Chancellor Philip Hammond’s Autumn Statement announcement of a new £23bn National Productivity Investment Fund, which will invest in infrastructure and housing, has sparked renewed interest among investors for infrastructure – now the buzzword of the moment. The Chancellor also alluded to a ‘potential future role’ for the private sector in public infrastructure projects.
Is this all political hype and spin, or could it be a game-changer for the sector? What role does infrastructure play in traditional pension fund and institutional real estate investor portfolios currently and how can we expect it to evolve? What are the attractions and risks of the sector to long-term institutional investors?
According to the 2016 Preqin Global Infrastructure Report, the majority of pension funds and institutional investors have current allocations to real estate of between 5% and 15% of total assets globally, while infrastructure exposure is somewhat lower, averaging 3.9% of assets. While infrastructure globally saw 661 deals worth $349bn in 2015, some 52% of institutional investors are planning to increase allocations.
While some investors have historically considered infrastructure as a separate asset class to real estate, others have grouped it under the umbrella of ‘alternatives,’ ‘private equity’ or ‘real assets.’ However, the boundaries have become increasingly blurred over the last few years, with many large pension funds, institutions and insurance companies setting up ‘real asset’ departments. These teams work together collaboratively on large real estate-related infrastructure projects and investments, as well as more traditional real estate.
Since infrastructure is not a homogenous asset class, defining it can also be a challenge, which is where the boundaries between traditional real estate and infrastructure assets can become blurred. While there are many different definitions, as it means different things to different users, a useful definition from the World Economic Forum explains that “infrastructure typically refers to the physical structures – roads, bridges, airports, electrical grids, schools, hospitals – that are essential for a society to function and an economy to operate.”
Beyond the current hype, here are five compelling reasons why pension funds and other institutional investors should be looking to invest in infrastructure in the UK over the long term:
Like most western governments, the UK government has massively underinvested in public infrastructure over the last 25 years. As a result of fiscal austerity measures since 2010, combined with weaker expected economic growth forecasts and lower tax revenues following the Brexit result, the government now faces approximately £58bn of additional borrowing by 2020/2021, causing total public net debt to rise from 84% to 90% of GDP. In order to deliver the promise of finding an additional £23bn for new infrastructure investment, against a background of deteriorating public finances, the Treasury needs to find alternative ways of accessing finance to fund new infrastructure developments – providing potential opportunities for the private sector to get involved.
The UK population is forecast to increase to 70 million by 2027, according to the Office for National Statistics. Our country’s ailing infrastructure and public service assets, such as those owned by the NHS, need to be upgraded and invested in, in order to meet the increasing demands of a growing, as well as an ageing, population. The private sector can provide some of the finance to help plug the deficit and also respond to a social need.
Assets backed by the government or local authorities have strong covenants, offering long-leased and more secure inflation-hedged income characteristics than traditional real estate assets. For these reasons, they have good asset liability matching characteristics for long-term investors and pension funds in a low bond yield and low-growth environment.
Infrastructure assets tend to be more defensive and less correlated to economic cycles than traditional real estate assets, such as offices and retail. While infrastructure covers a wide range of assets, with individual underlying economic drivers, performance tends to be more stable and less-correlated than demand assets such as equities. It is therefore a good diversifier in a mixed asset portfolio.
Investing in infrastructure requires scale and expertise; however, there are high barriers to entry – such as a lack of transparency and availability of historical performance and comparable benchmark data. Large institutional investors have the potential and scale to access and understand the market well, providing an edge over smaller investors.
As demand for infrastructure investments among investors has increased, along with the availability of debt financing, the market has begun to mature – putting upward pressure on pricing. It is now possible for investors to access the full spectrum of risk profiles, investment styles, structures and financing options – depending on investment objectives, strategy and appetite for risk. This could be debt financing, investing directly, or in unlisted or listed funds. These offer varying degrees of control and liquidity depending on the level of public/private ownership, as well as the management and operational involvement of the different players.
Investment risk can also vary. Low-risk options tend to be associated with a regulated infrastructure environment and are characterised by a solid income yield, while medium-risk is associated with income and capital contributions. The highest risk targets capital growth as the key driver, which could come from taking higher development or location risk, for instance. The stylised diagram below shows the risk/reward characteristics of core, value add and opportunistic infrastructure investments, compared to the other asset classes.
Chart 1 Risk/reward space for infrastructure
Source: MSCI November 2014.
For a traditional insurance company, pension fund or institutional asset manager, providing senior debt financing to public sector authorities or directly investing in the core low-risk infrastructure space in a regulated environment represents a good, risk-adjusted investment opportunity to match long-term liabilities. Canada Life Investments has a solid track record of acquiring and funding investments with local authorities and public sector bodies – which includes car parks, medical facilities, a library, a water treatment centre and most recently a ferry terminal. We are also committed to working in partnership with local authorities and public sector bodies in the future to further grow this business.
For example, we recently acquired the freehold interest in a former hospital site in South Manchester and will fund the development of a new medical and retail centre. Upon completion, this will be leased to NHS Property Services for 30 years at a rent subject to annual increases to retail prices index (RPI). The advantages of this finance lease transaction for Canada Life Investments are the solid covenant strength of the tenant, backed by the government and a 30-year lease commitment with annual rental indexation. From the tenant’s point of view, it avoids the need to fund their own development from the public purse, leaving them in management control of the building, unlike private finance initiative (PFI) schemes. They also have an option of buying the freehold for only £1 upon expiry of the lease term.
While the Chancellor’s recent announcement in the Autumn Statement about creating a new innovation and infrastructure fund is not likely to be a game-changer, it has provided some positive signals about the government’s willingness to boost the economy by investing in the upgrading of our country’s infrastructure. It also shows the government’s desire to work with private industry to achieve this. It should provide a further impetus for institutional investors to work in partnership with the public sector and increase allocations to infrastructure for the long term.
The value of investments may fall as well as rise and investors may not get back the amount invested.
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