Infrastructure risk, return and diversification

What sets the risk and return of an infrastructure investment?

Four things define expected risk and return: the type of asset, its stage of development, its location and the way the investment is structured.

Infrastructure risk and returntype, stage, location and structure together

• Stage Memorize greenfield highest, brownfield next, secondary-stage lowest
• Type of revenue Memorize lowest to highest risk
  • Social infrastructure Memorize availability-type payments; lowest risk
  • Regulated industries Memorize regulated or contracted revenue; low risk
  • Demand-based infrastructure Memorize revenue follows use and growth forecasts; highest risk
• Location Use it stable developed (Organisation for Economic Co-operation and Development, OECD) markets lower risk; emerging markets higher risk and higher long-run return
• Structure Use it direct unlisted equity highest; publicly traded debt lowest; long-term concessions most stable

Stage risk is the risk that comes from how complete the asset is. Operating secondary-stage assets have a track record of steady, bond-like cash flows, so they carry the lowest risk and offer the lowest return. Brownfield investments are incrementally riskier, and greenfield projects, which face construction and start-up risk, are the riskiest.

Type matters too. Regulated infrastructure (utilities whose prices a regulator sets) and basic social infrastructure usually have lower risk and lower expected return. Demand-based infrastructure , such as a new port or toll road, builds on forecasts of economic growth and use, so it is riskier.

Location and structure add to this. Developing economies need infrastructure to underpin growth, so the risks are considerable, but so are the returns over long horizons: greenfield projects there offer exceptional opportunities over very long periods. Structure also matters: less liquid forms of direct equity ownership offer the highest expected return with the greatest risk, while publicly traded debt offers the lowest. Assets backed by a stable, long-term concession (the right to operate an asset for a fixed term under agreed terms) provide the most stable returns.

Lower risk and return	Higher risk and return
secondary-stage (operating)	greenfield (construction)
regulated or contracted revenue (utilities, availability-paid social assets)	demand-based revenue (new toll roads, ports, merchant power)
stable developed markets	emerging markets
return mostly current yield	return mostly capital appreciation
listed debt	direct unlisted equity

What do the low, medium and high risk profiles look like?

Industry research groups private infrastructure funds into three illustrative profiles, with target equity returns net of fees.

Private infrastructure fundtarget equity returns are net of fees

• High risk (target 14%+) Memorize greenfield with no demand guarantee; OECD and emerging markets; mostly capital appreciation
• Medium risk (target 10%–12%) Memorize mostly brownfield plus some low-risk greenfield; mainly OECD; mix of yield and appreciation
• Low risk (target 6%–8%) Memorize brownfield, fully built, contracted or regulated revenue; most stable OECD; mostly current yield

Most funds gravitate to the medium and low profiles, which produce a long-term return of around 10% a year. Notice how the return mix shifts: the high-risk profile relies on capital appreciation from a project that has yet to prove its demand, while the low-risk profile mostly pays a current yield from assets that already operate.

$$R_{fund} = \sum_k w_k\,R_k$$

Why do investors hold infrastructure?

Investors expect infrastructure to produce stable long-term cash flows that also adjust for economic growth and inflation, and, as a second goal, capital appreciation, depending on the type and timing of the investment.

Infrastructure in a portfoliostable long-term cash flow first, capital appreciation second

• Inelastic demand Memorize people keep using water, power and roads in bad times
• High barriers to entry Memorize often natural monopolies or long concessions
• Inflation linkage Memorize regulation, concessions or fee contracts that rise with prices
• Low correlation Use it with public equities and the economy; public and private infrastructure also correlate little
• Liability matching Use it long-lived cash flows suit pension funds, insurers and sovereign wealth funds

• Inelastic demand means use barely changes when conditions change. People use water, power and roads in good times and bad.
• Barriers to entry are high: building a second airport or pipeline is costly, and many assets are natural monopolies or protected by concessions.
• Inflation linkage comes from regulation, concession agreements and fee contracts whose rates rise with, or above, inflation.
• The result is low correlation with public equities and the broader economy. Private and public infrastructure returns also show low correlations with each other. Infrastructure also gives some protection against changes in gross domestic product (GDP) growth.

Infrastructure debt tends to have lower default rates and higher recoveries than similar fixed-income instruments, and it moves less over the economic cycle. The long life of the cash flows also matches the long-dated liabilities of pension funds, superannuation schemes and life insurers. Sovereign wealth funds, with their long horizons, tend to make the largest allocations to the asset class, around 5%–6% of assets under management.

Why inflation linkage matters

$$V = \dfrac{N}{(1 + \pi)^{T}}$$

What can go wrong?

Infrastructure is not risk-free. The risks to name are construction delays and cost overruns, demand shortfalls (especially on usage-based assets), regulatory and political change, leverage, illiquidity and concentration in a few large assets. Listed infrastructure (shares and funds of listed infrastructure companies) is liquid and priced daily, but it behaves more like equities and is a small, clustered part of the market.

Exam tip To rank two infrastructure projects, compare stage first (greenfield is riskier), then revenue type (demand-based is riskier than regulated or availability-paid), then location.

Go deeper Listed versus unlisted infrastructure

Listed infrastructure trades on exchanges, so it offers liquidity, observable prices and diversification across assets, but its prices move with the stock market, so its correlation with equities is higher. Unlisted infrastructure is valued by appraisal, so reported returns are smoother and look less correlated, much as with private real estate, and the investor accepts illiquidity and a large minimum commitment in return. When a question gives a low correlation figure for a private fund, remember it may be flattered by smoothing.

Go deeper Regulated returns and rate reviews

A regulator allows a regulated utility to earn a return on its asset base, and reviews the allowed return and the prices it can charge every few years. Between reviews, revenue is steady and often linked to inflation, which is why the asset behaves like a long-dated bond. The risk is at the review: a lower allowed return cuts the cash flows. Demand-based assets have no such protection: revenue is whatever the traffic or sales turn out to be.