Infrastructure is a catchall term that refers to a wide varity of fixed assets used in transportation, energy, telecommunications, and services.
|Regulated assets||Water and wastewater, electricity transmission, natural gas and power distribution|
|Transportation||Toll roads, airports, seaports, rail, parking|
|Power generation||Conventional (coal, natural gas), renewable|
|Midstream||Pipelines, storage, gathering/processing|
|Communications||Cell towers, cable networks, satellite systems|
|Social infrastructure||Hospitals, schools, courts/prisions|
Infrastructure grabs a lot of headlines. In preparation for this year's G20 meetings, participants cited a 2013 report from McKinsey1 that referred to $57 trillion of infrastructure investment needed globally by 2030. Given the state of sovereign finances, public entities face challenges financing this on their own. Funding mechanisms such as gas tax revenues help, but are typically insufficient. As a result, governments have increased their reliance on private investment to build infrastructure assets.
The asset class has a lot to offer institutional investors.2 We review returns on infrastructure investing in Appendices I and II in the PDF; both show attractive returns, particularly for the best-performing projects and managers. However, the return dispersion among projects and managers is extremely wide (according to one analysis, wider than on venture capital and private equity).
Infrastructure is still a relatively recent addition to institutional portfolios.
Infrastructure is still a relatively recent addition to institutional portfolios. Current allocations among U.S. pension funds, for example, are roughly 1%–2% but expected to grow to 5% or more in the coming years. In our view, attractive core and core-plus infrastructure investment opportunities are available to institutional investors interested in their potential for long-term stable cash flows, diversification and inflation protection. However, as the historical dispersion of returns among projects and managers suggests, investment selection must be based on more than just the societal need for a given project and a government willing to sponsor its partial or complete privatization. While there’s a clear link among infrastructure investing, rising GDP and employment growth, what matters to investors are adequate protections and sufficient returns on capital.
What's the best approach? Infrastructure investing requires an acute understanding of the political process, the business cycle, natural resource risks and very localized competitive dynamics. In this PDF, we review some of the recent pitfalls that infrastructure investors have faced and how these experiences can be used to develop guiding principles that work over the long run to help ensure that institutional investors' objectives are met. We apply these principles to selected infrastructure sectors to illustrate the role they play in evaluating potential investment opportunities. This approach may end up deviating from many commonly used strategies. As such, it is often the road not taken, but we believe it is the right one.
Designing an infrastructure investment strategy for the long run—guiding principles
Our broad review of pitfalls experienced in infrastructure projects over the past decade (detailed in the PDF) informs our list of investment principles for institutions seeking core/core-plus infrastructure exposure. To summarize, we believe investors should assess the extent to which the funds that they invest in adhere to the following principles:
- Generally confine investment to established assets supplying essential services, with clear visibility around user demand.
- Avoid excessive leverage and financial engineering.
- Investments in markets, regulatory environments and jurisdictions without track records of private investment need to be priced correctly to account for the additional risk.
- Fund managers should concentrate on areas where they bring a deep knowledge of industry dynamics as well as the region’s political, economic and competitive complexities.
- Establish control positions to ensure that the fund manager's intended strategy for the asset is implemented.
- Negotiate agreements that foster a sharing of investment risks among stakeholders and ensure adequate compensation for bearing those risks.
- Provide diversified opportunities across region, vintage year and infrastructure type while being cautious of investments in market sectors where current popularity can lead to overpricing of infrastructure assets
Opportunities: Principles in practice
To illustrate the approach, we review these basic principles and a few select observations on potential opportunities (see more in the PDF):
Transportation projects have often suffered from rose-colored estimates of traffic volumes, reliance on the completion of subsequent development initiatives or the use of excessive leverage. There may, however, be select opportunities in new projects and in the unwinding of prior ones that are now distressed. To take advantage of these opportunities while addressing some of the pitfalls of the past, our teams are working on a new approach, which seeks to foster greater alignment of interests and a sharing of risks among operators, investors and state and local governments.
We see substantial capital needs in the North American power sector and the broader energy value chain as the shale gas story continues to evolve. Evaluation of investment opportunities in midstream pipelines (to deliver natural gas from exploration and production [E&P] sites to regional distributors) requires a thorough understanding of end-user demand for natural gas. Negotiating long-term contracts that entail a return on invested capital can help to mitigate some of the risks involved with varying decline rates and production costs.
We expect to see continued robust shale gas production, which is likely to sustain the cost advantage of natural gas, support demand growth and offer opportunities in natural gas transmission assets (for delivery of natural gas from treatment plants to homes and businesses). Rising asset valuations, however, offer a cautious note. As a result, our understanding of competitive and relative cost dynamics suggests that investment in existing local distribution company platforms may be the preferred investment option.