The Untapped Potential of Infrastructure Investments’ Influence on Humanity
Investments in infrastructure can perpetuate on the advancement of our societies, while providing attractive defensive elements to a portfolio.
Many public pension funds are still healing from the recession more than a decade ago and coping with a weakening funded status that has seen the increase of contributions of taxpayers and millions of American public sector workers to their pension plans. Intrinsically, these funding issues also mean the pension investment teams have launched advanced diversification efforts to prevent the same catastrophic damage from happening again.
While many asset classes provide unique characteristics to institutional investor portfolios, infrastructure investments provide an attractive blend of defensive elements that are perfect for investors with long-term obligations, such as public pension funds. At the same time, ensuring infrastructure maintenance and development needs are met is vital to the health of modern society. Pension capital can play a role in this, so there’s potential for a strong relationship that benefits the lives of millions of beneficiaries and citizens.
Clive Lipshitz, managing partner of Tradewind Interstate Advisors and guest scholar at New York University, explores this topic in his book “Bridging the Gaps,” in which he and co-author Ingo Walter discuss the relationship between infrastructure and institutional investors. They dissect the profound socioeconomic impact a mature harmony could perpetuate on the development and sustenance of our economy and local communities.
The authors discuss what they call a “virtuous circle” to describe a positive feedback loop between infrastructure financing and pension funding, and a “vicious cycle” to describe what happens when things do not work well.
“It is fair to infer a positive correlation between the state of a region’s infrastructure and the vitality of its economy,” Lipshitz says. “If infrastructure leads to job growth and a stronger tax base, that is ultimately good for pension systems … [and] the ultimate guarantor of pension solvency is the taxpayer. Infrastructure investments generate large external benefits that boost incomes to accelerate growth, which in turn reinforces the funding of public employee pensions and enhances the ability of pension systems to meet obligations as well as bolstering taxpayers’ ability to backstop any shortfalls.
“Done right, this encourages a virtuous circle,” Lipshitz said.
By contrast, he describes how regions can be ensnared into what would be called a “vicious cycle,” which is a consequence of inaction on necessary infrastructure.
“If a state or city has underfunded pensions, then they will eventually have to divert tax revenues to make whole those pension gaps,” Lipshitz said. “That means infrastructure won’t get adequate financing. And if infrastructure is underfinanced, that will eventually have a negative impact on the local economy and hence the tax base. This in turn will make it harder to fund the pension gap.”
Despite the potential for either of these spherical societal influences, institutional investors’ fiduciary obligations must be prioritized and, more often than not, that is propelled by portfolio performance. Therefore, it is wise when trying to persuade any institutional investor to embrace an asset class to highlight the benefits it can provide to meeting its portfolio benchmarks.
The Defensive Elements of Infrastructure Investments
Investments in infrastructure offer a host of characteristics that help reinforce the fortitude of an investors’ portfolio and simultaneously generate stable cash flow streams that could assist pension funds with hitting their benchmarks.
Marcus Frampton, chief investment officer of the Alaska Permanent Fund Corporation, and former head of real assets and absolute return, described the many attractive characteristics of infrastructure for his portfolio, and explained why many institutional investors have been slow to embrace the asset class.
In the asset allocations of institutional investors, “I do see infrastructure growing significantly,” Frampton said in an interview with CIO. “Everyone who looks at capital markets expectations at a high level without analytical rigor assumes public equity will return 8% per year, but others that have looked more critically over time at what the predictive variables will tell you in forecasting the next 10-year return in the stock market come to a more somber conclusion. The stock market is clearly very expensive today and all of these factors like cyclically adjusted P/E multiple and current corporate margins versus historical levels suggest that the 10-year return on equities will be 3%-4%, not the 8%-9% that many assume.”
“Then infrastructure looks fantastic in that framework; when APFC looks at private infrastructure transactions, we’re not underwriting them to 4% returns, we’re underwriting them to 11% or 12% returns,” Frampton said.
Lipshitz illustrated the historical performance of infrastructure across the board in “Bridging the Gaps.” The graph below—taken from an MSCI index cited in the book—demonstrates the quarterly returns of private market infrastructure bifurcated between current income and capital return. Lipshitz and Walter write that, “The data strongly support the assertion that infrastructure assets generate stable cash flows. With yield (largely contracted) representing a significant portion of total returns, the asset class constitutes a defensive investment.”
“We also like the real asset inflation protection characteristics. We’re very concerned about the quantitative easing by central banks and other unprecedented central bank policies. Infrastructure is an asset class that should hold up in an inflationary environment, should that come around,” Frampton said.
