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Listed Infrastructure: An Investment for Uncertain Times

The Lazard Global Listed Infrastructure Team

Investing is all about risk and return.  And so it should be for infrastructure. Today, however, it seems it is also about access.

Many large institutions such as pension funds have been considering an allocation to infrastructure. We believe that infrastructure sits in two separate positions on the risk return spectrum.  Infrastructure development is a high-risk investment, demanding the expectation of returns above that of listed equities.  By contrast, infrastructure “ownership”, where you invest in mature assets with existing operations, should be positioned between listed equities and fixed interest in the risk/return space.  Lower risk than general equities, but more risk than bonds.  And its return?  We think that the efficient, well-funded market that we have today, should price this risk at about inflation, plus 5% p.a., again between bonds,  inflation plus about 2-3% p.a. and equities, inflation plus 7-8% p.a.

It is this latter category that we find attractive for investors.

“Ownership” infrastructure is where Lazard seeks investment opportunities, what we call “Preferred” infrastructure, with key attractions for investors — longevity, low risk of capital loss, and revenues linked (explicitly or implicitly) to inflation. It is precisely these defensive qualities that are attractive for investors in the uncertain times in which we currently live. 

Most banking systems that were in peril a year ago have been “saved”, for the time being at least, though the cost of doing this is not at all clear.  Near-zero interest rates in many developed economies, and large government stimulus programmes worldwide, may have staved off the Second Global Depression that many feared a year ago, but the still unanswerable questions remain: how are economies to be weaned off monetary easing and fiscal deficits, back to normality? What will be the ultimate cost for each country, who will pay it, and how? Does deflation or inflation lie along the path?

We still do not know the answers to these important questions but we do know that the global financial crisis could have major impacts on the values of investments like bonds, equities and property.

In these still uncertain times, investors will continue to look for opportunities to allocate capital to stable asset classes and high-quality, long-term investments. Infrastructure assets offer such an opportunity, as people will continue to commute to work (toll roads, rail lines), turn on the water (water utilities), and power homes and businesses (transmission and distribution grid) even during an economic downturn.  In particular, Preferred infrastructure has attractive characteristics for the uncertain times we face, namely those that might leave investors with their real capital intact and with satisfactory total returns in the face of inflation and deflation while providing a reasonable return in the interim. These attractive characteristics are:

• Ownership of real assets. If there were a period of high inflation, rising replacement costs would sustain the real, long-term value of those assets.
• Stable demand. The more stable the demand for a company’s product or service, the less vulnerable it is to deflation or slow economic growth.
• Pricing power. The ability to maintain prices during deflation or increase them in inflationary times is an important stabiliser for profitability in turbulent economic conditions.
• Generous operating margins. For a typical industrial company, EBITDA (earnings before interest, tax, depreciation and amortization) averages around 15% of revenue. The equivalent for a fully operational toll road can be 90% or higher, and regulated utilities often earn a 60% margin or more. The higher this margin, the less geared the business is to a fall in revenue, whether from declining volumes, prices or both.
• Manageable debt. In inflationary times, equity holders in a company with real assets and plenty of debt can benefit at the expense of the debt holders, who are repaid in nominal dollars. But the reverse is true in times of deflation; and if debt cannot be rolled over, or falls due when interest rates are high, shareholders can be prejudiced and sometimes lose control of the business to the creditors. The important thing in uncertain times is for companies to be able to manage their debt and for it not to dominate them.

But as we noted at the outset, investing in infrastructure is also about access.

There are two main ways to invest in infrastructure: direct, that is through unlisted or private equity investments, or listed, that is through stocks quoted publicly on stock exchanges.  Importantly, the characteristics of the assets themselves do not change regardless of whether they are held directly or via an exchange.

Given a choice between the same assets (absent considerations such as liquidity and fees etc.), at the time that the investment decision is made an investor should be indifferent as to how they are held.  Investors should be more concerned with their entry point (i.e. the prevailing market valuations of the assets at the time they are investing) and the prospective risk-adjusted return.

The Global Listed Infrastructure team believes that today, listed infrastructure is selectively very cheap compared to history.

Today there is a mountain of capital seeking infrastructure investments on a direct basis.  Not only are the major funds looking for opportunities, there are a plethora of funds that have been formed to take investors into infrastructure.  Despite this plethora of direct unlisted managers available, the total market size of listed infrastructure is at least five times the size of the total unlisted market. 

