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Investing in Infrastructure

1. What is infrastructure?

Infrastructure encompasses the essential networks and services necessary for the proper functioning of an economy. These include transportation, communication systems, water, energy production, energy distribution, waste management, and public institutions, such as schools, hospitals, and prisons. The asset class is typically divided into sub-sections: economic and social infrastructure1.

Infrastructure assets are also categorised according to their stage of development. Greenfield investing relates to projects in their early stages in which assets are yet to be constructed. Brownfield assets on the other hand are established assets with some degree of operational maturity. Greenfield assets, given uncertainties around construction, financing and demand, are typically higher up the risk curve, but can provide ample premium to their brownfield counterparts if successful.

Common features across many infrastructure related assets include:

High barriers to entry and exit: Large initial investments into infrastructure assets and high operational complexity results in attractive enterprise power for incumbent infrastructure companies.

Resilient consumer demand: Consumption of many basic services, particularly in energy and communications tends to be relatively insensitive to macroeconomic fluctuations.

Long life span assets: Roads, bridges and tunnels, for example, typically have 50-year life spans; telecommunication cables can last up to 10 years, whereas electricity gridlines can go 60 years before requiring major maintenance.

Infrastructure as an asset class has grown tremendously in recent years and institutional investors are raising allocations either as a stand-alone component in their portfolios, or indirectly as part of their private equity, fixed income or real asset allocations depending on their approach to portfolio construction, as well as the nature of their investments.

For the purpose of this paper we will focus on equity investments in economic infrastructure, and will use the latter term interchangeably with simply ‘infrastructure’. Whilst social infrastructure may

1 Credit Suisse – Can infrastructure investing enhance portfolio efficiency? (2010) Page 2 of 14

add value to an institutional investor’s portfolio, anecdotal demand suggests the LCIV target this sub-asset class at a later point in time.

Infrastructure debt, which is not the subject of this paper, is being provided as part of LCIV solutions in Fixed Income.

Infrastructure equity strategies:

Infrastructure can also be broken down by investment strategy type, allowing investors to load up on, and or avoid, certain risk factors2.

Core

Characteristics: Investments in operating assets with established cash flows and good revenue security from contracts or a regulated position, situated in developed markets. Examples include long-term contracted power, mature regulated utilities and established transportation assets.

Risks: Wrong assumptions on operating costs, unanticipated future capital expenditure needs. Inappropriate leverage and regulatory change can also hamper performance.

Core plus

Characteristics: Assets with the same revenue security as core assets, but typically adding construction (though not development) risk. When successful, they migrate over time to the core bucket. Investing pre-construction offers a return uplift, and with carefully structured investments and the right technical oversight, construction can be well managed.

Risks: Early operational issues, construction schedules, diligence on equipment, contracts and engineering.

Value-add

Characteristics: These strategies can use a variety of methods to increase the value of an asset, with capital appreciation usually crystallized in an exit. Buy and develop, platform roll-ups, turnarounds and work-outs are examples. Managers often sell assets into the core/core plus market once enhanced. Investor skill and operational knowledge are key drivers of return.

Risks: Strategy implementation and execution.

Opportunistic

Characteristics: In developed markets, assets that exhibit development risk or less predictable service companies, some telecom investments or large greenfield projects. In emerging markets, assets where the investment case relies heavily on growth of the local economy revenues, such as uncontracted pipelines.

Risks: Thesis or market view proves incorrect or inaccurate.

2 Blackrock – Infrastructure rising (2015). Be aware that risk factors may somewhat overlap between strategies. Page 3 of 14

Core Core Plus Value-add OpportunisticReturn assumptions 5-9% 8-12% 11-15% 15-17%Main return driver Income Income & Capital

growth Capital growth Capital growth

Key risks Operating assumptions, leverage, Regulation Construction Strategy implementation

Market risk, Development risk,

currency risk Revenue certainty (Contracted) Yes Yes No In some cases

Already revenue generating Yes No In some cases In some casesGDP sensitivity Low Low High High

Greenfield or Brownfield Brownfield Mix Both BothDevelopment Risk No No In some cases In some cases

Return driven by exit? No No Yes YesOperating complexity Medium Medium High Medium/High

Infrastructure Equity Strategies

Source: Blackrock – return data as of 2015 and are indicative only.

