5.6 / 19 - Infrastructure as an Investment

Question 1

LO 19.1: Demonstrate knowledge of infrastructure assets.

Answer 1

• Identify the distinguishing characteristics of infrastructure as an asset class. • Describe three approaches used to classify infrastructure assets by their economic nature. • Discuss factors affecting the demand for infrastructure assets. • Discuss the supply of infrastructure assets.

Question 2

LO 19.2: Demonstrate knowledge of the key characteristics of infrastructure that dictate its risk-return profile.

Answer 2

• Describe the effect of the stage of maturity on infrastructure’s risk-return profile. • Describe the effect of the geographic location on infrastructure’s risk-return profile. • Describe the effect of the sector scope on infrastructure’s risk-return profile.

Question 3

LO 19.3: Demonstrate knowledge of attributes of infrastructure assets that make infrastructure attractive as a defensive investment.

Answer 3

• List and describe the twelve defensive attributes of infrastructure assets.

Question 4

LO 19.4: Demonstrate knowledge of methods used to access infrastructure investment opportunities.

Answer 4

• Describe infrastructure financing and investment options. • Discuss private infrastructure funds. • Discuss publicly traded infrastructure funds. • Discuss direct infrastructure deals. • Discuss publicly traded infrastructure companies. • Discuss debt type infrastructure investments.

Question 5

LO 19.5: Demonstrate knowledge of infrastructure fund strategy classification.

Answer 5

• Compare and contrast active management and passive management investment styles. • Describe stages of infrastructure asset maturity and the effect of asset maturity on the risk-return profile of the asset. • Describe the role geographic scope plays in shaping the risk-return profile of an infrastructure fund. • Describe the role sector scope plays in shaping the risk-return profile of an infrastructure fund. • Recognize the characteristics of core infrastructure and peripheral infrastructure.

Question 6

LO 19.6: Demonstrate knowledge of how infrastructure compares with other asset classes.

Answer 6

• Compare and contrast investment in infrastructure assets with investments in bonds, real estate, buyouts, and equities

Question 7

LO 19.7: Demonstrate knowledge of public-private partnerships (PPPs).

Answer 7

• Describe the characteristics, advantages, and disadvantages of PPPs.

Question 8

LO 19.8: Demonstrate knowledge of how regulation and public policy affect infrastructure assets.

Answer 8

• Discuss the rationales behind governmental regulation and public policy that affect infrastructure assets

Question 9

LO 19.9: Demonstrate knowledge of the historical performance of infrastructure funds.

Answer 9

• Compare and contrast the historical performance of infrastructure funds with that of other asset classes.

Question 10

Characteristics and Classification of Infrastructure Assets - (3 braod categories

Answer 10

1. Who pays for the services?
   a. End user paid assets, including utilities, communications networks, and toll roads.
   b. Government and taxpayer paid assets, including schools, hospitals, and parks.
2. Is the price of using the asset regulated or unregulated? That is, are changes in the price subject to the approval of government/public entities?
3. What is the role of the infrastructure?
   a. Economic infrastructure assets with value derived from revenues, including toll roads, bridges, highways, airports, and railways.
   b. Social infrastructure assets used by end users who are unable to pay for the services, including schools, hospitals, public roads, prisons, and various government buildings.

Question 11

Demand for and Supply of Infrastructure Assets

Answer 11

• Global demand for infrastructure assets for electricity, water, road, rail, and telecommunications is estimated to be 3.5% of world GDP by 2030.
• Given that the infrastructure needs will exceed available funding by a substantial amount, the difference will leave a sizeable infrastructure investment gap - Gov’ts can’t close this alone. Public funding has decreased
• The demand for infrastructure investments has generated significant opportunities, resulting in global capital inflows from institution investors. These investors include infrastructure funds, insurance companies, pension funds, sovereign wealth funds, and private equity funds.

