Is the smart money on investing in infrastructure?
- 3 May 2012
Last week, a massive Canadian retirement scheme joined up with a consortium of Japanese pension funds and banks to set up a $20bn infrastructure fund that will invest in major projects such as airports and roads.
The fund joins the growing infrastructure trend – pension managers like the security of long term, usually inflation-linked, returns that are in excess of bond yields – but here the almost unique selling proposition is that the assets will be controlled internally, cutting out expensive intermediary layers. Infrastructure funds have traditionally been sponsored by investment banks, private equity firms and other asset managers.
Ontario Municipal Employees Retirement System (OMERS) has committed $7.5 billion together with Japan's Pension Fund Association and a consortium led by Mitsubishi Corporation, Japan's largest trading house, toward the new fund.
A drop in the ocean
But this is a mere drop in the ocean – estimates from pensions consultants Mercers, which has recently geared up its infrastructure team, suggest that the percentage of pension fund assets devoted to longer-term infrastructure projects will rise more than five-fold over the next decade from some 2 per cent of funds to as much as 15 per cent of assets.
New Mercers signing Toby Buscombe said: "The current investment landscape is an exciting one for long term investors such as pension funds, and these investors are likely to have a greater role to play in the provision of finance to new projects, an area where we hope to be able to provide them with assistance and advice."
Rival consultants Towers Watson come up with similar figures – talking of $3.5trn.
And that again is small-scale compared with the Organisation for Economic Co-operation and Development''s that $53 trn, equivalent to an annual 2.5 percent of global gross domestic product, will be needed to meet demand for roads, hospitals, railways and telecoms systems over the coming decades.
Infrastructure has become a fast growing asset class in the last decade. The lower returns than equities or property have their compensation in stable cash flows, generally hedged against inflation and are underpinned by physical assets such as roads and pipelines. It appeals to pension and other long term funds which need to match liabilities to assets.
It's large-scale public systems, services, and facilities of a country or region that are necessary for economic activity, including those which have often been provided by government.
Economic infrastructure includes highways, water and sewerage facilities, and energy distribution and telecommunication networks whereas social infrastructure stakes in education, hospitals, public housing and prisons. The UK has seen a number of projects in student and other housing.
These projects have huge upfront costs and are often natural monopolies – you can only have one fast rail line between two cities so returns are usually regulated. Investors expect to see cash flowing for 30 or more years.
What distinguishes in infrastructure from more traditional equity or debt investments?
Infrastructure investors expect to invest in a single asset – like property but unlike real estate, those putting their money up do so for a set time with assets often reverting to the state (in some form). After 30 years, for instance, university housing becomes the property of the university in many schemes. Unlike bonds, there is always a real asset and unlike equities, the risk of prices rising or falling should not exist.
No investment is risk-free.
Here's some potential problems
- The asset does not last as long as planned. The bridge falls down. The hospital becomes obsolete or drivers stop using the road. Insurance can help.
- Political difficulties – the government decides to nationalise the asset, cuts the returns, increases the costs or imposes new regulations.
- Interest rate risk – investors will often borrow to buy into projects, sometimes highly geared. If rates move against the investor, the return is lower. It may be possible to hedge.
- Lack of marketability – there is no easy way for investors to sell on to others.
Infrastructure investment is for the patient. The returns are slow and relatively secure but need not be low, certainly not as low as present bond yields or equity dividends although capital growth is not generally on the agenda. These are defensive assets, with steady payments through economic cycles, and are not correlated with other asset classes.
So where is the bubble?
If the growth predictions are correct, then there could be too much money chasing too few assets. This could be especially so if returns on equities and bonds remain low. And because there is no active market in infrastructure stakes, it can be difficult to work out exactly when the price is wrong. There is a lack of expertise in many fund management groups so they may be reliant on the same bullish consultants and bankers.
And there could be solvency problems for pension funds, according to bond ratings agency Fitch.
It has warned that "the future ability of insurance firms to invest in infrastructure projects is likely to depend on whether they use internal models to determine their Solvency II capital requirements, and can persuade regulators that infrastructure investment merits lower capital reserves." Solvency II is a European Union directive.
According to Fitch, infrastructure investments can be suited to insurers because their cash flow features and long duration are a good match for insurers' long-term liabilities.
"However," it warns "these investments are treated penally under current proposals for the stan
dard formula, and the high capital charges mean that the risk-adjusted returns would be relatively low."
"Every infrastructure project is different and risk can vary significantly between projects," Fitch added.
Green, investment and bank in one phase
Meanwhile, in the UK, the yet to be launched Green Investment Bank has already had £180m pledged for green infrastructure, starting withwaste projects.
The bank is being established to "tackle risk that the market cannot adequately finance" in order to quicken the UK's transition to a low carbon economy. It will invest up to 80 per cent of its £3 billion budget over the first three years in five priorities areas – offshore wind, commercial and industrial waste and recycling, energy from waste, and non-domestic energy efficiency.
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