Infrastructure: A Large and Growing Asset Class

Alternative Viewpoints

May 13, 2016

Infrastructure investing is becoming an important focus for many investors looking for assets that can enhance portfolio return, improve diversification, provide a hedge against rising inflation, and, in many cases, deliver current cash flow. Infrastructure is a broad category, and it encompasses a wide array of exposures: from toll roads to hospitals to power plants. Additionally, there are a number of ways to gain access to the sector: senior debt, mezzanine debt, equity, and combinations thereof. Not surprisingly, different types of projects and investment instruments provide different risk and return profiles, degrees of complexity, and levels of liquidity.

The unlisted infrastructure market has been attracting significant amounts of capital in the last few years: $38 billion in 2015 and $39 billion in 2014, and is expected to experience rapid growth in the coming years1. In a 2014 study, Bain & Company estimated2 that infrastructure spending would reach $4 trillion by 2017. This latter figure dwarfs the amount raised for unlisted funds as it includes government spending on infrastructure projects. According to the Bain study, “Globally, the main sectors of infrastructure demand are power & gas utilities, oil & gas, and transportation.”2

In a report published in 2013, McKinsey Global Institute estimated that $57 trillion of global infrastructure investment is required from 2013-20303. Growing economies, primarily in the developing markets, and aging infrastructure in the developed markets is driving the need for significant infrastructure investments.

The estimates from Bain and McKinsey provide some perspective on the size and breadth of the global infrastructure market.

Infrastructure: How It Works

Before turning to how infrastructure investments fit in a portfolio, it is important to understand how the investment works. Infrastructure broadly refers to capital-intensive assets meeting important needs, such as power generation, energy, transportation, or societal infrastructure (i.e., hospitals, housing, prisons, etc.). The concept behind project finance is that the cash flows from the project will be sufficient to pay the debt service and provide a return on the equity.

It is important to understand the source and dependability of the project cash flows. Historically, the cash flows were contractual obligations, but project finance has migrated, and it is not uncommon to see projects that have exposure to the economy, growth projections, or commodities. The following graphic broadly depicts the cash flows of a project finance investment in the power market.

Exhibit 1 is a simple example of project finance, but it is illustrative of some of the vulnerabilities to the investment. Since there is generally no corporate or public entity to rely upon to make up cash short falls, it is important to understand the potential pressure points and vulnerabilities.

There is typically a large capital investment that is required to either build or purchase the infrastructure project. The project is designed to produce cash flow, and those cash flows should be sufficient to cover the operational costs, pay the debt service, and produce a return for the equity holders. Whether it is a toll road, power plant, or housing, there will be revenues and expenses, and the net cash flow needs to cover interest and principal payments.

In “old-school” project finance the cash flows are substantially known and the primary risk is the proper operation of the project. It is more common these days to see project financings that are subject to other risks, such as the health of the economy or the price of natural resources.

One of the benefits of project finance is that the asset being financed often has a useful life that is significantly longer than the term of the financing. Therefore, in situations where the project has problems it is possible to extend the term of the debt and still realize a reasonable return. One of the conclusions of last year’s Moody’s report on project financewas “Ultimate recovery rates for project finance bank loans average 80%. However the most likely ultimate recovery rate was 100% i.e., no economic loss . . .”,, and this is depicted in Exhibit 2.4

Exhibit 2: Distribution of Recovery Rates(BII)

Source: Moody’s Analitics Project Finance Data Consortium

Portfolio Construction: Return, Diversification, Inflation Hedge

It is broadly understood that adding diversifying assets to a portfolio should improve the risk-adjusted return profile of the portfolio. Additionally, the absolute return of the portfolio can be improved through the reallocation of the risk savings. This is the reason portfolio managers actively seek diversifying assets with attractive return profiles. Infrastructure is often an asset class that is held out as a good diversifier – generally it provides a return profile that differs from traditional asset classes and it has offered attractive returns in the past.

The long-term nature of the assets is another factor investors cite for holding infrastructure. Pension plans, insurance companies, endowments, and others are interested in investing in long-duration assets that provide attractive returns, and infrastructure generally fits that bill.