Question 12

Supply of Infrastructure Assets

Answer 12

To finance funding shortfalls, governments have increasingly turned to private investments through privatizations, PPPs, or project finance. The increased need for private funding sources is driven by the following:

• • Funding shortfalls due to shortage of available debt or limited capacity to increase taxes.
• • Divesting existing infrastructure assets to raise capital.
• • Use of private investments to gain management and technical expertise for greater efficiency.
• • Enhancing favorable PPP legislation.
• • Supply of debt and equity capital from private sources.

Question 13

PPPs (public-private partnerships) vs project finance.

Answer 13

Project finance involves asset financing though long-term loans where the financing costs are supported by cash flows from the projects. The loans are generally nonrecourse and are secured by the assets.

PPPs involve a joint relationship between a government and a private entity in which the private entity provides public service and assumes considerable project risk

Question 14

What are three ways to classify Infrastructure?

Answer 14

Infrastructure can be classified by

• stage of maturity,
• geographic location, or
• sector

Question 15

What are the two Stages of Maturity for Infrastructure?

Answer 15

Infrastructure assets can be referred to as either greenfield or brownfield, depending on their stage of completion.

Question 16

What are the characteristics of Greenfield stage Infrastructure INvestment

Answer 16

Greenfield refers to the initial stages of construction (i.e., development, construction, ramp-up). This phase tends to carry greater risk than later stage or completed assets given the significant time to completion of projects and significant risks, including

(1) design and technological risks,
(2) construction risk that could result in cost overruns, and
(3) economic, legal, and political risks.

Question 17

What are the characteristics of Brownfieldstage Infrastructure Investment

Answer 17

Brownfield refers to a fully constructed asset with a history of operations and transparent revenue and cost structure. As a result, brownfield projects typically carry less risk than greenfield projects. Brownfield risks include revenue risk and operational/maintenance risk.

• Revenue risk can arise from revenues that are overestimated (e.g., if fewer than projected drivers are willing to pay the toll on a toll road).
• Operational/maintenance risk tends to be low, but if technological obsolescence occurs, then high costs may be incurred.

Question 18

How is Infrastructure classified by Geographical Location?

Answer 18

Geographical location is primarily segmented according to developed and emerging markets.

• Projects in developed markets have lower political risk and have developed well-established legal and regulatory frameworks. Investors in developed markets tend to accept lower returns in exchange for lower risk
• Emerging markets often have developing legal and regulatory environments. The combination of long asset payback periods and higher political, legal, and regulatory risks may lead to a high-risk environment for infrastructure in emergent markets.
  
  • national governments may directly seize private property infrastructure investments or use discriminatory tax and regulatory practices to indirectly force investors out. This is known as expropriation and is more likely to occur in emerging markets.

Question 19

How is Infrastructure classified by Sector Scope?

Answer 19

Infrastructure can also be classified by sector or the nature of the services. In general, infrastructure assets not subject to revenue fluctuations due to price and volume changes are regarded as less risky.

• Where volume risk is present, this risk can be mitigated dependingon the nature of the service (e.g., providing water in a specific location) or the monopoly nature of an asset (e.g., a single airport servicing a city).
• Price risk can be mitigated by regulation (e.g., periodically adjusting utility prices) or by fundamental demand (e.g., toll roads in an important road junction).

Question 20

What are the 12 charactersitcis that alllow Infrastructure Assets to serve as Defensive Investments?

Answer 20

1. Inelastic Demand
2. Monopoly Positions
3. Regulated Entities
4. High Set Up Costs, Low Operating Costs
5. Low Operating Cash flow Volatility
6. Low Sensitivity to Economic Downturns
7. Technology Risk
8. Projects are long term
9. Inflation Hedge
10. Stable Yields
11. Low Coreelations with Traditional ASsets
12. Strong Risk-Adjusted Returns

Question 21

How does the following Characteristic allow Infrastructure assets to serve as defensive investments?

Inelastic demand

Answer 21

Many infrastructure assets provide essential services, such as water, electricity, and transportation, which makes them less sensitive to price and economic changes. Instead, their growth is tied to overall economic growth.

Question 22

How does the following Characteristic allow Infrastructure assets to serve as defensive investments?

