The Right Stuff
Infrastructure investments an ideal mix for pension funds

By Asieh Mansour, chief economist and strategist, RREEF Alternative Investments

An increasing number of opportunities in private infrastructure investments are emerging across North America. These are investments in the physical capital assets essential in the provision of public services including transport, energy and utility facilities, communications, healthcare and educational facilities, housing, and judicial and correctional facilities. While the U.S. has been a leader in developing the public markets for equity and debt real estate (REITs and CMBS), it has lagged behind Australia, Canada, and Europe in privatization of roads and other public infrastructure. Today, secular drivers for greater private financing of infrastructure in North America have emerged. These include budgetary provincial, state and local government fiscal constraints, the advent of successful public-private partnerships, and historical underinvestment in crucial infrastructure projects.

Traditionally, the municipal bond market has been the primary source of financing state and local infrastructure projects in Canada and the U.S. Current levels of spending on infrastructure combined with traditional means of financing infrastructure, however, have become woefully inadequate in meeting current and future infrastructure needs in North America. Part of the inadequacy is due to limited resources, limitations of current financing arrangements, and lack of political support for infrastructure projects at the provincial, state and local levels. State coffers are under increasing pressure to fund other projects, with less of a priority given to infrastructure.

From an investor’s point of view, infrastructure is well placed to evolve as an important new asset class for pension funds. Infrastructure investments typically carry greater duration than 30-year government bonds (i.e. the long-life of toll-road concessions) and offer the best of both worlds in terms of being bond-like in character. They are also an equity-like feature since revenues grow over time with demographic changes, providing pension funds an attractive hedge against wage and salary inflation. In addition, because they are typically monopoly assets, they are also highly regulated. The unique characteristics of infrastructure that renders it a compelling investment opportunity are briefly described below:

Monopoly: Infrastructure assets are typically large-scale investments with very high initial fixed costs. The high initial capital outlays act as a barrier to entry for new entrants. Such barriers to entry block potential entrants from entering the market profitably since incumbents face declining average operational costs. As a result, infrastructure assets have monopolistic or quasi-monopolistic characteristics.

Because of the quasi-monopoly and public good nature of infrastructure assets, however, their transition to the private sector has been accompanied by a high degree of regulation and government oversight. The utility industry is a prime example of an infrastructure asset that has been privatized but remains highly regulated.

Inelastic Demand: Infrastructure assets provide essential services to the community. Since these services are necessities, demand does not react to price movements. Demand for these essential services is immune to the broader vagaries of the business cycle. In addition, infrastructure assets have few substitutes and this also contributes to the inelastic nature of demand.

Stable Cash Returns: Since infrastructure assets are monopolies and therefore highly regulated, their cash returns are stable. Government oversight structured as long-term concessions provides a guarantee of base rent with escalations. The inelastic demand for infrastructure services renders them immune to the business cycle, ensuring stabilized cash returns. The stable cash returns are more a feature of mature infrastructure assets with a proven demand history. The typically stable income returns permit relatively high leverage ratios for infrastructure assets.

Long Duration: Similar to real estate, infrastructure assets are long-lived, lasting over 50 years. Durable assets that provide the potential for long-term investment horizons are much in demand by institutional investors. Public and corporate pension funds in particular are facing long-term liabilities and long-duration infrastructure assets provide a timely match. Concessions that govern many infrastructure privatization deals are also long-term, lasting anywhere from 30 to 99 years.

Inflation Hedge: Infrastructure is a tangible real asset and provides an inflation hedge. If we enter an inflationary environment, the replacement cost of the real assets also increases, hence protecting the value of existing infrastructure assets. In addition, concessions governing the structure of leases on infrastructure assets permit rent escalations, which are usually CPI-linked.

Hybrid Asset: Infrastructure shares many common traits with a variety of assets including real estate, fixed income, and private equity. Investing in mature, government-regulated utility is analogous to fixed income with the upside of having a degree of inflation protection. Developing infrastructure assets in India share common return characteristics and risks to opportunistic real estate development. An infrastructure investment in an airport is common to private equity investing where you are also investing in the operating company.

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