2. Why invest in infrastructure?

2.1 The opportunity set:

The growing demand for private capital:

According to Mckinsey, from 2016 through 2030, the world needs to invest about 3.8 percent of global GDP, or an average of $3.3 trillion a year, in economic infrastructure just to support expected rates of growth. Emerging economies account for some 60 percent of that need. But if the current trajectory of underinvestment continues, the world will fall short by roughly 11 percent, or $350 billion a year.

Some industry estimates show that investment in infrastructure typically has a socioeconomic rate of return of around 20 percent. In other words, one pound of infrastructure investment can raise GDP by twenty pence in the long run. These economic returns are transmitted through reduced travel time and costs, access to reliable electricity, and broadband connectivity that allows individuals and businesses to plug into the digital global economy. Some infrastructure investments, if well-chosen and properly executed, can have benefit-cost ratios of up to 20:13.

3 Mckinsey – Bridging Global Infrastructure Gaps (2016)

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Source: Mckinsey

With a rapidly growing global population, reduced government infrastructure expenditure in recent years (due to fiscal imbalances), and an ageing capital stock, the need for private sources of capital to support existing (and expanding) global infrastructure has never been greater. Moreover, investment in infrastructure can play a key role in reigniting productivity growth across the developed world.

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Where supply meets demand

The structural challenges facing the global economy are legion, and on the current trajectory, pension funds globally must continue to grapple with low interest rates, which create large funding gaps via the material reduction in discount rates. Equity markets are expensive, and many traditional fixed income investments are too costly to deliver a meaningful yield. The combination of high prices, rising levels of volatility and lowered expectations of returns in public markets in the context of a slower-growing world have led investors to seek investments which are more favourable from a risk-reward profile.

Institutional investors around the globe have been capitalising on the benefits of infrastructure investment, and, in recent years, have ramped up their allocations to the ‘alternative’ asset class; the average current allocation to (unlisted) infrastructure by institutional investors has grown to 3.9% today from 3.3% in 2013. Moreover, the average target allocation to the asset class is 5.2% suggesting that other investors are keen to deploy even more capital over time4. Furthermore, a recent Preqin survey also found that 94% of investors in infrastructure felt that the performance of their infrastructure investments have met or exceeded their expectations over the past twelve months5.

In recent years the average LGPS allocation to the asset class has been estimated to be near 0.5%, around 4-5 percentage points behind that of international public pension funds. Leaning on allocation assumptions by pension fund peers, Initial LCIV estimates suggest that around £1-2.5bn could be pooled amongst the LLAs into infrastructure in the years ahead.

2.2 Expected investment outcomes:

Fulfilling multiple functions

Infrastructure can deliver attractive long-term returns, combined with lower volatility (and some degree of downside protection) than publicly-traded instruments. Moreover, these long duration assets can be matched against long-term liabilities, and depending on the asset type, offer an attractive degree of inflation protection. Infrastructure can, therefore, be utilised as a key source of inflation linked cash flows for an extensive time period. Finally, investing in infrastructure can result in a trade-off of lower levels of liquidity, but pension funds with a long investment horizon stand to benefit from the “illiquidity premium” (i.e. higher returns in exchange for lower liquidity).

Whilst often thought of as a more defensive, cash flow generating alternative to fixed income, certain infrastructure assets may be viewed as a rival to the traditional ‘growth assets’ of an institutional portfolio. A growing number of investors are looking opportunistically at Greenfield projects, emerging markets, or projects that have potential for value enhancement through active 4 Preqin Global Infrastructure report (2017)5 Preqin Investor outlook: Alternative assets (2017)

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management of the asset. Naturally, capital appreciation will be a far greater driver of total return in these types of investments.

