October 2017

INSIDE VIEW: No longer an experiment

Great_wall_of_ChinaInfrastructure is still not a mainstream asset class, but the Long Term Infrastructure Investors Association has mapped out a path to acceptability, writes Eugene Zhuchenko.

Infrastructure as an asset class is fast changing. With the dollar value of institutional allocations to it increasing more than tenfold over the past decade, it is becoming less and less accurate to describe infrastructure as a collection of ‘experimental’ portfolios, on the margins of private equity or real estate allocations.

Struggling to finance required infrastructure developments out of public funds, governments triggered the initial growth and de facto discovery of the asset class by financial investors. These days, governments are focusing more and more on channelling long-term savings to finance new as well as existing infrastructure – a solution described as ‘smart money’ and praised by many economists.

About a decade of experimenting by asset allocators and asset managers has created the marketplace of institutional investing in infrastructure that we know today.  Many of the critical attributes of the marketplace – such as performance standards and structuring options – had to be defined from scratch.

Day-to-day investment practice has triggered the emergence of key asset class concepts such as ‘core’, ‘core plus’ and ‘value add’ infrastructure and its benchmarks.

Yet the exact meaning of those concepts is wide open to interpretations and the benchmarks in use tend to set normative expectations (for example, absolute return targets in real or nominal terms) rather than capture actual market performance.

‘Common wisdom’
This situation is bound to change. Infrastructure allocators, asset managers and policymakers all see the need for greater transparency and efficiency in the marketplace to encourage its further growth.

In 2012-14, several infrastructure research and data-collection efforts were initiated by private investors as well as by the OECD and the G20. For example, infrastructure was defined as a separate asset class under Solvency II, a financial regulation for managing risk exposure that is binding on many institutional investors in Europe.

Defining infrastructure as an asset class with predictable returns and low exposure to volume, financing and operational risks, Solvency II sets an important precedent globally of translating a ‘common wisdom’ of what infrastructure is (and is not) into a set of crisp and testable definitions.

The legislation also recognised benefits that investing in infrastructure should carry from the portfolio risk management perspective. In simple terms, reduction of the Solvency Risk Charge for qualifying investments in equities and debt has made capital allocations to infrastructure about 30% cheaper for many European institutions.

In June 2017, the European Commission finalised a legislative proposal – which may become a law later this year – widening the scope of qualifying investments.

North American and Australian policymakers are reviewing measures with similar stimulating effects for non-public infrastructure financiers. The OECD project on long-term investment in 2016-17 has produced several new policy recommendations, including in relation to risk allocation between public and private stakeholders and financing of low-carbon infrastructure.

The G20 is to look at mobilising support from public-side investors, such as national and multilateral development banks, in order to further improve definitions of infrastructure as an asset class and build a better regulation from there.

Data problem
The key element in defining any asset class is its financial performance benchmark. Since non-listed instruments are used for making most infrastructure investments today, building a reliable and representative benchmark requires market-wide access to private performance data. However, collecting a critical mass of the relevant data is not easy.

Firstly, investors tend to be sensitive to any disclosures and, secondly, many infrastructure investments have not been sold yet (which increases dependence on subjective value appraisals).

The Singapore-based Edhec Infrastructure Institute has been leading a major initiative aimed at challenging this status quo.

Tailored specifically to the information needs of long-term investors, EDHECinfra benchmarks are composed of asset-level data and their constituents are chosen to be representative of the full investment universe. This approach significantly reduces selection and availability bias compared to benchmarking products that rely on fund-level information and represent only that part of the universe that managers agree to disclose.

The first set of 384 debt and equity indices released by EDHECinfra in June 2017 cover 50% of the broad market capitalisation of 14 European markets. Six of the indices are also available via Bloomberg, tracking the European private infrastructure equity and debt markets, the project finance vehicles and private infrastructure corporates.

The benchmarking database today includes over 3,000 assets with cash flows going back 15-20 years.

Members of the Long Term Infrastructure Investors Association have been among the most active data contributors, driven by the shared belief that greater transparency and data-sharing can unlock efficiencies and market growth opportunities not seen before. Results from the first set of indices are indeed encouraging in that sense.

A better return
One simple finding is that, compared to investing in public equities, investing in unlisted infrastructure equities in Europe has historically delivered a better return and a better return per unit of risk (as expressed by the Sharpe ratio).

Another finding, perhaps a less obvious one, is that ‘core’ assets have contributed most to the infrastructure index performance.

For public institutions investing in infrastructure, ability to apply relevant benchmarks is as important as it is for private investors. While development banks and investment promotion agencies (such as the European Fund for Strategic Investments) typically target opportunities where the free market would fail. For them it is critical to know where exactly the market stands and what potential ‘gap’ there is to bridge, for example, through credit enhancement.

In summary, there are many stakeholders – private and public investors, regulators and policymakers – that can benefit from better asset class definitions and in particular from better benchmarking solutions.

Yet the magnitude of the benefit directly depends on how active those stakeholders are in sharing their data for constructing benchmarks. Compared to other alternative asset classes, data-sharing and transparency on performance in the infrastructure marketplace is still low, but it no doubt would grow as value accretion potential becomes more and more visible to the private side and as support from the public side continues to increase.

Eugene Zhuchenko is executive director of the Long Term Infrastructure Investors Association

©2017 funds europe