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Infrastructure as an «independent» class of investment:
A chimera

Dr. Roman von Ah

Dr. Roman von Ah


Economics Financial Markets

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Low or negative interest rates favored private market investments. High returns, low risks and correlations, so the mantra went. With a time lag, infrastructure investments emerged, with similar arguments in favor. Are the expectations realistic? 

Low or negative interest rates favored private market investments. High returns, low risks and correlations, so the mantra went. With a time lag, infrastructure investments emerged, with similar arguments in favor. Are the expectations realistic? 

The following table compares private market investments with traditional investments, also referred to here as public investments.

Large investors such as sovereign wealth funds and government agencies can invest directly in infrastructure. The barriers to entry are high. The majority (insurance companies, banks, public and private pension funds) invest via closed-end infrastructure funds managed by general partners (GP). There are also listed and open-end infrastructure funds.

Between 2008 and 2019, infrastructure funds grew from 59 billion to 486 billion dollars. Three types of transaction can be distinguished: “greenfield” (1/5), “brownfield” (almost 1/10) and “secondary stage” (the vast majority).

Greenfield investments are made in the construction of new facilities. Brownfield investments are made in the expansion of existing revenue-generating facilities. Secondary stage investments are cash-flow-generating infrastructure investments that do not require any capital expenditure. Greenfield and brownfield investments are riskier and do not generate distributions in the early years. Three-quarters of investor deals are secondary transactions.

Motivation for infrastructure investments

The attractive narrative of a new asset class with low economic dependency, low volatility, low correlation with equity markets and long-lasting, inflation-linked cash flows dominates.
Infrastructure investments have created their own ecosystem: investment banks receive buy-side and sell-side transfer fees, lawyers specialize in transactions and fundraising. Valuation service providers support due diligence. A “gatekeeping” industry acts as an intermediary between clients and investors. All with a significant interest in maintaining the status quo of the multi-billion-dollar industry. Even regulators favor infrastructure over other private market investments. [1]

Infrastructure sectors: an overview

Renewable energies: wind, solar, water, biomass, geothermal
Traditional energy: coal, nuclear, pipelines, refineries, storage facilities
Transportation: toll roads, parking and service areas, tunnels, bridges, railways and rolling stock, airports, airplanes, seaports, transport ships, logistics 
Social infrastructure: hospitals, medical facilities, retirement homes, student halls of residence, training centers, public buildings, prisons, defense facilities, police stations
Utilities: water treatment, distribution, power distribution, sewage treatment, sewerage, waste management
Telecom: Mobile and fixed-line telephone systems, wireless internet, cable television, satellite network
Various infrastructure projects

But do the returns generated match the sales arguments for private market infrastructure investments?

Scientific answers are rare. They mostly exist for private equity investments, of which infrastructure is a part, and stand in stark contrast to the mantra-like narrative. The high-quality study by Andonov et al. (2021) [2] is enlightening. The broad sample with a focus on the US shows that large sovereign wealth funds and government agencies sometimes invest directly; the majority of institutional investors invest in closed-end infrastructure funds. Direct investment (ownership, long-term leases) is thus a small part of institutional infrastructure; it performs somewhat better in terms of stability and long-term returns and has more predictable cash flows. The barriers to entry are high, including significant capital requirements, in addition to the need for expensive specialized expertise. The potential for stability and inflation protection is debatable, but remains an open question empirically. [3]

Despite a long-term horizon and the expectation of stable cash flows, investments are made in closed-end infrastructure funds with limited holding periods, which dominate institutional investments at 75%. The majority of these investments do not deliver the expected stable, long-term returns. Volatility and cyclicality are similar to private equity, performance persistence in the top quartile is lacking and performance also depends on a quick exit.

The synchronization with private equity and the poorer return characteristics of infrastructure contradict the expectations that have been fueled. Even in heavily regulated industries with long concession agreements, the business model of closed-end funds is not expedient (meeting the return requirements of the general partner, optimizing the internal rate of return; IRR) (see second table).

Over the past 20 years, no separate asset class that offers real diversification from ÖMI has emerged for private equity or, even less so, for infrastructure investments. The latter have never lived up to initial expectations. Private equity was able to fulfill at least some of these expectations in the 1990s, but has lost this advantage since 2008, when corresponding investments became increasingly fashionable. Andrew Ang's dictum “Private equity is not an asset class” [4] could thus be expanded to: “Private equity and infrastructure are not asset classes. The latter even less than the first.”

Public vs. private institutional investors

Public institutional investors in particular increased their infrastructure exposure in closed-end funds. They underperform private institutional investors. Strong environmental, social and governance (ESG) preferences or regulatory pressure (Paris Alignment, UNPRI, etc.) account for 25% to 40% of the increased allocation and contribute 30% to the poorer performance.

Infrastructure can be associated with societal benefits. The implicit assumption of non-financial objectives contributes to the underperformance of public investors and comes at a high price: an estimated USD 5 billion p.a. goes either to the underlying infrastructure assets as a transfer of value or to the managing general partners in the form of fees. These costs are paid by taxpayers or pensioners, or both.

Table of performance figures

This text was published under the title "Infrastructure as an «independent» asset class: a chimera” in the professional journal   "Schweizer Personalvorsorge / Prévoyance Professionnelle Suisse"  September 2024 issue (german only).

 

[1] : An amendment to the BVV2 in 2020 brought a more favorable regulatory treatment. Previously, infrastructure was considered an alternative investment; according to Art. 53 para. 4 BVV 2, it had to be diversified and invested collectively. New: separate quota, direct investments possible with appropriate diversification; no financing through debt capital.
[2] : Andonov, Aleksandar; Kräussl, Roman; Rauh, Joshua: Institutional Investors and Infrastructure Investing, The Review of Financial Studies 34 (2021), 3880–3934.
[3] : The case study “Low Tide – Benchmarking Risks in Infrastructure Investments. What the data showed about Thames Water”; EDHEC, December 2023, shows what can go wrong in infrastructure, including political influence. The monopoly activity “water and sanitation” on one of the most famous rivers led to billions in losses.
[4] : Ang, Andrew: Private Equity Is Not an Asset Class, in: «Asset Management – A Systematic Approach to Factor Investing», S. 592, 2014.

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