Infrastructure is a Hybrid Asset Class with Different Risk/Return Profiles

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1 Europe 20 Grosvenor Place London, UK SW1X 7HN Tel +44 (0) North America 6641 West Broad Street Suite 402 Richmond VA Tel Asia #37-06/10, Ocean Financial Centre 10 Collyer Quay Singapore Tel Infrastructure as Part of a Global Investment Portfolio Infrastructure refers to several types of facilities with an important role in the functioning of developed economies. These include major subsectors such as transportation (toll roads, bridges, airports, seaports), regulated utilities (water, electric, waste), communications (cell towers), social infrastructure (hospitals, schools, prisons), and energy (pipelines, storage facilities, independent power plants). The need for massive infrastructure investment (measured in the trillions of dollars) is not in dispute. In its recent global infrastructure report, the OECD made the following estimates of worldwide infrastructure investment needs through 2030: governments at all levels throughout the developed world are simply unable to supply the capital required for public infrastructure projects because of large deficits and severe budgetary pressures. The number of private infrastructure investment funds has expanded rapidly in recent years as the sector has drawn increasing attention from investors. Even so, it is estimated that globally, institutional investors have less than 1% of their assets invested in infrastructure. It is important to remember that institutional private infrastructure fund investment remains a young asset class. Only the private energy infrastructure sector has a long and robust track record (more than 20 years in some cases); traditional infrastructure investment through private funds is a much more recent development, with few fund managers having anything close to a decade of experience. Infrastructure is a Hybrid Asset Class with Different Risk/Return Profiles At the same time, governments at all levels throughout the developed world are simply unable to supply the capital required for public infrastructure projects because of large deficits and severe budgetary pressures. Increasingly, they are seeking to access private capital to build new assets, expand or renovate existing assets, and supply the provision of essential services. This long-term demand/supply imbalance should create strong fundamentals for infrastructure investments for many years to come. Many institutional investors, new to the infrastructure asset class, view it as a subset of commercial real estate or real assets physical, real, tangible assets generating cash-flows. Others view mature/core infrastructure as a substitute for long duration bonds with an embedded inflation hedge. The balance of investors regard infrastructure as a private equity play, with the focus on restructuring or adding operational value to the assets to generate capital gains. This broad range of views shows that infrastructure is a hybrid asset class, sharing characteristics with bonds, real estate, real assets, and private equity. PAGE 01

2 By selecting the type and maturity of assets, investors can target the type of risk/return profile they hope to achieve, including performance objectives, level of yield versus capital appreciation, and medium versus long-term time horizon. Chart 1 below shows the different risk/return profiles of four types of infrastructure assets. Types of assets range from those that provide a low risk-adjusted return (net 8 to 10% IRR per annum) with yield as the major component of the returns generally described as core infrastructure to those approximating private equity-type risk/return profiles (net 15%+ IRR) where returns are driven by a manager s ability to add value to the asset and realise it with capital gains. Altius refers to this latter type of investing as value-add infrastructure. Chart 1: Risk / Return Profile of Major Infrastructure Asset Types experience and exhibit the appropriate skills to invest in this sector. Although it s too early to reach many conclusions on total return performance, Altius has started to see the best managers delivering the target yields they set out to achieve. Although it s too early to reach many conclusions on total return performance, Altius has started to see the best managers delivering the target yields they set out to achieve. Chart 2 (page 3) compares 10-year net returns of three traditional asset classes (US equity, non-us equity, and global fixed income) and three real asset classes (public energy, listed infrastructure, and private energy). As the chart demonstrates, real asset classes have outperformed traditional asset classes over the past 10 years. Private energy has also significantly outperformed public energy. Due to similar market inefficiencies in both private energy and private infrastructure and the value that can be added by expert managers in these markets, we expect private infrastructure will follow a similar pattern, showing a long-term outperformance over listed infrastructure. It will take some time, however, before the empirical evidence will be available to substantiate this expected outcome. Source: Altius Associates Why Add Infrastructure to a Global Investment Portfolio? Infrastructure Returns The performance history for infrastructure investments is fairly limited on the listed side and almost non-existent on the private/unlisted side, due mainly to the immaturity of the asset class. On the private infrastructure side, there are a very limited number of managers that can display a deep and long track record generated at their current firm. This will change as managers acquire we expect private infrastructure will follow a similar pattern, that is show a long-term outperformance over listed infrastructure. For private infrastructure returns over the long term, the only reasonable proxy available is Macquarie s consolidated return across all of their private funds since inception (1996): this shows a 13% gross IRR through March 31, This is not fully satisfactory as it relies wholly on one manager, and does not reflect the foreign currency impact that investors experienced. PAGE 02