Historical performance

LCIV has compared the performance of listed and unlisted infrastructure indices to offer a flavour of the returns earned by investors in the asset class over time across both public and private markets. The Preqin infrastructure index captures the average returns on 200 individual unlisted infrastructure partnerships over time. The S&P global infrastructure index tracks the performance of 75 infrastructure related companies from around the world chosen to represent the listed infrastructure industry. LCIV have also added the MSCI would to gauge the relative performance against global equities more broadly. Given a lack data on unlisted funds pre-2007 we have used the end of 2007 to the 2016 period only6.

LCIV note a few findings from the performance chart above:

1. The Preqin infrastructure index outperforms the S&P global infrastructure TR index and the MSCI world by over 72 and 55 percentage points, respectively. The outperformance appears to be predominantly caused by it’s significantly better downside protection relative to the other indices.

2. The annual standard deviations of returns amount to 9.7%, 17.9% and 19.7% for the Preqin, S&P global infratructure, and MSCI world indices, respectively.

6 Returns used are total returns in U.S. dollars. These results should not be interpreted as comprehensive in allocating between listed, unlisted funds and global equities. Statistical discrepancies (especially commonplace in private markets) may produce biased results.

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3. The correlations between all three indices are high (+0.85 and above), particularly during times in which global equities are performing strongly. The correlation between the Preqin infrastructure index and the other two indices falls dramatically during global equity downturns.

Diversification benefits

Through the portfolio lens, infrastructure assets can be exposed to different risk drivers than traditional assets and therefore act as a diversifier to help dampen overall portfolio volatility for a given level of expected return.

Extending beyond our analysis on page 9, a study by Credit Suisse found that the returns of global listed infrastructure (proxied by the Macquarie Global Infrastructure index) exhibited correlations of 0.83, 0.32 and 0.40 to global equities, global bonds and commodities between 2000 and 20107. Deutsche Asset Management, in a 2015 white paper, found that unlisted infrastructure had a -0.25, -0.12 and -0.2 correlation with global bonds, listed infrastructure and listed equities respectively between 2009 and 20148.

It is crucial to note that infrastructure can deliver an array of different benefits and risks depending on the strategy, geography, vintage and sector(s) selected. The extent of the diversification will also depend on the correlation between existing portfolio positions and any newly integrated infrastructure assets.

Risks and challenges

No investment is ever entirely without risk, and investors need to take into account the following considerations, which if not given due consideration, could result in undesirable investment performance:

The lack of liquidity and long duration of the investment: The very nature of investing in infrastructure demands vigilance; if the project fails to deliver there will be no quick and easy exit, unless the investor is willing to endure a substantial loss of capital in exchange for a rapid exit.

Financial leverage: Whilst leverage can boost returns, it can also work against investors. There have been several high-profile examples of projects where the financial models turned

7 Credit Suisse – Can infrastructure investing enhance portfolio efficiency? (2010) 8 Deutsche Asset Management – Why invest in infrastructure? (2015). We caution that these findings rely on the calculations of the authors, and depends relatively small sample sizes and should therefore be interpreted with care.

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out to have been over-optimistic, and the shortfall in revenues was magnified by imprudent levels of financial leverage which investors had employed in a bid to boost returns.

Operating leverage: High fixed costs associated with infrastructure assets can cause profits to be highly sensitive to fluctuations in revenue. The appropriate degree of operating leverage should be considered in tandem with financial leverage.

Management quality: This is a key part of due diligence. In all likelihood, even an excellent asset purchased at an attractive price will fail to perform if management quality is found to be lacking. In the value-add and opportunistic space the assessment of management quality is critical given the operational complexity associated with each type of strategy.

