Understanding infrastructure investments
Kirsty Mackay-Fisher - Analyst - Investments - Berkley Group
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What are infrastructure investments?

There are various definitions of what constitutes infrastructure, but generally infrastructure refers to the large-scale public systems, services, and facilities of a country or region that are necessary for economic activity. The sector tends to be separated into two broad subsets - economic and social. Economic infrastructure includes highways, water and sewerage facilities, and energy distribution and telecommunication networks whereas social infrastructure encompasses schools, universities, hospitals, public housing and prisons.

Infrastructure assets are generally characterised by high development costs (high barriers to entry) and long lives. They are generally managed and financed on a long-term basis. Historically it was seen as the role of the government to fund and manage these assets for the good of the population. Today, the role of the government as the provider of public services is increasingly being questioned both in terms of the absolute cost to taxpayers and as to whether a government can deliver the assets as efficiently as a private company competing for the privilege. From the government's perspective there is a strong case for privatisation, where the debt raised by the private partner remains on their balance sheets, not on that of the Treasury's. These factors have resulted in a gradual migration from the public provision of infrastructure to the private sector. The private provision of these assets may take many forms from joint ventures, concessions and franchises through to straight delivery contracts. Essentially the private sector is being brought in to design, build, finance and/or maintain public sector assets in return for long term contracted payments from the government or access to the revenues generated from the asset.

The privatisation of infrastructure assets has created a large number of investment opportunities for astute private investors.

What distinguishes infrastructure from more traditional equity or debt investments?

Infrastructure assets display a number of characteristics that distinguish them from more traditional equity or debt investments. The assets themselves tend to be single purpose in nature, such as a gas pipeline, tollroad or hospital. The private investors' participation in the asset is often for a finite period. This is generally a function of the agreement the investor has made with the governmental authority, such as tollroads which are generally handed back to the government after a pre defined period of time (the end of the concession), or a function of the natural useful life of the asset. In either case, infrastructure assets are characterised by their long lives. In fact the capital invested in these projects is often referred to as patient capital, in that the initial development involves high upfront capital costs with payback occurring over the assets generally lengthy life.

Finally, one of the key characteristics of infrastructure assets, and what can make them particularly attractive as investments, is that they tend to be, or exhibit the characteristics of, natural monopolies.

Briefly, a natural monopoly is the provision of a good or a service for which there are large economies of scale, where the initial capital cost is large, but whose marginal cost of production is low. For example, the costs of re-building Telstra copper network would be enormous, yet the cost to Telstra of you placing a single local call is negligible. Under a natural monopoly, economies of scale are such that the unit cost of a product will be minimised only if a single firm produces the entire industry output. This environment has the potential to weaken market forces, especially when there are few, if any, alternative suppliers of the infrastructure. In this case, firms operating in a natural monopoly, protected from new competitors by the high barriers to entry, may be able to earn abnormal profits by charging higher prices. Whilst this may be attractive to a potential investor in infrastructure, clearly this is not in the best interests of the general public.

As a result of these monopolistic characteristics, infrastructure assets tend to be subject to varying degrees of government regulation, depending largely on the degree of natural monopoly. This is not necessarily to the detriment of investors in infrastructure, as it provides a level of surety regarding the income streams that will likely flow from the asset.

What are the risks?

The risks of an investment in infrastructure may be generally divided into those specific to the infrastructure asset and those affecting the broader asset class. The asset specific risks encompass risks pertaining to the design, construction and operation of the infrastructure asset. The asset class risks include market/economic risk and regulatory and political risk.

The asset specific risks will largely depend on the maturity of the asset. For example, in the construction phase, there is considerable risk associated with the construction process. Will the construction be on time and on budget and if not what compensation will the builder pay? Importantly, a key feature of infrastructure assets is that as an asset matures its risk profile declines and valuation increases, all other things remaining equal.

Of the more generic risks affecting the infrastructure asset class, perhaps the most pertinent is interest rate risk. The prevailing level of interest rates can have an impact on the discount rates applied to the valuation of infrastructure investments, and on the debt portion of the investment structure; such that as interest rates rise, the valuation of an infrastructure investment will generally fall. This is generally a short-term phenomenon. Over the medium to longer-term, this initial fall in value is mitigated as revenue from the underlying asset grows. Generally, revenue increases are derived from CPI linked pricing increases (CPI generally increases in a higher growth environment) and the volume increases that occur in a growing economy.

Where does an investment in infrastructure sit within my investment portfolio?

Although infrastructure assets vary in terms of the level of regulation they face, this regulation generally results in income streams that exhibit low growth. To compensate investors for this, infrastructure investments tend to be higher yielding than equity investments. In terms of capital values, this stable, high yield results in infrastructure assets displaying a lower level of price volatility than equity investments over the longer term. It also acts as a support to the price of infrastructure assets in periods of poor returns in the broader equity market. As such, infrastructure is often referred to as a 'defensive' asset, that being an asset that should provide a steady return throughout the economic/investment cycle.

Forecast returns from individual infrastructure investments vary depending on the characteristics of the underlying asset, its maturity, risk and taxation treatment; taken in the context of the prevailing macro environment. It is difficult to comment on the level of expected returns of the infrastructure sector as a whole. Especially given the Australian regulatory environment is relatively immature and there has been a clear trend toward increased competition in some segments.

Over the longer term, as industry structures and regulatory regimes mature, the listed infrastructure sector will most likely behave like a hybrid between an equity and a bond, similar to that of a listed property trust - although the ultimate drivers of infrastructure returns are different to that of property and as such the two sectors will not exhibit the same performance. This poses difficulties for investors, in that unlike listed property, there is not sufficient historical data on the sector to establish correlations so that it may be included within portfolios as a separate asset class. As such infrastructure is generally included within a portfolio's allocation toward equities.

The investment decision to allocate funds toward infrastructure is further complicated by the variation in the individual infrastructure projects available for investment. This does, however, enable investors to tailor their exposure to the sector by selecting infrastructure assets that best meet their requirements. Infrastructure assets in the earlier stages of construction will generally exhibit larger amounts of risk, higher potential growth and lower yields and so may be better suited to younger or more risk tolerant investors. More mature infrastructure investments tend to display lower growth and very high yields, which may be preferred by investors seeking a stable income over time, such as a retiree.

Investment in infrastructure has traditionally been the domain of large corporates and consortia. However, with the rapid increase in the number of listed infrastructure investments since the mid-1990's, infrastructure assets are becoming much more widely held by retail investors who are attracted by the sectors defensive characteristics. The infrastructure sectors relatively low correlation with more traditional equity investments, also means that their addition to an equity portfolio will aid in diversification.

* The information contained and accessed on this page is provided for general guidance and is intended to offer the user general information of interest only. The information provided is not intended to replace or serve as substitute for any accounting, tax or other professional advice, consultation or service. Based on specific facts or circumstances, the application of laws and regulations may vary.


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