The mountain of undrawn equity capital commitments that direct infrastructure managers are sitting has been raised between 2006 and 2008 when there were high return expectations premised on cheap debt and high levels of leverage. The global financial crisis has seen cheap, abundant debt disappear, and consequently the rate of new equity investment has fallen. We believe investors with existing undrawn commitments to direct infrastructure may not get fully invested.

The chart illustrates the new equity commitments made to direct infrastructure managers between 2000 and 2009 (the green bars), with a substantial increase from 2006 to 2008. It also illustrates Lazard’s estimates of the drawdown of direct infrastructure equity commitments (the orange bars) through new deals. With supply of capital outweighing investment activity, the end result is a balance of undrawn direct infrastructure commitments (the blue line) that has continued to grow at a substantial rate. Today the total balance of undrawn commitments of direct infrastructure totals more than US$100 billion.

We estimate it would take 20 years for the existing undrawn commitments to be fully invested, assuming no further capital raising and the same buoyant market conditions that existed during the period 2000 to 2009 applied in the future.

We believe the main reason for the significant drop in investment is the collapse of debt markets in 2008, and the subsequent tightening of lending criteria and leverage levels in 2009. Why is debt important? In order to achieve an equity return of 12% per annum or greater in a fairly-valued marketplace for mature infrastructure, it is necessary to use a leverage ratio greater than 50%. Put simply, the tightening of credit markets has meant there is insufficient debt available for direct investors to meet their target equity return hurdles, and consequently, the investment of committed capital has not been made.

An attractive alternative to investing in direct infrastructure is investing in listed Preferred Infrastructure. Currently, this offers excess risk-adjusted returns, transparent and competitive fees, and, importantly, suffers no issues with regard to delays in getting fully invested.  Looking back at its four year period of operation, our investment strategy, which focuses on Preferred infrastructure, has outperformed the MSCI World Index (MSCI) and the UBS Global 50:50 Infrastructure & Utilities Index in Local Currency. It has achieved this with consistently lower standard deviation (strategy 15.6% p.a. vs. the Index 19.2% p.a. and MSCI 20.2% p.a.), and a daily beta to the Index of 0.6 and MSCI of 0.5. 

The Global Listed Infrastructure team believes that investment returns promised by direct managers have been too high. With the tight credit markets that now prevail, these managers will no longer have access to sufficient cheap debt to meet equity return targets, and it is likely there will be a persistent overhang of undrawn capital. Preferred infrastructure is an attractive alternative for investors, providing immediate access to companies with inflation-protected, stable revenues, that on our own assessment, offer a 30% discount to a fair risk-adjusted return.

Exhibit 1:

Capital raisings, drawdowns, and undrawn commitments of unlisted/PE infracsturcture

As of 31 December 2009.

Source: Preqin Ltd., Macquarie Group, Lazard Asset Management.

Important Information

Published on 8 March 2010.

Securities and instruments of infrastructure companies are more susceptible to adverse economic or regulatory occurrences affecting their industries. Infrastructure companies may be subject to a variety of factors that may adversely affect their business or operations, including additional costs, competition, regulatory implications and certain other factors.

This commentary is being provided for informational purposes only. The information and opinions presented have been obtained or derived from sources believed by Lazard to be reliable. Lazard makes no representation as to their accuracy or completeness. All opinions expressed herein are as of the published date, unless otherwise specified, and are subject to change.

This is a financial promotion and not intended to be investment advice.

Issued and approved by Lazard Asset Management Limited, 50 Stratton Street, London W1J 8LL. Lazard Asset Management Limited is incorporated in England and Wales with registered number 525667. It is authorised and regulated by the Financial Services Authority.

© 2010 Lazard Asset Management LLC

Company Profile

 With origins dating back to the 19th century, Lazard Asset Management has a discreet yet considerable reputation for outstanding investment management expertise. We manage approximately £72 billion of assets* around the world across a broad range of asset classes including UK and global equities and fixed income. We have considerable experience of working with UK pension fund clients, managing almost £8 billion on their behalf via a number of relationships, including more than £2 billion for local authority clients.

 *All assets data as at 31 December 2009

 Please contact Louisa Vincent, Head of Institutions, on +44 (0)20 7448 2118 or louisa.vincent@lazard.com, or visit www.lazardnet.com.