Regulatory & political risk. Investors must understand clearly the political and regulatory environment in which they are investing. Some countries have gained a reputation for reneging on long-term infrastructure contracts, either because they can no longer honour their commitments (such as government subsidies to companies operating in the renewable energy space) or there is a change of government that may take a different view over the role of private capital in infrastructure.

3. Ways to access infrastructure:

There are three main routes to market when investing in infrastructure. These include:

i. Direct investments ii. Listed funds (public markets)iii. Unlisted funds (private markets)

There are different access options for investing in the Infrastructure market. Scale, liquidity, return profiles, desired control (and consequential governance arrangements), and cost tolerance, are ordinarily the key factors determining the optimal access route for an investor.

Direct investing

Investing directly into infrastructure assets is an attractive option to large institutional investors with significant in house resource as fund manager fees are bypassed and assets can be better selected, managed and tailored to the needs of the investor. Direct investments require the investor to be

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involved in all aspects of the investment process, including, deal sourcing, due diligence, valuation, execution and ongoing asset management.

Whilst this may be the optimal route to access the asset class, it can take several years for an institutional investor to build out their internal capability (and the associated complex governance structure), requiring a significant initial investment.

Listed infrastructure funds

Publicly listed vehicles are available on global stock exchanges and typically invest into a range of listed infrastructure stocks. In a similar vein to other managed equity funds, each will target different geographies and sectors depending on the investment objectives. Listed funds are generally liquid, offer enhanced transparency (given publicly available information), asset visibility, and allow investors to get quick access to infrastructure assets with minimal transaction costs and dramatically lower fees than their unlisted counterpart. That said, these funds, as shown in the performance analysis, often correlate highly with broad equity markets, leaving investors exposed to the wrath of market sentiment.

The listed infrastructure market cap according to AMP is around $2.6tn, which dwarfs the unlisted universe in terms of size9. There were 51 listed infrastructure funds in 2016, up from 31 in 2006. 58% and 50% of the 51 funds target the energy and transport sector, respectively. By geographic exposure, The UK is the most popular destination for investment with over 40% of listed funds looking to invest in the region.

Source: Preqin

Unlisted infrastructure funds

9 AMP Capital – Listed or direct infrastructure. Why not both? (2016)Page 10 of 14

Unlisted infrastructure funds, which fall under the private market umbrella, are pooled vehicles that allow investors to access portfolio companies (or underlying assets) that are not publicly available. These funds are generally only accessible by large institutional investors with significant capital, and are frequently structured as limited partnerships, involving a general partner (GP – the fund manager) and a number of limited partners (LP – the investors). GP’s aim to deliver appealing risk-adjusted returns through superior deal sourcing, valuation techniques, due diligence on investments, and using ownership control and operational knowledge to drive value out of assets until exit.

Unlisted funds are highly illiquid, which can be a source of both the illiquidity premium, as well as downside protection during risk-off market events (as can be seen on page 9). The lack of liquidity can allow portfolio managers to focus on assets with superior long-term risk adjusted returns, aligning themselves with the lengthier time horizons of their institutional client base. Whilst liquidity may be limited between the fund and the LP, an LP may look to sell the fund in the secondary market to another institutional investor.

Investors must also consider other factors such as fees and the nature of returns that are specific to unlisted funds as part of their evaluation. Fees vary widely from manager to manager but are usually in the range of 1-2% annual management charge and a 10-20% performance (carry) fee. With a dramatic number of new funds competing for capital, fees have been under pressure.

Capital commitments are usually drawn down by the fund manager over the first three to five years of the life of a fund as a manager sources and executes investable opportunities. Distributions are later returned to investors as the fund matures, resulting in a J-curve cash flow (and return) profile.

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According to Preqin, there are approximately 181 unlisted funds looking to raise a combined $115bn in 2017. The actual amount raised is typically far lower than the target however; last year only 52 funds closed, and between them raised a total of $52bn, around $70bn under target10.