Monopoly positions

Answer 22

Infrastructure assets often function as natural monopolies. For example, an airport services an entire city and it may not be feasible to build another airport, or where a sole power plant provides local electricity. These assets are often protected by government regulation against competition and exhibit low economic sensitivity.

Question 23

How does the following Characteristic allow Infrastructure assets to serve as defensive investments?

Regulated entities

Answer 23

Governments regulate the monopoly positions of infrastructure assets, including water, electricity, gas, and transmission assets, against unfair price practices that would disadvantage consumers. Government regulations require entities to sell their products at regulated tariffs that are expected to exceed expenses and provide a sufficient return on capital. Regulated prices provide downside protection while allowing for future increases (as costs rise), making these investments attractive to investors. On the downside, regulated prices tend to lag unregulated prices, and price increases may not be sufficient to keep up with rising costs.

Question 24

How does the following Characteristic allow Infrastructure assets to serve as defensive investments?

High setup costs, low operating costs.

Answer 24

Setting up infrastructure assets initially requires large amounts of capital, but these assets typically incur low operating costs during their lives, which may be several decades. This also supports higher leverage.

Question 25

How does the following Characteristic allow Infrastructure assets to serve as defensive investments?

Low operating cash flow volatility

Answer 25

Because infrastructure assets are regulated with limited competition and have a captive client base, their revenues and cash flows tend to be stable with little volatility. Low volatility supports higher levels of leverage.

Question 26

How does the following Characteristic allow Infrastructure assets to serve as defensive investments?

Low sensitivity to economic downturns

Answer 26

Infrastructure businesses provide essential services, which makes them less sensitive to economic downturns and demand and usage declines. Sectors in order of increasing business cycle sensitivity and decreasing nature of contractual cash flows are social infrastructure, pipelines, public railways, energy networks, brownfield highways, ports, airports, and greenfield highways.

Question 27

How does the following Characteristic allow Infrastructure assets to serve as defensive investments?

Technology risk

Answer 27

Technology risk is especially important for greenfield projects, and it is critical that the technology used has been proven or risk of failure is mitigated.

Question 28

How does the following Characteristic allow Infrastructure assets to serve as defensive investments?

Projects are long term

Answer 28

Infrastructure assets usually represent long-term projects, with time horizons that may exceed 50 years. This makes it easier to match long-term assets against long-term liabilities (e.g., pension plans and insurance companies).

Question 29

How does the following Characteristic allow Infrastructure assets to serve as defensive investments?

Answer 29

Cash flows of infrastructure assets may be adjusted for inflation through reference indices such as the Consumer Price Index (CPI), creating an effective inflation hedge against anticipated future price changes. However, unanticipated price changes are unhedged and create some risk.

Question 30

How does the following Characteristic allow Infrastructure assets to serve as defensive investments?

Stable yields

Answer 30

In contrast to private equity and venture capital investments, infrastructure assets are characterized by stable cash flows, providing stable and high dividends yields.

Question 31

How does the following Characteristic allow Infrastructure assets to serve as defensive investments?

Low correlations with traditional assets

Answer 31

Infrastructure assets have historically exhibited low correlations with traditional asset classes such as equity and debt. The low correlations may be explained by smoothed returns from appraisal-based data that characterizes infrastructure assets, including real estate. Further, the diversification benefits of infrastructure assets due to stable cash flows and inelastic demand may be overstated.

Question 32

How does the following Characteristic allow Infrastructure assets to serve as defensive investments?

Strong risk-adjusted returns

Answer 32

While the risk-adjusted returns of the various infrastructure classes vary, mature infrastructure investments in general provide yields in the 7–15% range.

