The difficulty large asset owners face in balancing sometimes conflicting messages around infrastructure were discussed at length in an online roundtable hosted by Investment Magazine and EDHECinfra, titled: The evolution of infrastructure portfolio construction: Benchmarking and understanding the risks.
Tim Whittaker, Research director – data at EDHECinfra, said it is a flawed approach for investors to go into infrastructure seeking smooth returns. Unlisted assets are more volatile than many asset owners realise, but infrequent valuations can hide this fact and give the illusion of greater stability.
“If you are unlisted and you’re only updating these valuations once a year, you’re never going to see that,” Whittaker said.
“So the way around that is obviously to try and mark to market as accurately as possible as often as possible. So quarterly, at the very least update your discount rates to take into account the movement and interest rates.” EDHECinfra produces quarterly market indices and monthly estimates for unlisted infrastructure equity and private debt.
Held at a time of major activity in the infrastructure space with the potential transaction of Sydney Airport and Telstra’s sale of half its mobile tower business, roundtable participants began by grappling with how to actually define ‘infrastructure’.
Danny Latham, partner and co-head of Australia and New Zealand, unlisted infrastructure, at First Sentier Investors, has been working in the infrastructure space since 1994. Infrastructure used to be considered defensive, monopolistic, with high barriers to entry and correlated in some way with inflation, with a focus on steady, predictable cash yields and a focus on capital preservation, Latham said.
But more recently, varied assets like the London Stock Exchange, lottery systems, and land title offices have been thrown into the mix.
Latham warned against the tendency to slap simple labels on assets. A data centre, for example, could be considered infrastructure, private equity or even real estate depending on factors like the contracted position, the counter-parties and the associated technology risk. The same could be said of a wind or solar plant.
“It’s beholden upon the market participants to unpick the various risk characteristics of the underlying asset, rather than just sort of throw everything in one bucket,” Latham said.
Whittaker, who co-created the TICCS® classification standard of infrastructure companies maintained by EDHECinfra, agrees that infrastructure assets are not just sectors but also ‘business models’ such as regulated assets vs. merchant or contracted infrastructure, as well as different types of companies. He highlights that project finance SPVs for example can be expected to behave completely differently from regular ‘corporates’, irrespective or sector or business model.
For institutional investors, categorising assets according to the various buckets of their mandate often depends on what they are solving for, for example stability and predictability, or correlation with GDP and inflation.
Asset types can move into, and out of, the definition of infrastructure in terms of what types of assets possess the characteristics 4D’s clients demand, agreed Sarah Shaw, 4D’s global portfolio manager and CEO/CIO. The midstream sector has moved into 4D’s definition, while the satellite sector has largely moved out to become “quite fringe”.
Assessing the risk premia of individual assets against a portfolio’s needs can help investors capitalise on assets that do not fit traditional definitions, said Dania Zinurova, Portfolio manager, real assets at WAM Alternative Assets.
“I had in the past situations where we were bringing something really interesting like, let’s say digital infrastructure, but from the risk/return perspective it was sitting more between infrastructure and private equity,” Zinurova said. “And then a client would be saying: ‘Well, where do I put it in the portfolio? I only have core infrastructure and there’s no private equity.’”
Of course, a total portfolio approach such as this comes with technicalities and challenges such as how to benchmark and how to meet strategic asset allocation targets, she said. EDHECinfra now produces analytics that answer these questions said Whittaker. For hundreds of sub-segments of the universe, quarterly reviewed and recalibrated risk premia and other pricing metrics can be accessed on the EDHECinfra platform to better understand where infrastructure sits in the portfolio,
Diversification is also important and the growing variation among infrastructure assets can contribute towards a more resilient portfolio. Michael Landman, executive director, portfolio management – infrastructure at IFM Investors said even within the theme of core infrastructure, there can be variation in terms of the resilience of cash flows and the level of market risk.
“Having you know, everything being core infrastructure, dead down the middle is impossible, and in fact, we don’t want it,” Landman said. “We want diversity.”
But Jerom Lotscher, Senior investment strategist at TWUSuper, said he is skeptical when investment managers talk about “pushing the boundaries of what infrastructure is.”
TWUSuper takes a traditional view of infrastructure, investing mainly in things like airports, seaports and toll roads and classifying them as core infrastructure, he said.
“Sometimes there may be merit in the argument, sometimes I think it’s maybe some kind of opportunistic thinking that might not be serving the client as well as it might be the manager,” Lotscher said.
Set and forget?
Infrastructure assets also can be considered to somewhat look after themselves, said Latham, but this, too, has changed.
Operational risk is a factor that should play into the decision about whether certain assets are right for the portfolio, he said. Social infrastructure assets like schools, hospitals or prisons involve the provision of a building and maintenance of that building without a lot of moving parts in terms of the operational business or the occupier. But “economic infrastructure” assets are much more complex businesses such as airports, with thousands of employees, millions of customers and constant, dynamic change.
“You need to have good management teams [for economic infrastructure assets],” Latham said. “So it’s effectively a private equity, management philosophy, but the underlying assets probably have a lower risk profile.”
