If You Build It, Will Yields Come?

From aiCIO Magazine's April Issue: Infrastructure for ­liability-driven ­investment.

To see this article in digital magazine format, click here. 

Roiled global markets have many institutional investors feeling stuck between a rock and a hard place. For some, the best way out may be to build a tunnel through one and a bridge over the other. Indeed, infrastructure investment has become an understandably appealing option for long-only asset managers. But how should investors operating within a liability-driven investment (LDI) framework approach it? 

On the supply side, an increase in public contracts available for private investment has arisen because of American state-level budget constraints. On the demand side, the appeal of infrastructure assets for liability-driven investors can be interpreted as a reaction to dismal yields and a looming shortage of suitable duration-matching, fixed-income securities. Compounding the difficulties has been the interminable global volatility and stark correlations among the SNAFU stocks that would ideally add oomph to portfolios.  

Fortunately, many investments in economic infrastructure (utilities, energy, transportation, and communications) are congruent with LDI mandates. Michael Underhill, CIO of Capital Innovations, says a number of his pension clients have benefited from a diversified portfolio of marketable and private market real assets and particularly infrastructure. “One of the best ways of understanding LDI is by looking at how asset classes behave at different points in a market cycle,” Underhill says. Infrastructure’s main value is that it seems to be more defensive than most asset classes. And as interest in its investible opportunity set grows, more dedicated infrastructure funds are hitting the road. According to Preqin, 2012 began with 144 infrastructure funds seeking $94 billion in assets worldwide. With 33 of those funds, the North American market is growing steadily.  

The most common way to invest in infrastructure is as a LP in an unlisted fund. The funds normally last around 10 years and compensation is based on the residual after the GP receives management and performance fees and carried interest. Michael Cook, Senior Managing Director of Macquarie Infrastructure and Real Assets, which has roughly $32 billion under management, says, “The fund model works because it allows investors to get a seat at a table that might otherwise be unattainable. For instance, a $25 million investment can garner a proportion of a half-billion dollar project.” He adds that “investors who want to collect cash flows directly alongside the fund can request co-investment options”. These funds are a solid addition to the return-generating portion of a diversified portfolio, and co-investment offers steadier cash flows. But the model isn’t designed for liability matching. This is partly a result of the misalignment between the long functional life of the underlying assets (railways, pipelines, plants, and the like) and the nature of private-equity style funds, which close due to an economic event after a decade or less. The two routes by which those strictly focused on liability-duration matching can partake in infrastructure investment are direct investment and investing in debt capital markets. 

Last year, the Canadian Pension Plan and Ontario Teachers reported direct infrastructure yields of over 13% each, with the former allocating $8.6 billion (just over 5% of its total $153 billion under management) to the asset class. That said, both of the above groups spend millions a year maintaining their impressive in-house infrastructure teams, thereby saving on the fees that would be incurred were they to use external managers. But what should smaller funds consider? If a sponsor has a long-term investment horizon and resources to develop in-house expertise, direct investments in infrastructure could be worthwhile. But you have to know what you’re buying. Nearly all infrastructure investment reduces portfolio correlation to some degree, but the nature and development phase of the underlying asset determines many of its other defensive characteristics. These include the dependability and timing of its cash flows, its inflation-linking properties, as well as the potential length of the investment. 

Georg Inderst, an independent adviser who has published whitepapers on infrastructure through the OECD and European Investment Bank, says, “Buying for the purpose of liability matching should tend toward projects in developed markets with less risk. Brownfield projects, in which an asset already exists but needs improvement or expansion, and secondary phase infrastructure, where an asset is fully operational and generating cash flows, are likely more suitable than Greenfield projects that require design and construction, which often come with a J-curve, or negative ROI in early years,” according to Inderst. 

Large economic assets like airports and toll roads often have built-in monopolistic characteristics, and certain infrastructure projects like utilities can offer lower elasticity of demand on the consumption side. In theory, this is well suited to LDI because it translates into stronger income protection during recessions. When possible, investors should seek assets with government concessions or clauses that outline the ability to increase fees to end-users. Andrew Hoffmann, Senior Vice President within Investment Solutions at PIMCO, points out that direct infrastructure investing requires due diligence on a project-to-project basis. “From an asset fundamentals perspective, infrastructure has many attributes that make it an ideal match for institutions with long-term liabilities,” Hoffmann says. “What might be underappreciated by investors is the level of operational, legal, and deal structure complexity that comes with these investments.”  

There is another avenue for infrastructure investment for investors: bonds. Most pensions have always had some exposure to infrastructure through debt securities issued by utility companies, developers, and other related businesses. But as Martin Jaugietis, Head of LDI Solutions with Russell Investments, says, “Infrastructure bonds may become more interesting due to the pending shortage in high-quality corporate bonds in liability hedging portfolios.” Jaugietis sees a similarity in the quality to corporate bond universes used to set discount rates, and potentially low default rates as the main draws for pension interest in infrastructure bonds. 

And the products are definitely on the auction block. In order to meet Basel III’s deleveraging requirements, European banks have been selling project finance loan portfolios at a discount. Mark Weisdorf, CEO of Infrastructure at JP Morgan Asset Management, says, “A number of these [loans] are investment grade and offer 200–300 basis points (bps) above LIBOR (a floating rate), which could be swapped for CPI+400 bps if investors are primarily concerned with inflation.” Furthermore, “their relatively low credit risk makes them a great addition to a blended portfolio with a 7% or 8% liability requirement”. 

High-quality assets offering LIBOR plus 200-300 bps for $0.90 on the dollar is a great deal, but the bonds still need to be considered in the context of an investor’s needs. As Inderst points out, “The chase for yield alone may not be enough justification for accepting infrastructure debt-specific risks. Unlike banks, pensions aren’t so familiar with managing infrastructure loan portfolios.” He says asset managers should consider that a number of infrastructure debt funds contain equity securities and mezzanine capital and have issues related to seniority, transparency, and concentration risk.  

In this space, there are only a few things that can be said for certain. The first is that cash is a defective king. The price-adjusted broad dollar index has lost over a quarter of its value since the mid 1980s. Long-only institutional investors including LDI-focused plans can adapt through more diversification and active investment where appropriate. Infrastructure investment is amply suited to these ends, and many of its forms have excellent liability-matching characteristics. So CIOs take note: a knowledge investment in infrastructure is likely to pay a higher-than-market interest rate. 

Aran Darling