By Serkan Bahçeci, head of Infrastructure Research, JP Morgan Asset Management – Global Real Assets Group
The purchase of the London City Airport by a consortium of Canadian-led pension funds for £2bn (€1.8bn) is just the latest expression of the growing interest of institutional investors in gaining exposure to infrastructure.
The asset class has long been an option in the armory of alternatives that can augment diversification and help drive returns, but it has come to the forefront more recently as a substitute or compliment for fixed income, given record-low yields on bonds.
Clearly, not all infrastructure investments or assets can be characterized as bond substitutes. The usual wish list associated with infrastructure investments, including characteristics such as stable yield, recession resilience, inflation protection and diversification benefits, can effectively be provided only by a conservative, diversified portfolio of existing, in-use and income-producing assets.
The challenge for institutional investors is that infrastructure offers a truly wide range in the risk-return spectrum but as a young asset class it does not provide the ample historical return data to make simple risk-return classification comparable to more established asset classes.
Despite the heightened scrutiny of investor interest and activity in infrastructure, differing terminology is sometimes used for the various approaches to infrastructure investing, making it worth clarifying.
Borrowing terminology from real estate investing, we can roughly divide infrastructure investment strategies into three categories: core, value-added and opportunistic. The underlying assets are mostly natural monopolies that cannot charge monopoly prices due to regulation, so they face a very stable demand profile with very low price and income elasticities.
Such infrastructure assets lend themselves well to core investment strategies that can provide portfolio diversification and the other benefits described above.
We define core infrastructure by its main observable financial characteristic: An infrastructure investment is core if it produces a stable cash flow stream, which is forecastable for at least a decade with a low margin of error.
Such an investment will be prudently levered and, in addition, will be based on infrastructure assets that (i) are located in transparent and consistent regulatory environments and/or (ii) have long-term contracts with credible counter-parties and/or (iii) are beyond their demand ramp-up phases.
Because most core infrastructure assets have monopolistic positions in and provide essential services to the markets they serve, demand is often very stable as mentioned above. For these unique assets, usage does not materially decline with price increases or during periods of economic weakness , e.g. there can only be one set of pipes delivering water, or only one airport serving a mid-size city.
This uniqueness however undermines the traditional analysis based on comparable assets. Service area dynamics, demand pattern, regulatory environment, contracts, etc. can be quite different between two physically similar assets.