Why are sophisticated investors so intrigued by infrastructure?

Our succinct perspective on key investment and wealth-related issues.

If you follow the financial news, lately you have heard a lot about “infrastructure.” You have likely seen headlines touting government plans to build new infrastructure – assets and networks that facilitate critical elements of our daily lives and economic activities (think of toll roads, airports, wind farms, data centers and cellphone towers as examples).

Infrastructure has also become an important topic in the world of investing. Notably, in recent weeks, two of Canada’s largest pension plans (the Ontario Teachers’ Pension Plan and Public Sector Pension Investment Board) announced plans to increase their already-sizable allocations to infrastructure. In fact, many large institutional investors (such as pensions, endowments, and sovereign wealth funds) have embraced investing in infrastructure assets – either through direct ownership of individual assets (like the Canada Pension Plan’s interest in Highway 407) or by allocating to pooled investment strategies that invest in a portfolio of infrastructure assets.

Why are the world’s largest and most sophisticated investors increasingly turning to private infrastructure as an alternative to stocks and bonds? Infrastructure assets offer differentiated risk and return characteristics, while providing diversification benefits inside a traditional portfolio.

Skilled infrastructure investors have the potential to generate enhanced rates of return due to the high barriers to investing. Unlike public equities, which trade on transparent exchanges, the market for infrastructure assets is illiquid and opaque. And while any fund manager or DIY investor can buy shares representing a fraction of a public company, purchasing ownership in an infrastructure asset usually requires an investor to commit hundreds of millions of dollars to a single transaction.  Furthermore, managing an asset like a toll road or a solar farm requires significant time and operational expertise (versus simply “buying and holding” a stock). These factors preclude most investors from bidding on infrastructure assets, limiting the pool of prospective buyers and thereby increasing the expected returns of the assets.

Along with the potential for superior returns, infrastructure assets have a less volatile return profile than public market equities. As businesses, infrastructure assets tend to provide an essential service (like energy, transportation, or communication networks) for which demand remains resilient throughout the economic cycle. And, in many cases, the revenues of these assets are guaranteed by contracts with governments or large corporations, which may extend to contractual revenue increases based on the level of inflation. In addition to their stable revenue base, infrastructure assets do not trade on exchanges, so their valuations are not influenced by short-term fluctuations in capital markets. This removes the “mark-to-market” volatility that characterizes many publicly traded investments.

The third important benefit of investing in infrastructure is portfolio diversification. Think of diversification as building your portfolio so that not all assets move in the same direction at the same time: when some “zig,” others “zag”… or, at least, do not “zig” very much.

Because infrastructure assets are often characterized by stable cash flows, low equity market correlation, and inflation protection, they tend to exhibit low correlation to the factors that make stocks and bonds “zig” or “zag” – namely changes in the business cycle, equity market gyrations, and interest rate fluctuations. This low correlation means that, all else equal, a traditional portfolio of stocks and bonds becomes less volatile when infrastructure is added to the asset mix.

Can you, as a high-net-worth investor, apply some of this institutional investor wisdom to your own portfolio? We believe the answer is “yes” – however, our discussions with clients stress a couple of important caveats.

For almost all high-net-worth investors, directly purchasing an infrastructure asset is not feasible due to the associated price tag and operational complexity. This leaves investing in a pooled infrastructure investment vehicle as the practical option. So, the first step becomes finding a wealth manager with the scale, industry relationships, and expertise to help you vet and allocate to high-quality infrastructure funds.

It is also crucial to have a strong understanding of your liquidity needs before making an allocation. Infrastructure assets do not change hands frequently, and therefore infrastructure investment vehicles typically require investors to commit their capital for between 5 and 15 years, depending on the nature of the strategy. So, in making an allocation to an infrastructure strategy, it is important to make sure that you have sources of liquidity elsewhere in your portfolio to provide for any expected (and unexpected) capital needs.

With interest rates at low levels, we think it is necessary for investors to evolve their thinking and embrace new ideas, as sophisticated institutions have, to achieve their objectives. With the right assistance, and a strong understanding of your financial circumstances, infrastructure investing can be part of the solution.