Investing in the infrastructure of the future

With government balance sheets around the world in disarray and pressure to continue to build and upgrade infrastructure, the growth outlook for the sector is looking good, writes Freya Purnell.

In both developed and developing economies, the development of ever-stronger, sophisticated infrastructure is critical to manage growth and drive productivity - whether it is in social assets such as hospitals; transport assets such as toll roads, airports and ports; or utilities and communications infrastructure. 

To achieve this, cash-strapped governments around the world have to turn to the private sector for assistance.

The European crisis in particular has significantly diminished the region’s ability to fund infrastructure.  

Zenith Investment Partners investment analyst Jonathan Baird believes the “economic restrictions on governments to be able to fund very large projects” will result in strong growth of the infrastructure sector over the next 10 to 15 years - whether that be through listed or unlisted vehicles.   

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There is also a re-emerging trend towards the privatisation of infrastructure assets through initial public offerings (IPOs), according to Geoff Frankish, head of infrastructure for Goldman Sachs Asset Management. While this was important to the growth of the sector over the last decade, the privatisation activity dried up as markets became inhospitable. 

“For governments, it’s now a more attractive proposition to think about preparing your balance sheets by selling some of these assets that may be even better placed in the private sector than staying in public ownership,” Frankish says.  

He believes that with a regeneration of privatisation activity, new assets such as transmission and distribution assets, hydropower stations and other renewable energy assets, may come into the Australian sector, while assets that had previously been privatised and sitting in the unlisted market may also be transitioned to listed vehicles. 

Offshore, the trend will be similar, particularly in Europe, according to Andrew Coutts, senior investment analyst, Lonsec, who points to the recent privatisation of airports in Portugal as an example.  

“With the Euro problems, heavily indebted governments are looking to off-load some of those assets, and many of those will find their way into the listed market in high quality assets that investors then have the opportunity to access,” says Andrew Coutts. 

Overcoming investor reluctance 

Against the backdrop of constrained economic growth, infrastructure can offer considerable attractions.

With underlying investments usually in essential services, infrastructure-related cash flows are relatively stable and less influenced by broader economic shifts, and growth tends to be more structural than cyclical, according to Peter Meany, head of global listed infrastructure, Colonial First State. 

“Compared to the ASX, which is very heavily weighted to financials or mining through the resource sector, you really do need a strong global economy for the Australian equity market to do quite well,” he says.

“With infrastructure, we have shown that the assets have an ability to grow through the cycle, even when things are difficult, because of the way they earn income. We have seen an ability to deliver 6 per cent per annum growth in income, on top of the typical yield of about 4 per cent.” 

Though these numbers are compelling for yield and income-focused investors, the lessons of the past are not easily forgotten. 

Five years has proven to be a long time in the world of infrastructure, and it has given retail investors a very mixed view of the potential of the sector. 

Back then, investors were still in the grip of a love affair with equities, and as large institutional funds started upping their allocations to infrastructure, the idea of infrastructure as a separate asset class began to gain merit. Funds which launched at this time often saw phenomenal initial interest.  

On the flipside, investors had mixed success in direct infrastructure investments during this period, and greenfields tunnel and transport projects failed, with overestimations of traffic forecasts leaving investors disappointed and swearing off the sector.  

“A lot of people lost some significant capital in some of those investments. In the period that followed, there was a significant deleveraging of this sector and a definite change in the way distributions policies were structured,” says Coutts.  

Charles Badenach CFP, financial planner and principal, Shadforth Financial Group says these changes in approach have resulted in a broad improvement in sentiment towards infrastructure.  

“Forecasts that were traditionally applied have now been revised to more realistic levels, like traffic projections for toll roads. Gearing levels have been reduced and the income is often fairly certain, and this has all given investors renewed confidence in the sector,” he says. 

The right stuff 

Infrastructure is also benefitting from a greater focus among investors for income certainty and yield.  

“People have been seeking out those more defensive sectors offering reasonable yields,” Coutt says.

“Infrastructure has outperformed broader equities over the last 12 to 18 months, and has also been less volatile, which is one of the key attractions of the sector.”  

According to Perry Lucas, portfolio manager, infrastructure, AMP Capital Investors, advisers are seeking to encourage their risk-averse clients away from cash and back into a diversified set of assets. 

“As people think about going back into the equities market, they are inclined to think about infrastructure and utilities first for two reasons - because it is at the lower end of the risk spectrum, and secondly, it does offer this pretty good yield, given that they are looking at moving out of a fixed interest environment back into equities,” Lucas says. 

Other attractive characteristics of the sector are that infrastructure assets are large, providing economies of scale: they hold strong market positions, therefore providing a reliable earnings stream; and they offer a good inflation hedge, as inflation is usually built into the revenue streams.  