Source: Preqin

Unlisted funds: Open vs closed ended?

Within the unlisted space it’s important to distinguish between open-ended funds and closed-ended funds. Whilst closed-ended unlisted funds have historically been the preferred vehicle for accessing the asset class, both do have different merits and faults to consider. In comparison to closed-ended funds, open-ended funds offer enhanced levels of liquidity (at best quarterly), asset visibility, and will mitigate the J-curve (for those funds that are already operating) which helps investors to access cash flow more quickly. In open-ended funds however, the investors will be exposed to redemptions by other investors which may force the fund manager to sell down assets below fair value. This may however be somewhat alleviated by lock-up periods, exit penalties and gate provisions. Additionally, total returns can be sacrificed in open-ended funds by focusing on maximizing cash flow distributions. Open-ended funds, given their nature, tend to be comprised of predominantly Core and Core-plus assets11.

The open ended fund market is still considered a niche part of the infrastructure asset class as it represent only 22% of all funds; a boutique alternative to the traditional 10-15year closed ended model12.

10 Preqin Global Infrastructure report (2017)11 Clark, T; Biskupska-Haas, A: Open-End vs. Closed-End Real Estate and Infrastructure Funds (2017) 12 & 13 Preqin Global Infrastructure report (2017)

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In the unlisted space, investors may also want to consider co-investments and secondaries as alternative ways to top-up their unlisted infrastructure exposure.

Co-investments

Co-investments are investment opportunities that involve the deployment of capital directly into assets alongside a fund. Assets are frequently offered to GPs their sourcing network and these opportunities often arrive after the unlisted fund has closed for raising. GPs approach favoured (and appropriate) LPs in search of additional capital in order to fund an acquisition.

The opportunity to invest in co-investments is typically agreed on at the outset of the relationship with LPs committing a pool of capital than can be called upon by the GP should the opportunity arise. LPs often choose the extent of their control of the assets, with some favouring a passive style approach in which they simply provide the capital, whilst others may prefer a higher degree of management (including veto rights) and oversight.

Co-investments are usually offered at no expense, with management fees and carried interest (performance fee) avoided. This can significantly bring down the average fee paid on committed capital, which is why institutional investors are increasingly keen on accessing co-investments as part of their infrastructure allocation.

Secondary market opportunities

Investors may also acquire interests in already established limited partnerships through the secondary market. Secondaries are often sold at a discounted price and can offer additional benefits such as no blind pool risk and J-curve mitigation (immediate access to cash flow).

This market is still developing however; the availability of (secondary) fund interests are unpredictable and may be difficult to access. In a 2017 Preqin survey, 97% of institutional investors stated that they would be unlikely to sell their fund interests on the secondary market13.

Optimal route to market for LLAs

At this time the LCIV do not have the internal resource, nor the mandate to begin investing directly into infrastructure assets. By the process of elimination this leaves the LLAs with the choice between listed and unlisted funds in accessing infrastructure.

According to theory, in the long-run returns for listed and their unlisted counterparts tend to converge14. But in the short-to-medium term, as the analysis on page 9 highlights, valuations between listed and unlisted assets can differ significantly, resulting in dissimilar risk and return profiles. Disparate correlations to other asset classes can also prove substantive in choosing

13

14 AMP Capital – Infrastructure investing: Combining Listed with Unlisted (2014)

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between the two vehicles. We summarize some of the key considerations for investors when assessing the appropriate route to market in the table below.

LLAs should decide which route is optimal for them, to which the LCIV can begin to design its product suite. This suite may be composed of a hybrid of listed and unlisted funds, or may just simply offer a series of either listed or unlisted funds over time. Given the illiquid nature of the assets and the scale required to effectively navigate the asset class it becomes crucial for the LCIV to have some visibility in terms of where LLA demand lies in order to build the optimal structure that can stand the test of time.

Ryan Smart – October 2017

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