to appeal. At the more aggressive end, infrastructure investing can generate some of the problems associated with private equity – high leverage and over-enthusiasm for deals leading to lax structuring, but this is generally not the case in the offerings available in the retail market, which are either focused on well-diversified direct investments or listed companies. Infrastructure is potentially a source of diversification and stable long-term returns.