“Infrastructure is growing in allocations really across the board, and we are seeing quite good support, both out of the adviser market and the SMSF market as well,” says Lucas. 

Risks in the sector  

While economic struggles are unlikely to have a negative impact on infrastructure - if anything, they may actually provide more opportunity for investors - regulation is a constant risk in the sector.  

Though one of the advantages of investing in infrastructure assets is that as natural monopolies in many cases, they face limited competition, the trade-off is that they are highly exposed to government regulation.  

Meany says globally, the most politically regulatory sensitive sub-sectors are electricity and gas utilities, particularly as governments pressure them to share reductions in spending. Frankish agrees that there are more challenges to come for energy transmission, distribution and retail businesses.  

“It follows that when you have got those near-monopoly businesses, they need to be regulated properly and in a balanced way for the system to work.

"Right now, there is plenty of debate going on about what exactly that balance might imply. The risk in that is that the corporates are going to be disadvantaged, so that’s a risk we need to watch very carefully,” Frankish says. 

Other sub-sectors within infrastructure are less impacted by this type of risk.  

“When we look at things like roads and airports, oil storage, and mobile towers, they are simply not in the general conversation around changing regulation or reducing prices,” Meany says.  

Another area of infrastructure that has certainly fallen foul of the private investment market is the development of greenfield projects, particularly for consumption-based assets such as toll roads.

As a result of some major failures in recent years, projects with patronage risks are seen as too hot to handle.  

“When you are investing against an estimate of traffic which in effect doesn’t come to pass, you have actually moved out of the basic metric for core infrastructure,” Lucas says.

“We are looking more and more for models with operational cash flows and predictability, where you don’t bear lots of patronage risk or construction risks.” 

Similarly, Zenith does not look favourably on greenfield projects, unless the company also has four or five income-generating assets.  

“But if you are going to invest in the company and you have to wait five years for the asset to be built and basically you are not going to earn any dividends, you’re not going to see any income, it’s a very slow process,” Baird says.  

From an advice perspective, Paul Kearney, financial planner and CEO of Kearney Group, says this is an area of the market he is very wary of.  

“If you’re an initial investor in an infrastructure investment, you don’t know what you’re getting. I much prefer to acquire investments that are up and rolling, where you know what the return profiles are like,” he says.

“You may not have the upside on it, but I don’t think you’re getting into infrastructure for the upside.”  

Risks also arise with infrastructure investments that are held in complicated structures, incorporating levels of gearing and trust structures, even thought the underlying assets may be simple enough for investors to understand, such an airport. 

“It really does pay to take the time to understand it, and use a manager that has experience in the infrastructure space to try and reduce some of that risk,” Meany says. 

Australian vs global infrastructure investments 

Though Australia represents an attractive market for infrastructure because of its stable regulatory framework, proximity to Asia and good income levels, in terms of the size of the market and diversity of investment opportunities, it has perhaps failed to deliver on an early leading position in privatisation of infrastructure assets.   

“The issue has been that governments have not been as proactive and as efficient as we had hoped in terms of privatising some of these assets,” Meany says.  

The net result is that while the Australian market is regarded as quite mature by global standards, it is still a very small pond to be fishing in. The S&P/ASX Infrastructure Index includes only 16 stocks, and there is currently only one Australian domestic infrastructure fund on offer for retail investors - the Goldman Sachs Australian Infrastructure Wholesale Fund. 

Frankish says this fund was established six years ago at the request of a client who was looking for resilient earnings and yields better than those offered by global infrastructure, with the tax efficiency that an Australian investment could provide.  

For Australian investors, these high yields and tax advantages continue to be the key attractions, along with inflation protection and avoiding the currency hedging issues that come with global infrastructure, and which can make yields “very lumpy”, according to Baird. 

The key disadvantage, of course, is the size and concentration of the Australian market, with large companies such as Origin Energy making up the bulk. The quality of infrastructure investment has perhaps not been as high as it could be.  

“It’s improved, but historically they were overgeared, there was a misalignment of interest being run by investment banks. So as time has gone by, things like Sydney Airport and Transurban have really cleaned up their structures and their alignment, and we see them as very much investible companies now,” Meany says.  

The size of the Australian market has also seen some assets included in the investment universe that perhaps don’t fulfil the crucial characteristics of infrastructure. 

“In the Australian infrastructure sector, there are a lot of assets or securities that some of the global managers would not touch, because they don’t believe that they are true infrastructure products,” Baird says. 

However, Australian companies still do feature prominently in many global funds.  

