Beware of potholes on the road to infrastructure investing

Infrastructure is an increasingly attractive asset class for LGPS investors. But Joanne Job argues that as seductive as it may be, there are still risks to assess.

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With the potential for high and stable yields, the long-term nature of the assets and their low correlation to other asset classes, infrastructure investment is an attractive proposition, particularly for investors with long-term liabilities, such as pension funds.

Indeed, over the last ten years, pension funds’ search for yield in a zero-interest rate environment and their need for greater portfolio diversification have favoured substantial capital flows into this asset class.

As investing in infrastructure is typically measured relative to the attractiveness of fixed income assets, strategic asset allocation has increasingly included an allocation to infrastructure.

With its structural diversifying properties and resilience during times of stress, the infrastructure asset class is here to stay.

Joanne Job

When considering strategic asset allocation, as always, portfolio diversification is key. Infrastructure can allow investors to increase allocations to investments with similar characteristics to fixed income, along with access to long-term, ESG-conscious assets.

The final two characteristics are especially important for pension funds, as long-term cash flows and the more stable nature of asset-backed investments, match well with their long-term liabilities.

Furthermore, pension funds are coming under increasing pressure to integrate ESG considerations into their portfolios and infrastructure, particularly renewable assets, has lent itself well to those considerations.

These factors, coupled with the fact that, inter alia, there is a demand-supply imbalance, whereby it is estimated that between 2016 and 2030 there will need to be approximately $3.3tn of investment in infrastructure across the globe, have provided an expanding opportunity set for institutional investors.

Scrutiny

Nonetheless, investing in infrastructure is not a straight-forward affair and as investors have turned to the asset class, the role of infrastructure within institutional portfolios has come under scrutiny.

Investors are faced with several considerations: Firstly, one could invest in infrastructure debt or equity; secondly, there are different investment routes, such as primary funds, funds of funds, co-investment vehicles, secondary funds; thirdly, there are different sub-strategies, namely core, core plus, value-add, and opportunistic, and the lines are often blurred therein (sometimes purposely by managers). There are also specialist funds like those focusing on renewable energy for instance which can align with pension funds’ ESG concerns.

Whilst the risk-return profile varies across the range of routes and strategies, and each has unique risks, there are some key risks that are common across all, including what the key drivers of returns are and whether an investor is actually getting the exposure they expect.

Infrastructure assets have experienced rising valuations and compressing yields in recent years, not unlike other areas of private markets, given the substantial capital flows and the finite number of low risk (core) assets.

To the extent that the asset class becomes more like private equity, we expect the dispersion of strategies and returns to increase, bringing fund selection and due diligence into heightened focus.

Joanne Job

As such, many managers are taking ostensibly low-risk assets that are classified as core, or core plus, and increasing leverage levels in order to boost fund returns.

While increasing leverage in itself is not a bad thing, especially when the cost of leverage is as cheap as it has been in recent years, it can increase the risk of assets, though with the potential to increase overall fund returns. This can alter the risk-return profile of an asset, or a fund, away from what is marketed.

This, coupled with increasing valuations, can lead to returns being driven by capital structure arbitrage: Buying an asset with little or no debt attached initially, applying high leverage to refinance and boost fund returns, and then, as valuations rise over time due to capital markets trends, adding further leverage. This cycle can repeat until the asset is sold.

However, valuations may drop, meaning that the equity cushion is hit by this fall in value, the debt to equity ratio rises, and the asset suddenly looks far riskier than initially thought. If valuations continue to fall and the manager has employed this strategy across numerous assets, investors could find that their investments would lose value very quickly.

But pension funds should not view such practices as doomed to failure. As mentioned earlier, when used prudently, leverage can increase fund returns. The key point to note is that the practice of capital market arbitrage changes the risk-return profile of investments; whilst a fund may only invest in typically low-risk core or core plus assets, increasing leverage substantially could lead to a risk-return profile that is more in line with a higher-risk strategy than marketed. That may not be what pension funds are expecting to receive and therefore may not be factored into their strategic asset allocation models.

Exposures

This leads on to another key risk of infrastructure investing, relating to expected versus actual exposures.

In theory, when an investor allocates to an asset class, they expect their exposure to match their targeted allocation. In practice, however, assets and investments may not match the exposures that were initially being targeted throughout the investment term.

As with all illiquid asset classes, infrastructure managers take time to draw and deploy capital, meaning that initial exposure will be below the full amount committed and will gradually increase during the investment period.

Additionally, an increasingly broad definition of infrastructure used by some managers (with private equity style investments in companies that undertake infrastructure-related activities becoming ever more common) may also lead to less certainty over how, exactly, the end portfolio will look, what the risk-return profile will be, and how much it will correlate with the other components of the investor’s overarching portfolio.

While the risks presented above should be kept in mind by all investors, infrastructure as an asset class continues to appeal. With its structural diversifying properties and resilience during times of stress, the infrastructure asset class is here to stay.

Nevertheless, it remains a complex and opaque asset class that can be risky. To the extent that the asset class becomes more like private equity, we expect the dispersion of strategies and returns to increase, bringing fund selection and due diligence into heightened focus.

Joanne Job is managing director, research, at MJ Hudson Allenbridge.