Question 33

Primary Methods to Access Infrastructure Investment opportunities

Answer 33

1. Private Equity Funds - Pluses: low vol, favorable management fee and fee structure for redemptions nad participation, active management. Negatives: illiquidity, lack of transparency, fund fees could be high. finite lives 10-15 years.
2. Direct Equity Deals - requires much skill and knowledge. Large upfront costs, Mimimum investment is large, so less diversification
3. Publicly Traded Equity Funds - share many risks in common with private. Public has infinite life, more liquid. Price volatility and higher correlation with other asset classes. Public equity funds cannot call additional capital - must issue equity.
4. Publicly Traded Infrastructure Companies - many similar characteristics as listed securities, including steady dividend yeild and low leverage. primarily include toll road, utility, airport entities. Given limits on leverage, risk-return proviles tend to be lower than unlisted securities.
5. Debt - infrastructure projects often leveraged with 60 to 90% of total financing. regulatory considerations important. performed through debt issuance OR instrastructure loans. Infrastructure Funds feature pool of loan financing through closed-end vehicle similar to PE type.

Question 34

Other Considerations for Investors to Review when investing in Infrastructure?

Answer 34

• Experience. Are investors experienced and knowledgeable? Those with significant experience include large institutional players such as endowments, pension funds, and insurance companies.
• Investment options. Investment options include equity and debt (including loans and mezzanine debt).
• Heterogeneous nature. Infrastructure projects are unique and range from low risk-return PPP projects to high risk-return renewable energy projects.
• Debt features. Debt can range from high yield to investment grade, low to high seniority, different maturities, and different protections against interest rate risk.
• Credit risk. Most infrastructure assets are not sensitive to economic cycles given the stability and predictability of their cash flows; therefore, these assets tend to be investment grade. However, other assets could be noninvestment grade with less transparent covenants.
• Inflation. Inflation risk is present given the stable nature of cash flows. Inflation protection may be an important investor consideration.
• Benchmarks. Benchmarks are important for institutional investors because it allows them to assess the success or failure of an investment. Unfortunately, there are no well-known benchmarks for infrastructure debt.
• Fund features. Fund structure (typically closed-end) and term (length of investment required), along with fee structure (which varies widely among funds) are additional important considerations.

Question 35

What are the 6 categories of Infrastructure Fund Strategies?

Answer 35

1. Active Management
2. Passive Management
3. Asset Maturity
4. Geographic Scope
5. Sector Scope
6. Core and peripheral infrastructure

Question 36

Describe the Infrastructure Fund Strategy below:

1. Active management.

Answer 36

Several fund managers take an active approach by obtaining control in companies and maintain significant influence on decision making in financing, strategic, and operational issues. They often have board representation that gives them the ability to appoint CEOs. Active managers tend to make large investments in a select number of companies. Such an active approach is similar to buyout funds, although infrastructure funds require incrementally smaller changes in companies over a longer time horizon rather than material changes over a shorter timeframe

Question 37

Describe the Infrastructure Fund Strategy below:

2. Passive management.

Answer 37

Passive managers hold minority stakes in companies and do not seek outright control. They do not seek board representation and therefore have less influence on company decision making. Passive managers allow company management to make decisions and are similar to core real estate funds. Given their minority stakes, infrastructure funds tend to hold a large number of companies.

Question 38

Describe the Infrastructure Fund Strategy below:

3. Asset Maturity

Answer 38

Classification by asset maturity can be segmented by project maturity with significantly different risk-return profiles.

• Greenfield infrastructure investments involve investments in new projects without the existence of previous facilities. These investments are riskier and investors should accordingly expect higher returns.
• Brownfield infrastructure investments make investments in existing facilities that already generate some cash flows. As a result, these investments are less risky and investors should expect lower returns. Investments in the growth phase may involve either slow growth in mature companies, or fast growth in new companies.

Question 39

Describe the Infrastructure Fund Strategy below:

4. Geographic scope.

Answer 39

Infrastructure funds differ significantly by geography and by economic cycles within geographic regions. Managers could maintain a regional focus or global focus. Funds must generate sufficient returns to compensate for the higher risk of investments in higher-risk regions.

Question 40

Describe the Infrastructure Fund Strategy below:

5. Sector scope.

Answer 40

Infrastructure funds typically target economic infrastructure sectors, although they may also invest in social infrastructure sectors specializing in water, transportation, roads, or airports. Sector specialist funds that invest in PPPs or in private finance initiatives (PFIs) (a form of PPPs found in the UK) have also gained popularity. PFIs do not have many of the typical risks such as demand risk that contractors typically face, and as a result these investments represent low-risk, low-return opportunities.