Even highly regulated assets shouldn’t be seen as “set and forget”, Landman said, as political pressure and growing headwinds from regulators can push down equity returns. Like other forms of risk, regulatory risk can be cyclical.
COVID-19, of course, brought greater complexity to how asset owners understand the performance of infrastructure assets over the long term. Nobody would have expected, noted Landman, that ports would be seeing record container imports only months after the initial shock of the pandemic. There was a similar story for trucks on toll roads.
Increasing regulatory risk is also emerging with regulated assets in Australia as the regulator sets its sights on valuation and benchmarking, noted Latham.
In other words, infrastructure assets are risky and these risks need to be measured and benchmarked if they are going to be managed at the portfolio level.
The challenge of benchmarking
The participants spent some time pondering how it’s possible to benchmark an asset class that is becoming very broad for some investors and still has a very narrow remit for others.
Michael Drew, trustee director, QSuper and professor of finance at Griffith University, said it was important for the industry to come together on the choice of an index to ensure it represents the opportunity set that large asset owners participate in. The depth of the index was important, as well as ensuring a mix of core and core+ opportunistic assets; dealing with survivorship bias issues; and having a mix of hedged and unhedged returns.
“Some of its very idiosyncratic to the actual asset class and speaks directly to the heterogeneity of these assets,” Drew said.
The benchmark chosen by the Treasury under Your Future, Your Super legislation “have the risk of oversimplifying and disregarding members’ interests,” Drew said. They may lead trustees to take more equity tail risk, and they rely on an assumption that a one-size-fits-all approach can apply to all members, regardless of age or stage of life. Good fiduciaries should be “in the business of being great at providing patient capital to great asset managers,” he said.
“The way the provisions are written, you could have a silly situation where a listed-type approach gives a particular outcome but [doesn’t] incorporate long term real assets that actually would give a better risk-adjusted return for the member.”
Zinurova said many global asset owners do use the approach of comparing private infrastructure assets to comparable listed assets with the aim of outperforming public markets by around 2.5% with a mix of core and opportunistic strategies. “They use this approach, what they call public market equivalent,” Zinurova said. “For their purposes, [it’s] more in line with the thinking: ‘If I take on illiquidity risk, then I should outperform public markets,’ and they would use it for private equity, for infrastructure and for real estate.”
Landman said IFM had written a letter to Treasury, arguing a single benchmark is not appropriate for such a diverse asset class. “We didn’t get very far,” Landman said. “So they weren’t taking a very pragmatic approach, whereas I think we needed to have a pragmatic approach.”
A listed index is definitely not appropriate, Landman stressed, and settling on a non-listed index was an achievement for the industry, despite it being a solution “which is not perfect”.
“But my view is, it’s something that the industry should be able to live with, notwithstanding that there needs to be greater governance of the chosen index,” Landman said.
New approaches to benchmarking
Currently most asset owners are taking a relatively simple approach to benchmarking.
Lotscher says TWUSuper uses a simple CPI plus 5 per cent per annum benchmark for its infrastructure assets. Shaw said 4D Infrastructure uses an absolute benchmark of CPI plus 5.5 per cent. Latham said First Sentier Investors uses a 9 per cent local currency net benchmark. Landman echoed IFM’s choice of a CPI plus 4 per cent benchmark.
Creating a truly representative benchmark for infrastructure investment involves having a broad selection of the asset class to allow for situations where markets fail to value assets correctly, Whittaker commented.
“As long as your index is broad representative of the asset class, it allows you to tell a convincing story associated with the underlying assets and help with some of these asset allocation decisions,” he said.
Addressing survivorship bias in particular is essential, said Whittaker, who leads a team of researchers and analysts who maintain the largest database of infrastructure investment data in the world, tracking hundreds of assets in 25 countries. Market changes over time cause the same asset to face significantly different dynamics, for example the changing view towards renewables or alternatives such as energy storage. Going back to data from 20 years ago is no simple feat.
“So how is it that you can match all of these different sort of dynamics over time?” said Whittaker. “That’s one thing that we’ve spent a lot of time thinking about, mapping the market and how it evolves over time. “So a utility that you owned 20 years ago is not the same as the utility today. And I would argue that it’s not going to be the same in five or ten years time either.”
Via its suite of monthly indices that show at how risk premia change over time and using leveraging data and secondary market valuations, EDHECinfra has created a suite of monthly indices updates cash flow models on a quarterly basis and correct for reporting factors, such as the so-called “June quarter effect” where sudden changes in valuations at the end of the financial year can be detected as asset owners get their houses in order for the auditors.
Whittaker highlighted this data is available on EDHECinfra’s online platform which gives investors the ability to create more accurate discount rates and better valuations on a more timely basis.
The group pondered, as the regulation of infrastructure investment takes a step towards using market benchmarks, whether the absolute return benchmarks currently preferred by the Australian industry come to pass.
The choice of benchmark made by the regulator for APRA’s performance tests was an opportunity for a detailed discussion, the group concluded.
While the use of listed benchmarks was unanimously rejected for the purpose of performance benchmarking, unlisted indices also brought the questions of representation, biases and accuracy of the metrics to the fore, issues participants in the discussion noted trustees are well aware of.