3 Still, we think that it is the best proxy available and roughly indicative of what sort of return investors might expect in the long-term from a well-structured portfolio of private infrastructure investments. Chart 2: Annualised Net Returns for 10 Years Ending September, private infrastructure has positive, but modest, correlations with other asset classes and should therefore provide good portfolio diversification. Low Correlation / Good Diversification Sources: Cambridge Associates, Brookfield, Preqin, Yahoo Finance. Indices used: Non-US Equity/ MSCI EAFE; US-Equity/S&P500; Fixed Income/Barclays US Aggregate; Public Infrastructure/Dow Jones Brookfield Global Infrastructure Composite Index; Public energy/osx; Private Energy/ Cambridge Associates LLC Energy Upstream & Royalties and Private Equity Energy Index Typically, demand for infrastructure services is somewhat inelastic but not immune to the business cycle. Chart 3 below shows correlations of public and private infrastructure returns with other asset classes. Because there is no published return series for private infrastructure, the private infrastructure data utilised below was created by Credit Suisse Asset Management. It represents a customised mix of transportation and energy subsector returns, and approximates the results from a private infrastructure strategy. As the chart below indicates, private infrastructure has positive, but modest, correlations with other asset classes and should therefore provide good portfolio diversification. As one would expect, publicly-traded infrastructure stocks are more highly correlated and provide less diversification. Chart 3: Asset Class Correlations Source: Credit Suisse Asset Management PAGE 03

4 Inflation Hedge Infrastructure projects are generally tangible real assets and can be expected to provide an inflation hedge. In an inflationary environment, the replacement cost of real assets increases, thus boosting the value of existing assets. In addition, infrastructure concessions and contracts generally include inflation-linked price adjustments or have an effective means to pass through the impacts of inflation to customers. Chart 4: Infrastructure Outperformance During Periods of High Inflation Public infrastructure and utility stocks have served as an effective inflation hedge. As shown in Chart 4, this sector has significantly outperformed world equities during periods of 3% or greater inflation. Investing in infrastructure and other real assets offers investors a solid hedge against inflation. Because of the lack of historical return data, it is difficult to provide quantitative evidence that private infrastructure has served as an effective inflation hedge. JPMorgan tried to overcome this obstacle by creating its own financial models, using cash flow as the main criterion for measuring performance. Using EBITDA figures (or cash flow proxies for governmentowned assets), JPMorgan calculated the cash flow performance of infrastructure and other asset classes for a 20-year period and produced some meaningful outcomes. These results were published in a 2008 report entitled Infrastructure Investing, which concluded that Over time, infrastructure cash flows grow faster than CPI and should therefore provide some protection against inflation. Due to massive amounts of liquidity being injected into the global economy by governments around the world, there is a substantial risk that inflation will reappear once a solid recovery starts. Investing in infrastructure and other real assets offers investors a solid hedge against inflation. Source: UBS Developed Infrastructure & Utilities index (TR), MSCI Daily TR Gross World USD US CPI Urban Consumers YoY NSA, Bloomberg, CFSGAM, Colonial First State Asset Management Mitigating the Effects of the J-Curve / Cash Yield Because investments in mature infrastructure assets provide regular cash-flows, the J-curve effect for infrastructure funds is expected to be shorter and shallower than it would be for a typical private equity fund. The mitigation effect depends on the share of mature, cash-generating assets in the total infrastructure portfolio held by the investor. Core funds, rather than value-add funds, will generally serve as better mitigators of the J-curve. Rather than optimising risk-adjusted returns, core infrastructure assets seek to produce long term positive cash flows, which closely mirror the long term liabilities of many institutional investors such as pension funds and insurance companies. PAGE 04

5 Good duration match for pension / insurance liabilities Rather than optimising risk-adjusted returns, core infrastructure assets seek to produce long term positive cash flows, which closely mirror the long term liabilities of many institutional investors such as pension funds and insurance companies. This strategy is particularly relevant for investors with long term liabilities that are directly linked to inflation, such as pension funds and insurance companies. Some may argue that infrastructure return streams are a type of fixed income with slightly more risk and therefore slightly higher return. These types of investments are increasingly being considered as an alternative to traditional matching assets, such as inflation linked securities. The momentum in the industry was temporarily slowed by the financial crisis, reaching a cyclical low point in 2009; however, infrastructure demand and investment has rebounded and the outlook is positive. Conclusion Institutional private infrastructure is a relatively new investment area, although starting to mature. The momentum in the industry was temporarily slowed by the financial crisis, reaching a cyclical low point in 2009; however, infrastructure demand and investment has rebounded and the outlook is positive. The asset class has gained and will continue to gain importance and recognition for the following reasons: It has an attractive expected risk/return profile while also offering downside protection if implemented properly; It provides an inflation hedge; It has modest correlation with other major asset classes; Demand for private infrastructure has been growing and is expected to grow at a sustainable pace over the next decade. For all these reasons, Altius believes that it makes sense for institutional investors to add or maintain a private infrastructure allocation in their portfolio, as a stand-alone asset class or as part of a broader real assets allocation. Authors: Reyno Norval Infrastructure Specialist UK +44 (0) reyno.norval@altius-associates.com Jay A. Yoder CFA, Head of Real Assets US jay.yoder@altius-associates.com This asset class shares characteristics with several other asset classes such as fixed-income, real estate, and private equity. Many larger institutional investors now have a specific infrastructure allocation in their portfolio. Registered, U.S. Patent and Trademark Office This document is prepared by Altius Associates Limited which is authorized and regulated by the Financial Conduct Authority and registered with the SEC. This document has been issued by Altius Associates Limited for information purposes only. This should not be construed as a solicitation or an offer to purchase or sell any security or other financial instrument and is not an invitation or inducement to engage in investment activity. No representation or warranty, express or implied, is made with regard to the information contained in this document or to the achievement of any future gains. PAGE 05