Infrastructure Investor (II): From your vantage point as a fund administrator specialising in alternatives, what impact has COVID-19 had on the attractiveness of infrastructure assets?
Simon Burgess (SB): A number of solid alternative investment strategies have been rocked by the pandemic and the uncertainty around how long it will last, particularly those investing in retail and leisure businesses and associated real estate investments. Many mainstream private equity and private equity real estate strategies have been dented to some degree.
For infrastructure GPs and LPs, however, COVID-19 has presented an interesting opportunity. One significant trend supporting investment into the asset class is that economies globally are experiencing ultra-low interest rates. Governments have been purchasing bonds and creating a lot of cheap money, and the expectation is that the cost of borrowing will remain low for the foreseeable future. That's interesting for promoters seeking finance for infrastructure projects which require predictable interest rates over an extended period. This characteristic matches the needs of the investment class.
From an investor perspective, we have seen many sovereign wealth fund (SWF) and state pension funds materially increase their allocation to infrastructure over many years to generate a return that matches their own liabilities. For those currently facing an asset/liability mismatch exacerbated by COVID-19, infrastructure serves their requirement for investing in an asset class that provides a predictable income over a longer-term period. For example, investing in a toll road is a 30- to 50-year play, which matches these funds' investment horizons, compared to investing in a real estate fund, for example, that tends to operate over a five- to nine-year lifespan.
II: But many infrastructure strategies have been seriously undercut by the pandemic. How are LPs chasing a long-term return approaching that risk?
SB: Big funds are able to look at the widest risk spectrum and identify strategies to diversify away from higher risk concentration. Buying one type of asset doesn't protect you from risk because you don't have any diversification. One option for a SWF or pension fund is to build a portfolio of directly held investments across a range of infrastructure assets, businesses and/or real estate. A portfolio of an airport, a fuel container operation, a hospital, solar park and toll roads, for instance, includes different risk profiles. Or as an LP, your option is to invest into a blind pool managed by a third-party fund manager. At that level, I think we will see managers develop new fund propositions that target certain sectors within infrastructure rather than a blind pool investing across a range of asset types. It's a challenge for LPs to ensure they get the right blend.
II: Why is that difficult?
SB: Within the asset class there is a clear need for an enhanced classification system to accurately profile infrastructure investment risk. The use of industrialisation classifications or real estate comparisons doesn't quite hit the mark for infrastructure. The Infrastructure Company Classification Standard is an attempt to rectify the situation by standardising the classification of infrastructure investments and risks with the goal of assisting investors to understand the relative risk profile of one type of asset versus another. It covers four key areas: business risk; industrial classification risk; geo-economic – meaning local, national and international – risk; and governance of the investment.
II: As a service provider, how do you help your clients manage risk?
SB: The key area for us is managing corporate governance and independence of key activities. We scrutinise how the fund is governed and managed, and take responsibility to ensure it is operating in accordance with its objectives and the constitutional documentation that regulates the fund. Our role in striking the NAV also provides an independence that investors value.
We've also been working in the alternatives space for many decades and have specific asset class experience. This helps when our senior team members sit on the board of the fund and/or the underlying asset holding companies, whether they are directly or indirectly held. Investors like it, knowing they have directors with relevant expertise and fund managers like it because it makes the fund operationally easier to run.
II: What are key operational and reporting challenges?
SB: In infrastructure, valuations can be complicated beasts. In a real estate investment, you can measure the income flow from an asset or property and compare it with similar buildings sold in the market, make adjustments for specific differences, apply a yield and generate a capital value. A private equity business typically applies a multiple of its EBITDA to arrive at a capital value. In infrastructure, understanding the different approaches of valuation techniques is increasingly important. Asset valuers typically use discounted cash flow methodology. This requires them to examine in much greater depth the data they use to calculate the net present value of the future income to form their opinion of capital value. They also need to review the approach they take because the projected income flow and yields may vary considerably over time.
II: Has it become more complicated in the current COVID-19 environment to collect the data?
SB: Not so much complicated, but uncertain. We are seeing more valuations for infrastructure and other alternative assets cross our desks with material uncertainty clauses attached. The capital value of an asset today, say an airport, is determined by its future income flows. How do you calculate that when you don't know how long COVID-19 will continue to affect flights for? If we knew the pandemic would definitely last two years, an airport could anticipate limited income from landing fees for that period of time and then generating income in perpetuity after that, which could be capitalised and brought forward. But it can't. And that uncertainty is reflected in valuations.
II: What's your involvement in valuation disclosures?
SB: As directors on the board of the fund we are ultimately responsible for determining the value of the assets. To support this process, directors rely on third-party valuers which the directors then review and scrutinise. Although they prepare the figures and give their opinion, we need to be alive to market pressures. Infrastructure assets have been impacted by the pandemic no doubt, but not all sectors have been hit at the same level. Some assets, like certain ports, have not been so adversely affected. Solar parks and energy are still in demand. Toll roads are still generating some, albeit reduced revenue. Government-backed projects are probably the most secure.
II: Are managers changing the way they structure their funds in response to COVID-19 and the new investment circumstances it has created?
SB: It's probably a little too early to draw conclusions. I wouldn't say they are altering their preferred fund structures, but certainly more managers are looking to raise funds in response to increasing interest from institutional investors to allocate more capital to infrastructure. I think the typical 3-5 percent portfolio allocation to infrastructure from those institutions is likely to increase. However, focus will be on price and identifying if price bubbles are growing in certain sectors. With increased investor appetite for certain assets, we should see capital value enhancement, which of course is interesting to those managers that want to sell.
II: Are you seeing new pools of investors from different geographies and do they have different requirements?
SB: One of the most interesting markets at the moment is the UK. It's significant in size and range of assets. Pre-COVID-19, the UK government announced a number of new infrastructure projects, including a consultation on freeports, or trading hubs with their own tariffs, customs and tax rules. Establishing those would require a lot of investment and would need private capital to develop. Investors from China, Malaysia and South Korea, interested in safe markets that they know and understand, would find those sorts of assets attractive. South East Asia generally is an area where there is a lot of capital flow and we'll see more capital from that investor base targeting European markets too.
Africa is also an interesting space for infrastructure investment although with a different risk profile. We have seen a growth in activity focused there especially through our funds business based in Mauritius.
Originally published in Infrastructure Investor on 02/11/20
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