Question 41

Describe the Infrastructure Fund Strategy below:

6. Core and peripheral infrastructure.

Answer 41

The investment criteria used by some infrastructure funds has widened in recent years. An example of this is that some infrastructure funds invest in logistics and support services companies that benefit from a global supply and demand imbalance, offering higher-risk, higher-return opportunities for investors relative to typical infrastructure investments.

Question 42

Compare Infrastructure versus bonds

Answer 42

Both infrastructure assets and bonds provide steady cash flow streams. Both are subject to interest rate risk from rising interest rates, which exposes them to increased finance costs. However, infrastructure assets are typically fully hedged against this risk, while long-only bond portfolios are not. Infrastructure assets are also noncallable and, therefore, exhibit less negative convexity.

Question 43

Compare Infrastructure versus real estate.

Answer 43

The stable cash flow generated by infrastructure assets, including from toll roads, oil pipelines, and electricity transmission cables, is similar to the stable rental income from real estate. Cash flow variability nevertheless tends to be greater in infrastructure assets. Greenfield infrastructure projects (e.g., new airports, power plants, and maritime facilities) are similar to opportunistic real estate, although infrastructure assets can be riskier at the development stage.

Question 44

Compare Infrastructure versus buyouts.

Answer 44

Both infrastructure and buyout funds generate return by using unique techniques (e.g., innovative financing terms, changes in management, improvements in operational efficiency) to achieve operational improvements and a more optimal capital structure. However, investments in infrastructure assets tend to be longer term (often 20 years or longer) and involve less radical changes in the underlying companies than buyout funds. In contrast, buyout funds typically make significant management and structural changes to their companies and seek to exit after 4–6 years and generate returns through capital gains.

Question 45

Compare Infrastructure versus equities.

Answer 45

Infrastructure assets have lower betas and are less sensitive to business cycle fluctuations than equities, and the two asset classes tend to have low correlations.

Question 46

Describe Public-Private Partnerships (PPPs)

Answer 46

• joint projects between the public and private sectors that act as a form of risk transfer from the government to the private sector.
• Projects include water and waste management, transportation, and social infrastructure assets, including hospitals, schools, and prisons.
• PPPs differ from regulated assets in that PPPs represent finite contracts for concessions with agreed-upon pricing, whereas regulated assets represent assets owned by the private sector under a license with periodically reset rates.
• PPPs are complex arrangements that typically involve the private investor acting as concessionaire (i.e., investor operates business on government properties) by setting up a special purpose vehicle (SPV).
• Typically funded through Debt and investor equity
• used for both Greenfield and Brownfield
• Have received criticizm for perceived lower accountability, contradiction of private profit with public interests, underinvestment, and poor asset maintenance. Public perception plays a role.

Question 47

• Discuss the rationales behind governmental regulation and public policy that affect infrastructure assets.

Answer 47

Very high startup costs make infrastructure assets similar to natural monopolies in which a single firm can produce goods or services at the lowest cost and greatest efficiency. As a result, governments may enact regulation to reduce competition and create statutory monopolies. In order to ensure that monopolies do not engage in excessive rent seeking, their behavior can be controlled through regulation or under PPPs with agreed-upon pricing.

Question 48

• Compare and contrast the historical performance of infrastructure funds with that of other asset classes.

Answer 48

• Infrastructure funds outperformed all asset classes, including equity, bond, hedge fund, and managed futures indices during the 2007–2014 period in terms of return (7.8%), with the exception of the S&P 500 equity index.
• The standard deviation of infrastructure funds (9.1%) was lower than those of the equity and hedge fund indices, while its Sharpe ratio (1.2) was the highest among all asset classes, with the exception of the U.S. bond index.
• Infrastructure funds also showed very low and even negative correlations with all other asset classes, offering meaningful diversification benefits. This can partly be explained by stable cash flows and data smoothing.