The infrastructure investor's To Do List

It is a fact that infrastructure is becoming increasingly attractive to pension funds. However, it remains a very specific investment category that presents asset allocators with very different challenges than traditional equities or bonds.

March 22, 2023

infrastructure | infrastructure | road | fork | city | metropolis | transport | mobility


A new Swiss regulation

If some Swiss pension funds took the step more than 10 years ago to invest in infrastructure, it was generally through their investments in non-listed assets such as private equity. The amendment of the Ordinance on Occupational Retirement, Survivors' and Disability Pension Plans (OPP2), which came into force in October 2020, has given infrastructures their letters of nobility by considering them as an investment category in their own right with a maximum quota of 10%.

But what are we talking about? Infrastructure consists of the construction of major facilities in different sectors (energy, transport or communication) such as a highway, an airport, a wind farm, a pipeline or a network of 5G antennas or charging stations for electric vehicles. Most infrastructures have two characteristics: on the one hand, their construction requires a significant initial investment, and on the other hand, their development requires the agreement of a local (e.g., water distribution network) or national (e.g., rail network, gas terminal) authority in order to obtain a concession, i.e., the right to build and then operate the infrastructure over a long period of time (50 years or more).
 

What's in it for the pension funds?

Large American and Canadian pension funds have long understood the appeal of infrastructure investments due to their duration, illiquidity and low correlation with traditional assets. Pension funds have liabilities with a very long duration: they collect premiums today to pay pensions in 10, 20 or 30 years. However, infrastructures such as a motorway concession also have a very long lifespan, ranging from 15 to 30 years. Infrastructure therefore allows a pension fund's assets to have a duration in line with that of its liabilities, which is not the case for corporate bonds, which often have a maturity of 5 to 7 years.

Illiquidity is another strong point of infrastructures. Because of their size, their uniqueness (there is generally only one electricity network in a city) and their contractual specificities (concession granted by a public authority), the transfer of an infrastructure concession can take months. Financial markets reward this lack of liquidity with an additional expected return, and few investors can afford to have their assets tied up for 15 or 20 years. EDHECinfra's Infra300 index, which measures the performance of non-global listed infrastructure, for example, has shown a return of more than 11% per year over the past 10 years, compared to 8.1% for the MSCI World. But these returns are not available to everyone: pension funds have an advantage over investors who are forced to ensure daily or even monthly liquidity, since they can afford to hold long-term infrastructure assets.

Finally, the correlation between infrastructure and equity investments has historically been very low, providing good diversification. A low correlation between listed and non-listed assets is indeed typical as the latter are revalued only 2 or 4 times a year, but it is even lower in the case of infrastructure as it can be affected by specific factors such as regulation or local aspects (e.g. environmental).
 

Is the macro environment favourable? 

Measures to combat global warming are contributing to the growth of this asset class. Indeed, Europe and the United States have announced stimulus plans in 2020 that focus on infrastructure. Europe, for example, has launched its Green Deal to finance electricity network projects between Italy and Tunisia and a natural gas terminal in Gdansk, Poland. The United States has passed a law to renovate its aging infrastructure (roads, bridges and railroads) as well as its drinking water network. In addition to these major projects, infrastructure is also benefiting from the development of renewable energies (solar and wind power), green hydrogen and the deployment of charging stations for electric vehicles.
 

What are the risks associated with infrastructures?

First of all, some infrastructures are dependent on geopolitical issues. For example, some European countries have changed their tax support policy for the deployment of solar panels, which has significantly reduced the profitability of these products. The privatization of certain public services such as drinking water distribution could also be called into question in the event of a change of political regime, not to mention the Nordstream II gas pipeline, which is suffering the collateral effects of Russia's invasion of Ukraine.

Although many infrastructures are not affected by economic cycles, such as the consumption of electricity or drinking water, some are nevertheless sensitive to them. For example, airport activity dropped sharply during the Covid-19 crisis, and air traffic has still not recovered to its 2019 level, despite the strong economic recovery.

On another level, the illiquidity of infrastructure investments is certainly an advantage since it can generate an additional liquidity premium, but it also represents a risk insofar as a pension fund commits itself for an average period of 15 years.

Finally, the attraction of infrastructure creates strong competition. Large North American pension funds, European insurers and Middle Eastern or Asian sovereign wealth funds have expert teams and a great appetite for infrastructure, which can be intimidating to venture into.
 

What process should be put in place?

While the OPP2 allows Swiss pension funds to invest up to 10% of their assets in infrastructure, it is probably wise to limit the investment to 5% or even 7% in order to respect the upper range if the value of other assets should drop significantly.

It is also essential to be accompanied by internal or external experts as the due diligence process is even more dense for infrastructure than it is for a highly liquid asset.

Finally, a portion should be invested in renewable energies in order to accentuate the impact of the investment, considering however that diversification remains the key given the risks exposed.

 

Published in Sphere magazine - March / May 2023 issue

Nicolas Mougeot, Head of Investment Strategy & Sustainability •  March 22, 2023

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