Conversations with investors indicate that concerns about inflation are growing, and investors are more actively seeking assets that provide some level of inflation protection. Inflation sensitivity is a consideration that drives many investors toward infrastructure. Part of the reason that infrastructure can be a good diversifying asset is that it should perform well in inflationary environments (real assets generally increase in value with rising inflation), and the long-term nature of the investment means that the inflation benefit will be in place for an extended period of time. Other inflation sensitive assets, such as TIPS, have significantly lower expected returns.

These characteristics are largely viewed as the primary reasons for the growth in infrastructure investing. The asset class is increasingly attracting new investors who are focused on improving the overall performance of their portfolio.

Infrastructure Investors

The number of new investors in the asset class has increased over recent years. Exhibit 3 from Preqin’s recent report on the infrastructure market shows an increase in both the average current allocation and the average target allocation to infrastructure.

Exhibit 3: Average Current and Target Allocations

Source: Preqin Infrastructure Online

As of the end of last year, the average target allocation among surveyed investors was 5.7%, up from 4.9% in 2011. Some investors have specific allocations to infrastructure, for others it is part of the real asset or private equity allocation, and in many cases it falls into the “other” bucket.

The mix of investors is also interesting. We generally think of pension funds as the investors with an appetite for long-duration investments, but as Exhibit 4 shows, investors across the spectrum are involved in the infrastructure market.

Exhibit 4: Investors Across the Spectrum

Source: Preqin

Reasons cited for the appeal of infrastructure are: the long-investment horizon, stable cash flows, and inflation-hedging characteristics. The low level of interest rates has driven many investors to look to new investment categories in an effort to meet return targets. As shown in the previous chart, pension funds (public and private) account for approximately one-third of infrastructure investors.

The survey found that 74% of investors expected to either increase (48%) or leave unchanged (26%) their capital commitment to the sector in 2016. This is not to say that everyone is increasing allocations to the market. The survey found that 26% of investors were looking to reduce their investments in the category, and surmised that the decline in expected returns in the sector could be the rationale for this planned reduction.

Understanding the Underlying Exposures

There are a large number of asset types that are included in the infrastructure asset class, and it is important to understand the underlying source and dependability of each specific project cash flow. Ideally the cash flows are contractual obligations of credit-worthy counterparties, and the projects are essential and regulated, but in many situations that is not the case. This is especially true of infrastructure projects such as toll roads, bridges, and merchant power plants. For these types of investments there may be a host of exposures that are not immediately obvious, such as the health of the national or regional economy, or, as we have seen recently, the level of commodity prices.

It is desirable to invest in projects that provide essential services that cannot be accessed through other means, i.e., inelastic demand. If a highway project is dependent on tolls to cover debt service then you should be wary if there are less expensive, easily accessible alternatives. Drivers may be willing to pay the toll during good times, but may opt for the more time-consuming, less expensive route during the down times. Additionally, there will likely be fewer drivers on the road when the economy stumbles. In fact, it isn’t just a decline in traffic, but traffic that is below projections. As we’ve seen a number of times, the projections may be overly optimistic, and this is especially true for uncontracted greenfield projects.

If the project relies on economic growth or stability, then the exposure may have risks similar to an equity portfolio. For example, an equity or debt investment in a project may be dependent on specific levels of activity in order to meet its debt service payments and provide the equity investors with the desired return. A slowing of the general or regional economy could result in less traffic and therefore have a negative impact on the investment. It is important to understand these exposures.

Toll Roads

There are numerous examples of toll road defaults. One that is often mentioned is the Indiana Toll Road (I-90), a 157-mile highway that runs across northern Indiana. ITR Concession Co. LLC, which bought the right to operate the highway for 75-years in 2006, filed for bankruptcy protection in 2014 with more than $6 billion in debt. The project did not generate sufficient cash flow to service the debt, and the company’s CEO pointed the finger at the global recession. Traffic volume fell significantly since the 2006 investment, and even with higher toll rates, the revenues were not sufficient to cover debt service. The project was sold for $5.7 billion to an Australian consortium in 2015.

Exhibit 5 demonstrates the relationship between miles driven and the health of the economy. The chart represents a national view, but toll roads are regional. Therefore, even a slowdown in a specific region can have a negative impact.

