Rush for assets
There was a time when some investors wouldn't touch infrastructure assets. But infrastructure - long viewed as a boring, old-style investment - is close to becoming its own asset class, particularly in market-leading countries such as Australia. So much so, in fact, that demand is outstripping supply there, and infrastructure investors are looking offshore to find new channels for their capital.
It has reached the stage where new funds indexed to infrastructure are appearing regularly, offered by industry participants such as Australian investment banks Macquarie and Babcock & Brown (see box, Listed versus unlisted investments). And increasing numbers of structured products referencing infrastructure underlyings are being offered, as hitherto soaring equity and commodity returns have been stuttering in some markets (see box, Infrastructure-based structures).
Infrastructure's long duration particularly appeals to pension funds and life insurance companies seeking stable assets to offset their liabilities. "The whole attraction of infrastructure funds is that you are getting 20- to 50-year investments that are typically inflation-linked or protected," says Nick van Gelder, executive director at Macquarie Bank in Singapore. "There are very few assets that offset a pension fund's liability in the same manner."
There is a clear trend for institutional investors to invest in infrastructure directly or through unlisted vehicles, says Peter Hofbauer, head of global infrastructure at Babcock & Brown in Sydney. "That is driven by greater understanding and appreciation, and by increased capital flowing in from regulation that is encouraging savings globally," he says. "That money needs a home and wants long-duration investments linked to inflation, with low correlation with other assets to provide attractive risk-adjusted returns."
Another lure for investors - such as Victorian Funds Management Corporation (VFMC), with more than A$40 billion ($33 billion) of assets under management - is that the scale of infrastructure assets means "you can put a reasonable amount of money into them", says Andrew Elliott, VFMC's joint head of private markets in Melbourne. VFMC's infrastructure interest arises from its mandate to manage the pension and insurance liabilities of Victoria's public sector.
For similar reasons, industry superannuation funds were among Australia's earliest adopters of infrastructure investments. Melbourne-based UniSuper, for example, has been investing in infrastructure since 1996. On top of the attractive risk-adjusted returns and diversification offered, infrastructure's long-term stable and predictable cashflows match UniSuper's long-dated benefit liabilities. The company manages A$20 billion of assets for workers in Australia's higher-education and research sector. Its current infrastructure allocation is split 80% domestic and 20% offshore, with direct equity investment into projects being the predominant domestic vehicle, while offshore investments are either made as direct equity into projects or via unlisted pooled funds.
Infrastructure is increasingly being viewed in Australia as a distinct asset class. The evidence for that is the number of listed and unlisted infrastructure funds being set up, says Craig Stafford, global co-ordinator of infrastructure and utilities research at UBS in Sydney. And VFMC's Elliott points to the development of infrastructure securities funds. "It speaks to the maturity of the sector that it is possible to set up these funds and create an index to cover the sector," he says.
Infrastructure is becoming more like property and getting its own allocation, agrees Steve Bickerton, chief executive of Sydney-based Challenger Infrastructure Fund (CIF), set up in August 2005 by Challenger Financial Services Group. "That will continue as more products come to the market," he adds. "It will be dictated by what products are available."
But therein lies the rub - as in many other asset classes, investor demand is exceeding supply. Hence, new asset types are being added to the infrastructure group, including CIF's EUR565 million purchase in April of a 66% stake in LBC Group, the world's second-largest independent operator of storage terminals for bulk liquid chemicals, with assets across Europe and North America. "Whereas 10 years ago, you couldn't fund a toll road for love nor money, we are now looking for opportunities to leverage off new assets and take advantage of the potential re-rating," CIF's Bickerton says. "Infrastructure was old economy and nobody wanted to know about it, but now it's selling like hot cakes."
For example, climate-change issues have led Greg Roder, Sydney-based head of infrastructure for Australia and New Zealand at investment manager AMP Capital Investors, to predict changes in the way water is valued and priced, and in its ownership. "It is hard to make money if the commodity moving through the assets isn't properly priced," he says.
VFMC's Elliott says the degree of competition in the Australian market is leading people to look offshore for deals. For example, VFMC's first direct investment in an infrastructure asset is a major stake in Birmingham International Airport in the UK. It acquired this in partnership with Canada's Ontario Teachers' Pension Plan in May. Unlike its earlier investments in wholesale funds, direct investment gives VFMC "influence at the board and stakeholder levels, as well as pre-emptive rights, which are very valuable in this environment, where assets are hard to come by", says Elliott.
Meanwhile, AMP Capital Investors has opened offices in Singapore and London to facilitate its development outside Australia and into Asia and Europe. Roder says the company's recent activity in Europe will see its infrastructure funds under management approach A$4 billion by the end of the year.
