For some years, many professional investors and corporate superannuation funds have included an infrastructure component in their investment mix. Tim Farrelly explains what, up until now, retail investors have been missing out on.
The term “infrastructure” encompasses all those fundamental services that are essential to the operation of modern economies, such as roads, airports, railways, ports, power grids and telephone lines. They form the backbone which more complex industries rely on for support.
Historically, these assets were predominantly publicly-owned, and opportunities for private investment in infrastructure were scarce until the 1970s. About that time, governments in many developed western economies, under pressure to reduce deficits, began to privatise.
The trend away from full public ownership extends to new assets as well, so increasingly governments and private enterprise are joining forces to construct, own and operate new infrastructure projects.
So what are the attractions of infrastructure to investors and what should be expected from an investment in the sector?
One of the first advantages of an infrastructure investment is their predictable cash flows. Many infrastructure assets enjoy strategic advantages that can underpin their cash flows over long periods. Privatised airports, for example, often have concession periods of 50 years or more attached to their ownership and management rights. This, together with the natural limitations on direct competition, mean that their patronage and therefore cash flows can be predicted with reasonable certainty.
A predictable cash flow also means that infrastructure investments can possess great defensive attributes. Reliable income flows mean that the capital risk of investing in infrastructure is typically lower than other forms of direct equity. With investors becoming increasingly interested in alternative assets, the yield and relative security of infrastructure are valuable defensive attributes.
There are also diversification benefits attached to using infrastructure investments as a growth part of a portfolio. The values of infrastructure assets are not affected by the sentiments and behavioural influences that tend to drive markets in listed securities. Nor are they subject to the cyclical swings that see different types of shares move in or out of favour. In times of share market volatility therefore, infrastructure offers diversification benefits within the growth component of a portfolio.
Infrastructure investments also offer attractive long-term capital growth. Projects typically increase in value over time as they progress from early stage development through construction to completion and into the mature operational phase (as shown in the graph below).
Normally the gains are greatest for early stage investors who provide capital during the higher risk phases. They are rewarded as the risks dissipate during the project’s lifecycle and the asset is revalued upwards. Long-term investors receive that reward by way of capital gains when the asset is disposed of, usually via a trade sale or public listing.
So where are the opportunities? Even allowing for the spate of privatisations that have already taken place, there is no shortage of infrastructure opportunities in Australia – and certainly no shortage when we look overseas to other developed economies.
Increasingly, it is not just transport and energy assets that are being privatised but also social infrastructure such as hospitals, schools and courts. Nor is infrastructure restricted to the privatisation of existing public assets. Today there are many greenfields projects under way where new assets are being created in industries such as telecommunications and data transfer.
As the sector as a whole has matured, a much deeper secondary market for infrastructure assets has developed. This not only aids liquidity, but also provides trading and restructuring opportunities for managers with the necessary skills and resources.
Where does infrastructure fit in an asset allocation model? In most allocation models, infrastructure is a sub-set of equities, although there are those who argue that it also has some of the characteristics of property.
Perhaps the best answer is to take a lead from the wholesale superannuation funds who are typically moving towards a 5 to 10 per cent allocation to private equity in its various forms. Some of this is going into specialist funds that provide start-up and development capital, typically to companies in the technology sectors. This is high-risk money. To balance it out, the funds are committing substantial amounts to infrastructure, which sits at the low risk end of the private equity spectrum.
There is a strong case for including infrastructure as part of the growth component of your clients’ portfolios, particularly where they are:
long-term investors;
more interested in capital growth than regular income;
looking for diversification beyond traditional asset classes; and
prepared to accept the trade-off of lack of liquidity in return for the prospect of higher returns.
Tim Farrrelly is the head of adviser services at Macquarie Financial Services
