By Reyno Norval
Due to the long-term/international nature of private infrastructure investing there are a number of challenges within the infrastructure market facing investors today.
One challenge is rising asset prices, especially for core brownfield assets. This sector of the market is being seen as a “safe haven,” and the promised yield is viewed as an attractive replacement for low-yielding fixed income securities – though the truth here, to quote Oscar Wilde, is rarely pure and never simple. As a result we have seen capital rushing into the space, bidding up asset prices and likely reducing future returns.
A second challenge is the divergence in expectations of returns that core brownfield infrastructure will provide to a portfolio. Some managers, often unrealistically, project mid-teen internal rates of return (IRRs) and yields of 5%, while more conservative managers target an 8-10% IRR with a similar yield. We believe that investors entering the asset class with an expectation of the higher return profile are likely to be disappointed.
Thirdly, regulatory risk is alive and well in the sector. A recent example is Norway’s proposal to cut tariffs for future Gassled gas transportation contracts by 90%. Gassled is a true regulated monopoly located in oil rich Norway and transporting about one-sixth of the gas consumed in the European Union. Gassled seemed like a “safe” investment with a risk profile that one major firm said “can best be described as a Norwegian government bond”. The firm in question was expected to provide its investors with a 7% pre-tax inflation-linked return. Today, however, the risk/return profile has changed dramatically. Combine this risk with the rising assets prices and one is left with very little downside protection should regulation negatively impact on a project’s revenue stream.
This brings us nicely to the next challenge: determining which geographies provide the optimum risk/return profile for an infrastructure allocation. With few exceptions, emerging markets have not produced returns commensurate with the additional risks involved. Therefore what should the allocation to these markets be? Should there be one at all? Or consider Europe, the so called ‘more developed’ economy, and the uncertainty it has created for investors over the past few years. For example will Greece leave the euro? What is happening politically in Italy and Spain, which for so long looked like a great place to deploy capital in renewable energy generation projects? If the decision is taken by investors to stay away from these regions, the logical thing to happen will be that more capital is deployed to other ‘safer’ economies, pushing up prices and reducing returns, which in turn changes these risk/return profiles.
Another challenge is that infrastructure, excluding energy, is an emerging asset class. Therefore, there is limited historical return series to analyse which, in turn, makes it much more difficult to evaluate managers because of limited operating history and short track records.
Selecting a benchmark for private infrastructure investments is yet another challenge. There are no widely-accepted industry standards. Given that real assets are expected to hedge against inflation, one benchmark that might be appropriate is a premium over an inflation index. A benchmark of CPI+6% or so would require the fund to earn a return of 9%, which is between those expected from fixed income and equities, during periods of average inflation (3% historically). Another potential benchmark is simply the investor’s absolute expected return target. If 12% return is expected, this figure could serve as the fund’s benchmark.
Finally, environmental and social impact could cause a challenge for certain types of investors, especially regarding headline risk. Infrastructure projects planned on greenfield sites could cause environmental degradation, the clearing of forests, or diversion of water flows from their natural path, to mention but a few. The impact on a society can be equally damaging as some residents may be relocated or neighbourhoods disrupted. The uproar in the UK by certain constituencies in relation to the building of high speed rail 2 is one example of this. Objections to infrastructure projects on environmental and social grounds can block or delay matters indefinitely.
Reyno Norval is a senior associate at Altius Associates
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