Infrastructure's globalisation also reflects a desire for geographical diversification and the large size of projects leading to capital being sought globally in many cases. In this respect, Hofbauer says it is significant that US investors are still looking to understand infrastructure as an asset class. "The key to that door hasn't been unlocked but it isn't far away." Indeed, van Gelder says Macquarie is regularly raising money in Europe and the US for infrastructure, predominantly from pension funds and life insurance companies.
The right reasons
Despite the benefits of having a stake in infrastructure assets, investors should be selective and clear about why they invest in infrastructure, says VFMC's Elliott, particularly in view of the high level of gearing involved. Infrastructure can support relatively high levels of debt, agrees Stafford at UBS, pointing to the increased use of leverage, as well as private equity involvement, such as Kohlberg Kravis Roberts and Texas Pacific Group's $32 billion bid in February for Texas utility TXU Corporation.
Moreover, it is widely agreed that essential infrastructure - with its relatively inelastic demand and revenue linked to inflation - is an effective hedge against inflation. UBS research (Q-Series, Infrastructure & Utilities, November 10, 2006) shows that infrastructure underperforms equities when bond yields rise, as often occurs when inflation rises. Babcock & Brown's Hofbauer says the correct comparator is not nominal, but real - or inflation-adjusted - bond yields. Stafford says that, if real interest rates are steady, infrastructure should generate good returns due to its inflation-linked pricing and high earnings margins. "Yes, the costs go up, but there is good operating leverage to make pretty good returns," he adds.
Not all infrastructure assets behave in the same way, says VFMC's Elliot. Those that are highly geared or have market risk, such as greenfield toll roads, may be less-effective hedges against inflation, while established infrastructure that is essential to the community, with relatively inelastic demand and strong pricing power, will be effective inflation hedges.
A further point to consider is that market valuations of infrastructure assets tend to be marked down at times of rising interest rates on the assumption that a higher discount rate is required, says CIF's Bickerton. Deutsche Bank research, contained in its March publication Characteristics of Infrastructure Investments, says investments in infrastructure projects tie up capital for a long period. The interest rate environment and financing conditions thus play an especially important role in the valuation of these investments.
As with longer-dated bonds, changes in interest rates and, therefore, the discounting factors have a strong influence on the present or market value of the relevant infrastructure project. This interest rate sensitivity in a period of declining long-term yields was an essential reason for the exceptionally good performance of infrastructure investments in the past.
Yet to mark down infrastructure asset valuations automatically at times of rising interest rates ignores the fact that infrastructure owners can hedge their funding costs while benefiting from the rise in revenue that normally accompanies higher interest rates. "That is an education process," says Bickerton. "Infrastructure is more like an inflation-linked product as opposed to a nominal bond."
LISTED VERSUS UNLISTED INVESTMENTS
Infrastructure investments include bonds with cashflow explicitly linked to infrastructure, hybrid debt/equity instruments, structured products and mezzanine debt associated with private-sector acquisitions of infrastructure. But listed and unlisted equity is by far the most common infrastructure investment.
A popular vehicle is equity in listed infrastructure-related companies, such as Australian toll road operator Transurban. Since 1994, it also has been possible to invest in listed infrastructure funds, such as Macquarie Infrastructure Group (MIG). Set up in 1996, MIG has controlling interests in toll roads around the world.
According to UBS research Private Equity Intelligence in September 2006, nine infrastructure funds had been started so far that year, with a further 17 in start-up. Nine funds started trading in 2005 and seven in 2004. And the average size of funds rose from $300 million in 2005 to $700 million in 2006.
While some fund managers have the scale and expertise to invest directly in infrastructure - such as Sydney-based AMP Capital Investors, which invested in Sydney's harbour tunnel in the late 1980s - the scale of many such assets puts them beyond the reach of most investors. Infrastructure funds therefore facilitate access to these assets.
"It takes a lot of time and energy in terms of due diligence to commit to an infrastructure asset, so even large funds can see the benefit of coming through a conduit," says Nick van Gelder, executive director at Macquarie Bank in Singapore. Unlike investing in infrastructure companies, he adds, infrastructure funds such as MIG that have an independent manager give investors not just the management team within the company, but "the expertise and resources of the whole Macquarie Bank group".
Infrastructure's popularity is such that many of the largest fund managers in Australia offer an infrastructure securities fund. This recent development gives investors access to a diversified mix of listed infrastructure-related companies and funds, and perhaps some unlisted assets. Unlisted infrastructure funds aimed at long-term institutional investors are also multiplying courtesy of asset packagers including financial services groups Challenger and AMP and domestic banks Babcock & Brown and Macquarie.