“If you look at the global infrastructure universe, Australia probably would be overrepresented in portfolios, because of the maturity of the Australian market and some of the names there,” says Coutts. 

However, with a whole world of opportunity at the global level, the worldwide competition for investment is much more fierce.

The S&P Global Infrastructure Index includes 75 stocks from around the world, with three distinct infrastructure clusters - utilities, transportation and energy.

In this environment, managers can often find better value opportunities offshore. For example, Meany gives the example of buying Lufthansa in Switzerland over Sydney Airport.  

“It has all the characteristics we know and love about Sydney, but I can buy it at half the price because it happens to be part of Europe where people have been worried about the environment,” he says.  

Recent reviews by research houses have also endorsed the increasing quality of infrastructure funds.

In its 2012 review, which involved eight global funds reviews, Zenith awarded both the Australian hedge and unhedged RARE Infrastructure Value Fund and the Magellan Infrastructure Fund a highly recommended ratings, while CFS Wholesale Global Listed Infrastructure Securities, Lazard Global Listed Infrastructure Fund and RARE Series Emerging Markets Fund were all given a recommended rating. 

Lonsec’s 2012 Infrastructure Securities Sector Review, which also canvassed eight funds, saw two funds given a Highly Recommended rating for the first time (the RARE Infrastructure Value Fund and Lazard Global Infrastructure Fund).  

Emerging markets infrastructure 

As developing countries seek to fund much-needed infrastructure, managers also see considerable potential in emerging markets.  

“Clearly there is potentially more growth in general [in emerging markets] because those markets are actually developing more, in order to be able to build out and improve their infrastructure to a much greater extent than what developed economies have to do,” says Tim Wong, fund analyst, Morningstar. 

But despite the underlying demand, weaker regulatory and political regimes add extra risk.  

“That’s where a lot of managers would differ - some of them will be happy to invest in Asia, and some of them won’t be, based on what they believe to be loose regulation,” Baird says, adding that despite these challenges, investments such as the RARE Emerging Markets Fund have performed well in the short term. 

These concerns are typically pointing managers towards more mature assets in emerging markets, and small allocations of up to 10 or 15 per cent.  

“China has obviously been the big story, and there are some China toll road operators that appear in portfolios. Brazil has also been an area of interest, and companies like DP World, which is Middle East-based but with diversified exposure to emerging markets, have also been quite popular,” Coutts says. 

Kearney says his company is currently using infrastructure in the emerging markets sector of its client portfolios to add diversification and as a way to access economic growth in those markets. 

“We’ve invested in funds that are involved in ports and roads and railways, because we believe that these are without question going to grow over time, and so provide a nice stable entry point into those emerging economies.” 

Accessing infrastructure investments 

Another challenge for retail investors has traditionally been gaining access to infrastructure investment options, with wholesale funds dominating the space.

Even for those funds which would grant access to retail investors, “the documentation was difficult to understand, the fee structures have been high, the assets have been very difficult to value, and generally you can’t redeem your investment at short notice”, says Badenach. 

According to estimates by Russell, there is now approximately $15 billion in infrastructure assets in unlisted closed-end Australian wholesale funds, which is managed by around 12-15 fund managers, compared with around 144 unlisted infrastructure funds in the global market, representing around $94 billion in FUM (according to Preqin figures). 

In line with growing investor interest, there has been an increase in the number of options, both in terms of listed securities and managed funds, in Australia and offshore, and retail investors are often opting to go through the listed market. 

According to Coutts, one of the advantages of being invested in a listed fund is that the portfolio can be reweighted to accommodate changes in behaviour by different subsectors of infrastructure, depending on the market environment.  

“In a very low or poor growth outlook for GDP globally, they can weight their portfolios more defensively, and that is to head towards more regulated utilities, which have a more stable cash flow and as an essential service, are less linked to the health of the broader economy.

"As opinion on the outlook improves, they may then weight their portfolios to more GDP-sensitive subsectors like transport, such as ports, airports and toll roads,” Coutts says. 

Meany agrees that flexibility within an infrastructure fund can enable managers to respond to different economic and interest rate environments. 

“That’s why we tend to have a mix in the portfolio of a whole range of sectors, including regulated utilities, which do have some attraction but perhaps are more bond yield-sensitive, all the way through to roads, airports, railways companies, oil storage and mobile towers,” he says.

While listed securities and funds also offer the advantage of better liquidity, unlisted vehicles demonstrate less volatility in their valuations.  

“What you get unfortunately is a disconnect sometimes between what you think the valuation is and what the market tends to want to do, which is the whole sentiment volatility issue that sits across listed equities,” Lucas says. 

When it comes to choosing listed or unlisted for clients, advisers are led by the particular clients’ needs and preferences. Badenach says while he would consider the unlisted side of the market for the right client, the price has to be right. 

