Institutional capital is increasingly taking the place of bank lending, as banks deleverage and the low-return investment environment forces institutional investors to diversify their portfolios. The UK chancellor, George Osborne, has set the government the ambitious target of securing £200 billion of institutional capital for investment in British infrastructure projects.
At first glance, infrastructure appears to be an ideal asset class for institutional investors. Pension funds and insurance companies, with long-term liabilities and exposure to inflation risk, are attracted to the stable, inflation-linked cash-flows of infrastructure. Sovereign funds, which need to deploy large amounts of capital over a long-term horizon, are also often attracted to the potential returns from the asset class.
Yet there has been some frustration with the slow rate of progress in accessing capital from these institutional investors for investment in infrastructure. Better communication between investors and those seeking their capital, as well as creative structuring of investment opportunities, is needed in order to bring the two sides of the equation together.
Anyone seeking to attract institutional capital needs firstly to understand how infrastructure fits into the overall portfolio of an institutional investor. As the February 2014 Infrastructure Investment Policy Blueprint report from the World Economic Forum highlights:
“Investors evaluate an infrastructure opportunity in relation to other asset classes such as government bonds, equity markets and private equity. That is to say, investors evaluate not just how but whether to invest in infrastructure at all.”
People seeking investment need to understand that not only are they competing for capital with other infrastructure projects in their country, but they are competing against other asset classes and across global markets.
Institutional investors are generally conservative and invest predominantly in gilts, corporate bonds and listed equities. It is normal for such an investor to have no more than 25% of their portfolio invested in what they term ‘alternative’ asset classes, which encompasses a broad range of assets from hedge funds to private equity and infrastructure.
Allocations to ‘alternatives’ have increased over the past 10 years, due to low gilt yields and a low-return investment environment. However, infrastructure is still fairly novel to the institutional investment community and is often considered more cutting-edge than asset classes that may on face value appear riskier, such as hedge funds.
Who’s Afraid of Construction Risk?
There is an urban myth that institutional investors will not invest in greenfield projects as they are deterred by construction risk, but this is not always the case. Many pension funds and other institutional investors are aware that in order to secure higher returns from their infrastructure assets, they need to take some of the construction risk.
More importantly, the ‘Holy Grail” for pension funds is inflation linkage (since their liabilities are inflation linked) and with most secondary market assets, this has been stripped out. Pension funds are increasingly aware that in order to secure inflation linkage, they need to structure the assets themselves, which means involvement in the construction phase.
On the other hand, institutional investors can be reluctant to invest in projects with significant demand risk, hence the preference for taxpayer-funded social infrastructure projects. To secure more funding for UK infrastructure projects, Britain’s government should consider ways of managing demand risk. There have been many creative solutions proposed, such as franchising regions of road networks rather than seeking investment in a toll road.
One Size does not Fit All
It should also be borne in mind that pension funds, sovereign funds and insurance companies have slightly different needs and risk tolerances. Pension funds have to comply with statutory guidelines on risk and diversification, and insurance companies have regulatory capital requirements.
Sovereign funds, which do not have fixed liabilities and have the longest term horizons, are more likely to seek the high returns from economic infrastructure projects – such as the HS2 rail link from London to northern England or investment in nuclear power. Some pension funds prefer the low-risk, predictable cash flows from social infrastructure and renewables.
Targeting the right institution and creating an investment portfolio which fits the requirements of the targeted investor will be key in securing financing for infrastructure projects.
It’s Good to Talk
Greater dialogue between the government and institutional investors can ensure that investment opportunities are packaged in a way that is both attractive and comprehensible. Clyde & Co has been working closely over the past several years with a range of institutional investors and academic institutions across the world, including the seed investors in the UK’s pensions infrastructure platform.
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