Exhibit 5: Moving 12-Month Total on ALL Roads

Source: Federal Highway Administration, Office of Highway Policy Informtion

Of course, there can be problems even if the economy is resilient. A recent example is highway SH130 near Austin, Texas. A section of the highway was constructed as part of a private-public partnership (PPP). The 41-mile stretch of road is known for having the highest posted speed limit in the country, yet that was not sufficient to entice enough drivers to use the road. The highway did not experience the level of traffic that had been projected, and SR 130 Concession Co filed for bankruptcy protection in March 2016 – just four years after the roadway opened. It does not appear that the blame can be attributed to an oil & gas-led economic slowdown because the project was downgraded by Moody’s in 2013, well before energy prices started to plummet and only a year after the roadway was opened.

These examples make clear the importance of understanding the performance drivers of an infrastructure project. In the case of toll roads, poor projections, an economic collapse, or a change in fuel prices5 can impact the outcome of the investment. This caution is also true for other infrastructure projects especially as market moves away from the contracted cash flow model.

Power Plants: Contracted vs. Merchant

As highlighted earlier, it is important to understand the risks associated with infrastructure investments relative to other risks in the portfolio. This is especially important if the reason for investing in infrastructure is diversification.

Merchant power plants provide current examples of the importance of understanding the exposure in project financings. Merchant power plants generally do not have power off-take contracts – they receive the market price for electricity, and they pay the market price for fuel.

In February, Moody’s released a report addressing the impact of the fall in natural gas prices on merchant power plants. Projects without power purchase agreements (PPA) suffered as a result of the fall in natural gas prices and subsequent fall in the price of electricity. The Moody’s report concludes that “Unregulated merchant power projects that rely heavily on energy margins for cash flow to make debt-service are most at risk, especially those in Texas and California because, unlike power projects in other markets, they do not receive capacity revenue.”6 So investors who invested in this type of infrastructure may not find the diversification they were seeking if they had other investments in related commodities.

In a portfolio context, the strategy of using infrastructure (in the form of merchant power plants) as a diversifier may actually compound the risk if the fund also uses commodities as a diversifier. In this instance, instead of being a diversifying investment, the exposure to infrastructure would have been additive to the portfolio’s risk and could accelerate a drawdown.

In the report, Moody’s mentioned that fully contracted projects were not completely immune to low commodity prices. Moody’s concern was with the impact that the fall in natural gas prices could potentially have on the counterparties to the off-take contracts. While this may be true, a contracted project will still be less exposed to commodity pricing than will a merchant project.

Rising Valuations

While infrastructure is relatively new to some investors, many sovereign wealth funds have been large players in the sector for quite some time. They understood the portfolio benefits of the asset class: return, diversification, inflation sensitivity, and long-duration. Furthermore, they saw the ability to invest large sums of capital in single projects.

These advantages have not been lost on other large global investors, and this has resulted in an influx of capital to the sector and in some cases a bidding war for assets. This inflow of capital drove up prices over the past few years, especially in the large project area. However, in early 2016 it was reported that several of Canada’s large pension funds were passing on some large global infrastructure investments which may indicate that pricing discipline has again returned to the market signaling a return to investment opportunities.

In addition, we continue to see value in certain sectors of the market, specifically in middle-market projects that are too small to be attractive to the larger investors in the market.


Investors are actively seeking investments that enable them to improve the return profile on their portfolio, and for an increasing number of investors infrastructure looks appealing. In addition to returns, many investors are attracted to the diversification, long-duration, current cash flow and inflation sensitivity available in the asset class. It generally appeals to investors who can handle the illiquidity of the investment and are looking for longer-term investments, such as pension funds, insurance companies, foundations, and endowments.

1 Preqin

2 Bain & Company study, February 4, 2014

3 “Infrastructure Productivity: How to save $1 trillion a year”, McKinsey Global Institute, January 2013.

4 Moody’s Investor Service, Default and Recovery Rates for Project Finance Bank Loans, 1983-2014, March 17, 2016.

5 Michael Sivak, University of Michigan Transportation Research Institute, “Cheap Gas is a Thrill”, New York Times, December 11, 2015

6 Moody’s Investor Service, “North American Project Finance Issuers Are Vulnerable to Weak Commodity Cycle”, February 29, 2016

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