Want to cover 3 topics this morning:The Context for Private Investment into InfrastructureHow investing serves the needs of Institutional FundsMaking your infrastructure investment appealing to institutional investors
The world has a large infrastructure gap and institutional investors have an increasing appetite to invest private capital into this area of the economy. The investment gap is unlikely to be filled by governments and typical financial institutions like banks alone. Government debt has risen dramatically as public treasuries have been used to stimulate economic recovery from the 2008/09 financial crisis. Governments are looking to rein in spending making less government funding available for infrastructure replacement. Banks are being pressured through regulation to carry more capital to respond to liquidity needs. Institutional investors such as pension funds are increasingly interested in infrastructure investments because bond and equity markets have too low returns to meet their long term liabilities and equity markets are too volatile and unpredictable.
As a result, Global investments by pension and private equity funds has once again been increasing after the 08/09 economic downturn. About $160 billion of private investment into infrastructure funds was raised from2004 to 2011.
And Canadian pension funds are increasing the percentage of their total portfolio held in these infrastructure funds and direct investments. Depending on the life cycle of a pension fund today, a pension fund would likely be advised to have $40 million invested in infrastructure assets for each $1 billion of total portfolio. Some might advocate even higher portions of perhaps $100 million for each billion of assets in the portfolio. This math can produce some large capital pools. For example:Ontario Municipal Employees Pension Plan has about $15 billion invested in infrastructure assets, CPP nearly $10 billion, and Ontario Teacher about $8.5 billion
Highlight Income, Correlation and volatility in keeping with solving the problems that plan sponsors faceThe reason the appetite is getting large is as follows:Infrastructure investments provide stable cash flows through the annual dividends paid by these investments, dividends that are typically higher than bonds but largely just as secure because they are backed by government assets that are essential to the economy like toll roads, bridges, schools, pipelines, airports and so on. Typically these annual returns through dividends and capital appreciation tend to rise regardless of economic conditions because the assets held are monopolistic and not subject to competition. Often revenues are based on contracts with governments and/or are regulated by a public utilities board. The greater certainty of investments works well for pension funds because it allows them to have some degree of certainty that they will have the cash to pay for their obligations to pension beneficiaries.
Typically, Canadian institutional investors have been global leaders in this type of investing. This chart shows the returns from infrastructure investing for selected Canadian institutional investors. These investors increased the value of their holdings in infrastructure by 1 and a half to 2 and half times from 2004 to 2011.
This chart shows that the total returns to the end of 2011 from infrastructure for selected large Canadian Institutional investors for their infrastructure investments relative to returns for the TSX and DEX Bond universe. It shows that over the longer term 7 year time frame, infrastructure investments have had moderate to significantly greater returns than Canadian equity or bond indices.Infrastructure investments are by their very nature, long term buy and hold investments which typically offer lower volatility of returns. However they are also quite illiquid and can’t be sold as easily as publicly traded stocks or bonds. Therefore they have a unique but increasingly important role in a pension funds portfolio of assets. To illustrate the growing role of infrastructure investing by pension funds, a 2013 global survey of institutional investors sponsored by Principal Global Investors found that 45% of defined benefit pension plans (mostly in OECD countries) are intending to increase their allocation to infrastructure investments within their portfolios.
To this point I’ve largely covered the first two topics I talked about at the outset. Allow me to now turn to my final point. Let’s say you are a government entity thinking of looking for private investment into an infrastructure project. The good news right now is that there is more money chasing deals than there are deals in which to invest. I would say it’s more or less a ‘sellers’ market’. But pension fund investors or funds are always looking for quality. And different investors have different preferences depending on their portfolio needs or the risk/return appetite of the fund. Generally project fall into one of three categories along a continuum. At one end is the more stable predictable brown field asset. This asset is typically operating well, is in no or very little need of capital upgrade and is well managed. You’re selling an existing asset and the buyer/ investor is looking for stable cash flows and some capital appreciation. At the other end of the spectrum is a greenfield asset, brand new, not yet built, no operating track record, with some degree of construction risk. In the middle is a rehabilitated brownfield, an existing asset that is need of upgrading.
The expected total return profile of these different types of assets varies. The higher the risk, the higher the expected return. With a brownfield, most of the return comes in dividends. With a greenfield or distressed asset, most comes in terms of capital appreciation. Rehabilitated brownfield projects are typically half capital appreciation and half dividend yield in their total return profile. The reason it’s important to know this is that different funds or investors will be interested in different types of investment opportunities.
In addition, there are different risk profiles investors will consider depending on the nature of the asset itself as shown here. Two ways to think about his are whether the asset is GDP linked or regulated and contracted in terms of the nature of its revenue flows. An airport is a GDP linked infrastructure asset. Airports by their very nature are monopolistic. If you own one, it’s unlikely someone is going to come along an build another one nearby and compete. However, depending on how strong GDP is at any point in time, flight volumes can vary. People use airlines even in weak economic conditions but they use them more when the economy is growing and this drives revenue and ultimately investment returns. On the other hand water and sewage treatment plants tend to have revenue streams that are contracted with a government and water rates are set based on the need to pay for the costs of the treatment plant and are more stable. People turn on the tap or flush the john pretty much the same regardless of whether the economy is growing at 1% per year or 4% per year.
I’ll wrap this up with a few final observations about creating successful infrastructure projects that will attract private investors. One is deal size. Typically the amount of background study, procurement effort and negotiation, contracting involved requires that the project be of a certain size in order to be viable. This is often the case for P3s or public private partnerships. A rule of thumb is that the project needs to be around $100 million to justify these soft costs associated with getting the project successfully to a financing stage. A number of smaller project that are similar can be bundled to create a project or program of $100 million such as a series of schools. Leverage is another factor. Typically investors like to place as much equity in a project as they can justify. Governments on the other hand like to keep the equity portion as small as possible to keep the cost of capital lower and maximize the debt portion of the finance which is at a lower rate of return than equity. An investor doesn’t typically want to go to a lot of work to place a small amount of equity. Lastly, other risks need to be considered. Obviously the experience, track record, capability of the counter party, not only the investor but the operator is important. From the investors point of view equally is the political risk of a new government coming along and wanting to break or re-write the contract, or whether users will rebel in paying a toll for example on private bridge, or whether the demand will be sufficient to generate the required user fees. These issues also have to be carefully considered.
Meeting the Needs of Institutional Infrastructure Investors
Meeting The Needs of
Nov 21st, 2013
D I S C I PL I N E D
The Context for Private Investment into
2. How investing serves the needs of Institutional
3. Making your infrastructure investment appealing to
America: $6.5 trillion
America: $7.4 trillion
equity market volatility
correlation in public
Note: Total projected cumulative infrastructure spending 2005-2030
Sources: Booz Allen Hamilton, Global Infrastructure Partners, World Energy Outlook, Organisation of Economic Co-operation
and Development (OECD), Boeing, Drewry Shipping Consultants, U.S. Department of Transportation
Global infrastructure fundraising ~ $160 billion to 2011
Source: Probitas Partners’ Infrastructure Institutional Investor Trends Survey for 2012
A Few Final Considerations
Success in attracting institutional infrastructure investors is also
influenced by other factors such as:
Deal Size: i.e. $100 million deal size for PPP projects.
Deal Characteristics: i.e. leverage, governance arrangements
Other Risks: Counterparty risk, political risk, user demand risk