While listed investments have greater liquidity, their valuations are influenced by overall equity market sentiment that is unrelated to the underlying infrastructure assets. Hence, long-term investors that value steady portfolio returns, including pension funds and insurance companies, prefer unlisted vehicles. Other institutions, particularly offshore investors that are mandated to invest predominantly in listed securities, prefer listed investments. Retail investors fall somewhere in between, says Steve Bickerton, chief executive of Sydney-based Challenger Infrastructure Fund.
Most investor interest lies in established infrastructure with proven cashflow. Investments in infrastructure in developing economies or in private equity firms that focus on infrastructure have quite different risk/return profiles, as do investments in infrastructure under construction.
Most infrastructure-related structured products revolve around an index or a basket of stocks, says Lucas Kiely, head of structured derivatives trading at UBS in Australia. Indexes include the Infrax-Index, Macquarie Global Infrastructure Index and UBS Global Infrastructure Index.
Some products enable investors to take a view on a particular infrastructure segment. For example, investment banks can write options on a basket of toll road stocks or the toll road sub-index of an infrastructure index. Bond and call option structures are used in products that offer capital protection with constant participation in the upside performance of the basket or index.
Other products use barrier options to provide protection on the downside and either enhance yield or provide exposure to upside performance. In short, a full suite of structured products has been written on infrastructure indexes and stocks. Kiely expects this to continue in the same way that structured products over global real estate investment trusts (Reits) developed.
Callable range-accrual and yield-enhancing strategy (Yes) structures have highly defensive characteristics and relatively high-yield. Both suit investors that are moderately bullish on the market or expect share prices to trade within a range. They are unlisted and issued by investment banks such as UBS.
Yes products use options to provide full capital protection and enhanced yield. The options reference the 10 stocks with the highest historical dividend yield in the 16-stock UBS Australian Infrastructure & Utilities Index. Coupons vary with market movements, with the targeted rate of 9.5% a year coming from the underlying stocks' dividends plus option premiums from writing collars on those shares.
Yes products offer some potential for capital growth to the extent that underlying share prices can rise to the call strike level before performance is capped out. They will outperform a long-only share strategy when share prices are steady or falling, and also when they rise moderately without triggering the call options. However, it tends to underperform in stronger equity markets, because the upside is limited through writing collars to boost income.
Callable range accruals pay quarterly coupons if all the underlying stocks close at or above a set accrual strike - for example, 90% of the starting price. The coupon accrues each day this occurs. For example, if the quarter has 60 trading days and on 10 days one or more stocks close below 90% of the starting price, the coupon will be 50/60 x 16% x 1/4 = 3.33% or 13.33% annualised.
The structure is callable at par each quarter if on quarterly observation dates each underlying stock closes at or above the autocallable level - for example, 94% of the starting price. If one or more of the stocks closes below this level, the structure will not be called and another quarterly coupon period begins. If one of the stocks consistently trades below the accrual level, no coupons will accrue and the original investment amount is repaid at maturity.
Retail investors, along with some small institutions that seek capital protection, are among the buyers of callable range-accrual and Yes structures, says Kiely. They also appeal to high-net-worth individuals because some of the underlying stocks may pay tax-deferred distributions that can reduce tax obligations in a particular year.
THE BENEFITS OF INFRASTRUCTURE INVESTMENT
The key characteristics of infrastructure assets are that they provide predictable, long-duration cashflows with inflation-linked revenue. Such assets tend to be highly regulated and often their size and capital intensity represent high barriers to entry, giving them monopoly-like features.
This combination gives relatively high investment returns and low volatility. Between 1994 and 2007, infrastructure outperformed cash, bonds, equities and emerging markets but with less risk than equities and emerging markets (see figure 1).
Global real estate has generated higher returns than infrastructure, but with higher risk, displaying a standard deviation of 12.7%, versus 8.2% for infrastructure.
Infrastructure has better risk-adjusted returns than real estate, says Craig Stafford, global co-ordinator of infrastructure & utilities research at UBS in Sydney. Australia's ageing population is increasingly turning to infrastructure as having more potential than property in its search for high-yielding, income-producing defensive assets, says Stafford.
A UBS Q-Series report on infrastructure and utilities dated November 2006 attributes infrastructure's strong performance over the past 10 years to three factors. The first is a upwards re-rating of asset valuations, as investors have come to better appreciate infrastructure's characteristics. Second, the global fall in bond yields has reduced the cost of capital assumptions that drive infrastructure's discounted cashflow valuations and, given infrastructure's bond-like long duration, it outperforms equities when bond yields fall. The third factor is structural change - namely, the availability of infrastructure investments coinciding with growing investor demand for stable, income-producing, long-dated assets.
Furthermore, infrastructure offers diversification through its low correlation with other asset classes. Infrastructure with fixed-life concessions - often the operation of infrastructure is based on long-term contracts or government-regulated prices - is more akin to bonds than equity in some respects, while offering superior capital-gains potential than bonds.
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