Jeff Brenner, CEO of IMPACT Community Capital, which has invested over $1 billion in affordable housing on behalf of its institutional investors, shared that the inherent characteristics of its affordable housing investments, which it considers to be infrastructure-like, can be beneficial to the diversification efforts of institutional investors. “The performance of investments in affordable housing can have a lower correlation to more traditional fixed income investments, because while they share many similarities to more traditional fixed income investments, like Treasury bills or corporate debt,” Brenner said, “these investments are less cyclical, and tend to perform throughout cycles, whereas performance of corporate debt can be tied to swings in the economy.”
“Investors would say it provides some yield pickup, lower volatility, and is not highly correlated to their other fixed income investments,” Brenner said. “Most recently, we’ve seen investors begin to show concern about the high levels of corporate debt, and begin to seek other alternatives for fixed income investment opportunities.”
“Bridging the Gaps” investigated the reasons why several different public pension funds adopted infrastructure into their portfolios. Of the 25 largest public pension plans investing in infrastructure, the most common reasons are inflation protection, yield/steady cash flows, diversification, and defensive characteristics. Diversification benefits are evident in the correlation table below, which the authors include in their book (they note several constraints that apply to the index—see the book for details).
In recent years, infrastructure has performed well against other asset classes while maintaining other sought-after benefits, including a low correlation to equities, steady cash flow streams, and inflation protection.
For the Alaska Permanent Fund Corporation, Frampton shared that infrastructure investments have generated healthy returns recently. The sovereign wealth fund’s one-year, three-year, five-year, and since inception investments generated 7.3%, 14.64%, 15.86%, and 11.8%, respectively.
Powerful Asset Class, but Low Allocations?
Why then, have allocations to infrastructure, at least in the United States, seen such slow adoption and growth in the portfolios of institutional investors? Despite data showcasing strong diversification potential, inflation protection, and healthy and predictable returns, investors in many cases do not have an allocation upwards of 3%, with the average across the public pension system being about 1%.
“When you look at how the public funds make asset allocation decisions, it’s sub-optimal,” Frampton said.
“We have a consultant who does an asset allocation study for us, and they’re pretty conservative people. So, when you move into infrastructure or private equity, there’s some resistance to dramatic asset allocation changes, even if they make sense. They’ll show peer plans and say, ‘No one has more than X in infrastructure or private equity.’ They run the optimization models with the variables— the correlation of the asset classes, the expected return of the asset classes, and the expected volatility of the asset class—and infrastructure scores very highly on all of those, to the point where when you run the model, unconstrained, it would say mathematically to have a 30% portfolio in this. The consultants will then constrain private equity and infrastructure to high single digits and low teens allocations and effectively override what the unconstrained math would tell you is optimal.
“There’s just this inertia in our industry, we’re like the opposite of Silicon Valley, regarding our appetite for change,” Frampton said, “and as fiduciaries serving our fund’s stakeholders, we need to resist this bias to the extent possible.”
Despite a slow beginning, those institutional investors with interest in the space have expressed their willingness to continue to engage with the asset class at an increasing pace. The California State Teachers’ Retirement System’s (CalSTRS) Director of Inflation Sensitive Investments Paul Shantic told CIO the characteristics of the asset class are great for supporting the pension’s fiduciary obligations.
“CalSTRS has a growing interest in infrastructure as a long-term investor because infrastructure provides portfolio diversification, positive cash flow characteristics, and considerable downside protection,” Shantic told CIO. “The asset class has continued to gain in popularity among other institutional investors who are looking for further portfolio diversification and income.”
Any growth must be slow and steady, however, as an influx of too much capital into the infrastructure investment industry can cause some imbalances in the economy of the asset class.
“You’ve got to be careful not to have a supply and demand imbalance,” Tradewind’s Lipshitz explained. “The reason infrastructure has drawn so much capital is it’s done very well. But the capital allocation has to grow in concert with the deal flow. If not, it will just drive valuations up.”
“In the long term, there’s lots of potential for infrastructure development,” Lipshitz added. “In the United States and throughout the world, there’s a large infrastructure financing gap. The US muni bond market isn’t going to provide for all financing needs.”
“Certainly, any investment by a pension fund must be evaluated solely from the perspective of what is best for the pension system. The economic benefits of investments in infrastructure—great as they might be—cannot supersede that fiduciary duty,” Lipshitz added.
The below graph illustrates commitments to infrastructure by the country’s 25 largest pension plans.
Until there are ample opportunities to deploy capital in attractive infrastructure investments, a stable pacing plan is helpful to adhere to, so investors only deploy capital to the highest-quality investments.
