A Rationale for Adding Infrastructure Exposure to Your Investment Portfolio
The White House recently announced the “Legislative Outline for Rebuilding Infrastructure in America”, a 53-page plan to stimulate $1.5 trillion of investment in infrastructure in the US. While there are valid points to both the pro and con arguments for the plan, we’d like to share our insights into our process and rationale for obtaining infrastructure exposure in an investment portfolio.
The immediate potential beneficiaries of infrastructure investment are companies that provide design and construction services for infrastructure projects, as well as the producers of materials needed for such projects.
While there are exchange-traded funds (ETFs) that specialize in these types of companies, we prefer to pick up this exposure through broad equity market index vehicles, as we believe the US equity markets are generally efficient. We also believe that, to the extent infrastructure investments boost GDP, the rising tide will lift all ships, so to speak, and broad equity markets will benefit.
Taking an Informed Approach to Infrastructure Investing
We define infrastructure as essential physical assets required by society to function that generate stable, growing cash flows, which are typically linked to inflation. In our view, the best long-term approach to infrastructure investment is to own the physical assets.
Examples of attractive infrastructure assets for investment can include:
- Toll roads
- Cell towers
- Oil & gas pipelines
- District energy
- Power generation
- Electric distribution
These assets are typically natural monopolies (it doesn’t make sense to have two highways running in parallel, for example), and are government-regulated, allowing for a specified rate of return on investment for the owner. Cash flows generated by these assets typically have low correlation to short-term changes in the economic cycle, but grow over time with long-term population and GDP growth, as cars driving on a toll road increase, for example. The regulated nature of these assets allows for long-term contracts with built-in inflation escalations, meaning cash flows are predictable over long periods of time and increase with inflation, providing an investment portfolio with some insulation from rising costs.
A Global Opportunity
For governments around the world to close the $50 trillion funding gap in infrastructure over the next 15 years, infrastructure spending would need to increase from $2.5T annually to $3.3T, according to McKinsey. For reference, the World Bank reports that approximate total annual government spending was $12.5T globally in 2016.
This funding gap has increased willingness to open the doors to private ownership and operation of infrastructure in some countries, which provides capital to government owners of infrastructure. That capital can in turn be used to relieve the debt burden taken on to build said assets, and can eliminate the need for governments to continue spending to maintain the assets.
Examples of private ownership include the passing of a law in India in June of 2016, allowing for foreign ownership of airports. Additionally, governments in Colombia and Australia have recently sold transportation and power generation assets to private owners.
Here in the US, we aren’t accustomed to privately-owned roads and bridges, but other infrastructure assets, such as electric grids and energy pipelines, are often owned by private enterprises. In other parts of the world, privately-owned roads, bridges, and other infrastructure is common.
The White House’s infrastructure plan provides a few avenues to encourage private ownership of infrastructure assets:
- The potential divestiture of federally-owned assets (power transmission, airports, parkways, aqueducts, etc.) to other owners, including private capital
- Increasing the term for leases of publically-owned assets to private operators from 80% of the expected life to 95%
- Broadening the scope of Private Activity Bonds (municipal bonds that provide funding for privately-owned projects) to include such assets as roads, bridges, tunnels, hydroelectric plants, and broadband services
The need for capital is especially acute in rapidly-growing emerging market countries, which account for 60% of the total funding need. This situation creates an opportunity for investors to gain exposure to emerging market countries–emerging market economic and consumer activity in particular–rather than exposure to broad emerging market equities, which includes companies that rely on exports for a significant portion of their revenue.
How to Choose the Right Infrastructure Exposure for Your Investment Portfolio
Exposure to infrastructure investments can be obtained through publicly traded or private investment vehicles, and both types of exposure have the potential to benefit a diversified portfolio. Private funds are structured in a similar manner to private equity funds, in which the investor makes a capital commitment to a fund that is drawn over several years as the fund manager invests in various infrastructure projects. Private funds typically invest in development projects and distressed assets that need a turnaround to achieve peak earnings (referred to as Development Stage and Opportunistic assets).
Public infrastructure vehicles are typically Limited Partnerships or Corporations, and are traded on major stock exchanges such as NYSE, allowing for an investor to buy and sell the investment daily. Compared to private funds, they tend to own lower risk assets that are already in operation, and perhaps in need of minor operational improvements to maximize earnings (known as Core and Core Plus assets).
Public vehicles have the benefit of higher liquidity and less operational/development risk, and typically have a lower expected return than a private fund. Public and private infrastructure investments exhibit relatively low correlation to major asset classes, which helps to diversify portfolios and can reduce overall portfolio volatility.
Owning productive infrastructure assets over the long term can be an attractive addition to an investment portfolio, due to the long-term visibility into cash flows, a natural hedge to inflation, and returns that exhibit low correlation to other major asset classes.