“They tend to be quite expensive structures, and at the end of the day, in a lower yield environment, that’s a pretty important issue for investors,” Badenach says.  

Kearney says it is very much a ‘horses for courses’ approach with his clients as well - whether they prefer to invest in direct shares, or in managed funds. 

“What we look for in managed funds is what the fund is invested in, what their attitude is, and making sure they’re not getting themselves caught up in heavily debt-ridden projects. It needs to show that it’s a relatively liquid fund in order for us to be interested in it,” Kearney says.  

Fee structures for infrastructure funds 

A recent paper by Russell Investments criticised the base plus performance fee structure commonly used by infrastructure funds, as being inappropriate for the sector, given its limited ability to add value and the need for an appropriate benchmark. 

Across the managed infrastructure fund sector there has been increasing pressure on fees, and some managers of infrastructure funds have responded to this by making changes to their fee structures. Wong points to the RARE fund, which recently moved to maintain its base fees but did cap its performance fee.  

“We as a firm had pointed out to them that we believe that a performance fee structure over an absolute return benchmark was not appropriate.

"I would like to think that there may have been some feedback effects from research houses as well, that have had some influence in making sure that managers are responsive to investor needs and looking at whether or not their fee structures are appropriate,” Wong says, adding that making cost or fee structures more appealing, particularly where investors might be shy of what they perceive to be risky assets, may help managers gain an edge in a competitive market.  

Meany says that when the Colonial First State fund was established, having a straightforward fee structure was important to appeal to the retail investor segment.  

“We don’t do any performance fees and there is no carried interest. I think generally we have been seeing an improvement in that space, in that I think the funds have tried to simplify the fee structures and reduced the complexity, but there is probably still some way to go in the unlisted market,” he says.  

While some advisers are deterred by the fee levels attached to infrastructure investments, Kearney says the level of fees would not necessarily be a deterrent in and of itself, if the fund could deliver the outcomes and portfolio benefits they were seeking. 

“We’re obviously interested in the net return that a fund provides, as opposed to the management fee, and we’re interested in solid long-term performance, not just what’s happened in the last six or 12 months,” Kearney says. 

Infrastructure in the portfolio 

Advisers have also had to rethink the role of infrastructure in the portfolio. Though infrastructure might traditionally have been seen as a defensive asset, the lessons of the past, particularly in the listed space, have shown that not to be the case.

With falling bond yields, the attractions of infrastructure in delivering yield from relatively conservative assets have been strong. But advisers and investors shouldn’t lose sight of the fact that many infrastructure investments, due to the type of asset or the structure they are held in, will behave very much like equities. 

And this is why it’s important to look under the bonnet of individual infrastructure investments before considering what part of the portfolio they should fit into and the risks that they carry, rather than applying a blanket ‘equity’ or ‘property’ asset class label.  

Australian Unity Personal Financial Advice head of investment research, Jeff Mitchell, says distinguishing between different types of infrastructure assets, such as consumption assets and social assets, is crucial to determining which will behave more like property and which will behave more like equities. 

“You aren’t getting this return just for turning up in the morning,” Lucas says.

“You need to go through those thorough processes of knowing what you are investing in, having managers who know what they are investing in, and certainly on the direct side, it is a specialist area.”  

There is even debate over whether infrastructure should be seen as a sector in itself, or as a subsector within other asset classes such as equities and property.

Frankish argues that infrastructure should actually be considered a separate asset class, with allocations made appropriately.  

“Infrastructure and utilities funds do have sufficiently different characteristics from general equities and property to be able to be a really good diversifier in a balanced portfolio. I think that is an issue that some of the market gets and some of the market hasn’t,” he says. 

Outlook for performance 

Infrastructure funds have performed strongly, outperforming equities in recent times.

The direct market has been delivering good returns, with the S&P/ASX Global Infrastructure Listed Index (Australian dollar-hedged) having returned over 18 per cent for the 12 months ending 30 September 2012. 

While Baird expects to see continued moderate growth and reduced volatility, investors need to be cautious about getting too excited by these numbers, however, and keep in mind infrastructure’s key characteristics.  

“Investors should be aware that they are looking at something that might generate 3 to 5 per cent growth per annum, and steady income through the cycle,” he says.

“While infrastructure may underperform the general market in many conditions, you would hope that throughout the period it would keep pace or outperform in the long run, given its certainty around the assets.” 

And though yield is a strong attraction to the sector, investors should also focus on total returns, according to Wong. 

“If you take the income-only approach and potentially overlook some of the other factors that may happen to your total return, you are not being fully aware of all the risk you may be getting yourself into.”