“We’ve been committing on average about $600 million-$700 million per year in infrastructure,” Alaska’s Frampton said. “I think our pacing is appropriate. If you try to do more, you’re lowering the bar a little bit, because we’ll dot the best $600 million of opportunities a year. If we were to increase to a billion a year, for example, it would be a little bit lower quality on the margin.”
Money Builds Our Society, and Institutional Investors Have A Lot
Institutional investors can have a part in closing the large infrastructure financing gap. Early in President Donald Trump’s administration, the White House issued a list of priority infrastructure projects, but not much action was taken afterwards in regard to their funding. Sourcing billions of dollars for investments can be problematic, but institutional investors, given enough motivation and appetite for defensive investments, could potentially be a major source of capital to fulfill an infrastructure wish list.
“Underfunding of public pensions threatens promises made to beneficiaries and bondholders, fiscal integrity of government entities, and ultimately taxpayers,” note Lipshitz and Walter in “Bridging the Gaps.” “Pension asset allocation to infrastructure projects may hold promise as part of the solution. Meanwhile, underinvestment in the maintenance and development of infrastructure threatens a key element of future US economic growth and depends on large applications of public or private capital.”
Pension funds and other investors may not have the appetite for greenfield risk, however, and this might shy them away from city-scaping the earth in a direct fashion. However, there is a popular way in Australia to circumvent greenfield risk while still helping to build new projects: asset recycling.
Under the asset recycling approach, investors purchase long-term concessions of existing infrastructure projects, and the government takes the new capital to infuse it into new greenfield developments. It’s a great model for investors who only want to purchase assets that have proven, historical data on their cash flow revenues much like any other brownfield transaction, but the greenfield development twist at the end results in much-needed infrastructure projects.
The United States has been slow to adopt this model. The series will investigate why this is the case in the future, but Alaska’s Frampton offered his insight on the lack of popularity of asset recycling in the United States.
“It makes all the sense in the world to do it,” Frampton told CIO. “The cost of capital is lower on brownfield, existing projects. I’m speculating, but I think there’s so much municipal-owned infrastructure in the US, if ownership were more centralized, it might be conducive to smart policy. We may be so decentralized here that it’s an impediment to coordinated strategies like that. If on a federal level, people got together and said, ‘Hey, that model really makes sense,’ it might not be that actionable because so many of these assets are owned by municipalities.”
For such a large, diverse country with thousands of different local government units, finding a federal answer to facilitate any type of asset recycling or one-size-fits-all infrastructure development framework will be challenging.
“It’s a matter of program design and determining the challenges and risks of projects for individual communities,” Shantic told CIO. “While Congress has a role to play, a majority of infrastructure projects in the United States are developed at the state and local governmental levels. Infrastructure development in the United States is a local and regional market and not standardized in terms of project development and cost determination. There are about 89,000 local government units in the United States with different levels of transparency, sophistication, and needs. There is not a model that fits all of these entities in terms of infrastructure development and procurement.”
Even so, the largest influence of infrastructure developments will be had on emerging markets that lack modernized infrastructure. There is a slew of caveats to investing in such regions, such as legal and political instability, but promises of a growing economy, rising income levels, and a steadily increasing population hold promise for stable revenue streams supporting the construction, operation, and maintenance of infrastructure projects.
“When you’re looking at the social impact, it’s those newer areas that need more attention and more capital, where there is a big impact. Because if it’s the United States, and it’s some municipality selling an existing toll road to the highest bidder, it might be a good investment but there’s not a good amount of social impact there,” Frampton said.
Inefficiencies in emerging markets, just like with traditional asset classes, offer pockets of opportunity for investors to exploit and capitalize with developments that far exceed old technology.
“There are countries that are still running diesel-fired power, and if you’re selling into a competitive electricity market, you might be able to do a solar development that generates power at half the cost to you, netting you outsized returns on capital.” he said
Contracted revenue schemes limit the amount of capital an investor would potentially make from infrastructure investments. Promises of economic and population growth do not do much to influence the revenue generation of infrastructure investments, but they do help businesses grow and flourish, benefitting private equity-style investments in those areas.
Regardless, political and legal instability must be tackled in order for investors to flock toward emerging markets regions.
The focus should be on de-risking projects and explaining to the investment community why the government is very stable, and it’s not going to change the tax framework. Argentina is a great example, as it expropriated foreign-owned oil reserves in the country.
Related Stories:
Ontario Teachers’ Next Key Markets: Asia, Europe, and Infrastructure
Los Angeles Explores Direct Infrastructure Investment Strategy for Local Projects
Exclusive: With Five-year Returns Higher than 60%, New CIO Discusses Alaska’s Co-Investment Success