The trillion-dollar gap

Investment in infrastructure provides many benefits including high returns, stability of returns, portfolio diversification, and inflation hedging.  Currently, there are four main avenues for investment in infrastructure:  Listed shares, listed funds, unlisted securities, and un-listed funds.  While listed securities are the most accessible for all investors, there are very few infrastructure assets large enough to list shares on public exchanges.  Listed funds are by far the most popular with retail investors seeking to gain the benefits of having infrastructure; but these do not provide the full beneficial characteristics of infrastructure.  Infra funds are typically not made up of true infrastructure assets, but of companies in the infrastructure space such as construction, design, supply, and maintenance firms.  Furthermore, the high fund fees (1.5% to 2.5% of committed capital) associated with professional management and vetting investments, along with short fund durations, detract from the healthy returns and long-term stability of true infrastructure assets.  Additionally, infra funds are subject to market risk, manager risk, strategy drift, comparability, and liquidity risk. There are typically three forms of direct investment in infrastructure assets: Equity, Mezzanine, and Debt.

Equity investment is typical made by the project sponsors such as the construction firm, equipment suppliers, development banks and other financial investors.  The financial investors include infra funds, insurance companies, pension funds and private equity funds that typically enter at a later point in the project after the start-up phase.  These financial investors often buy-out the original project sponsors.  The capital contributed can take different forms but is usually cash or project assets such as land or equipment.  Equity investment corresponds to shares in the Special Purpose Company and can confer certain voting rights.  Equity is normally is the range of 10%-30% of the total capital, and provides returns in the range of 15%-20%.  Currently, only Australia, Canada and the UK have robust secondary markets for infra equity shares, but the US market is growing slowly. Similar to commercial real estate, mezzanine investment is an interest bearing loan that is subordinate to primary debt, but can increase in value with the growth of the project.

Mezzanine investment is used when equity investment is insufficient or too expense, or if debt is limited.  Mezzanine investment interest rates are based on expected cash flows and project covenants.  Also, it can be tax deductible and may confer certain rights of information, participation or control. Debt investment is typically 70-90% of the capital raised and is primarily provided through bank loans and bonds.  Due to the size of the loans required (often over $50mil), the loans are syndicated between a consortium of different banks.  To entice World Bank and Development Bank support, these bank syndicates often include small local banks when the project is in the developing world.  Interest rates vary based on the project and sponsor specific risks, but the spread is typically 80-140 bps above the risk free rate.  The loans cover the entire life of the asset and are secured by the project collateral and contract covenants.  These are usually fixed rate loans and are often swapped. Bonds or notes are also often widely used for P3 developments raising over $100mil in debt.  Bonds can potentially offer a lower interest rate than loans depending on the credit rating of the project.  However, the broad distribution of bond holders can make bonds less flexible in case of project problems that require capital restructuring.   Also, because bonds are typically issued at one-time in one lump-sum, interest payments may have to be made prior to the actual need for capital (loans can be drawn down as necessary).  Bonds are also used if the project term is over 50 years.   Bonds can be placed privately for purchase by institutional investors, or listed on the open market.  While open market sales offer more liquidity, the process for public offerings is cumbersome due to regulatory requirements and restrictions.  However, the need for a robust public market for P3 debt increases with number of P3 transactions as seen in Australia and Canada.  In order to facilitate P3 debt issuances Government programs such as TIFIA, USAID and the Overseas Private Investment Corporation will often subsidize or enhance debt offerings. Although direct investment in infra provides better economic returns and is a better model than funds due the reduction in fees, most investors don’t have access to direct investment and tend to approach the asset class through funds.

Most retail investors also don’t have the investment, engineering, tax and legal expertise to vet quality infra assets.  Additionally, infrastructure as a retail investment is hindered by the novelty of the asset class, lack of investor knowledge and experience, shortage of data, and unfamiliarity with investment vehicles.  Historically, direct investment in unlisted infra assets also required significant allocation for large chunks of securities which were restricted for resale causing limited liquidity. So, given that retail direct investment has not historically been a widely used source of capital for P3 project developers, what are the incentives for considering public offerings of securities?  First, due to the reduction in underwriting and syndication fees, the cost of capital associated with public offerings can be lower by 200-300 bps (reference?).  Second, advancements in technology allow for greater investor knowledge and potential reliance on investment platforms that provide asset evaluation as part of their value proposition; increasing the retail demand for infra securities.  Third, public investment reduces P3 developer political risk by reducing public perceptions of excessive returns for the financial industry, returns being primarily received by foreign investors, lack of transparency, and foreign control of domestic assets.  Finally, recent changes to securities regulation allow for easier and less costly public offerings of securities.

Read More