Infrastructure raises its asset profile

Investing in infrastructure projects is about to become much more of a mainstream activity. After mixed results from early forays into the nascent infrastructure asset class, investors are increasingly drawn to the potential steady, long-term returns that can be realized through these types of investments.

There are challenges: many are still struggling with how to analyze investments with extended time horizons, particularly after some players were burned by pre-crash overleveraging.

But the big picture is that government retrenchment in the U.S. and Europe is forcing a rethinking in how to pay for maintaining and improving essential transportation networks as well as water, power, and communications facilities. More private sector investment appears essential, but public-private partnership structures have been slow to catch on in the U.S., frustrating private capital sources and operators. Many of the nation’s road and water systems, meanwhile, are approaching the end of their lifecycles, and population gains are putting additional stress on aging systems.

The debt- ridden U.S. federal government is allocating less to state and local governments, which are hard pressed to increase taxes or user fees on constituents to pay for necessary infrastructure improvements. Something has to give.

In examining this issue, I met and interviewed several prominent investment industry leaders. One overall conclusion is that over the next decade, infrastructure will become a widely accepted asset class and a vehicle to deliver steady returns while meeting a public need. Investors benefit from long-term contracts (offering an inflation hedge) with partners that have strong credit.

And there is growing need: governments around the world, particularly in the U.S., will require greater private capital infusions to construct and operate systems which meet rapidly changing 21st century demands.

An evolving landscape

The United States once had the world’s most modern infrastructure. But today much of the nation’s vaunted interstate highway system is 40 to 50 years old and approaching the end of its life cycle; many water systems and sewage treatment facilities require overhauls as well.

The country requires new airports and more mass transit to keep pace with the demands of increasing population and congestion, and the nation has fallen behind global competitors in high-speed rail and state-of-the-art ports. On the power front, the country’s electric grid dates to World War II and needs to accommodate new sources of energy, including renewables (solar and wind stations) and natural gas powered plants.

In recent decades, government funding of defense, Medicare, healthcare, and social security has crowded out federal infrastructure spending, and the slow deterioration of essential systems has only recently become more noticeable. The longer the country delays, the greater the likelihood of higher price tags to address repairs and the possibility of greater dislocation from potential systemic failures.

Most new projects continue to be financed through the bond markets, pushing costs to future generations, while a new procurement market slowly is evolving to join together government planners with private operators and institutional funding sources. Despite some recent progress in establishing new procurement practices, obstacles remain, including deficit reduction and old financing habits.

The inevitability of public-private partnerships

While public-private partnerships have been tried with mixed success over the last several decades in the U.S., they will have to become more widely accepted as the public sector needs increase and private capital seeks investment opportunities. From the perspective of politicians and taxpayers, it may seem like selling out, but this is largely a perception issue. The reality is that when handled correctly, the public gains access to capital for needed repairs and updates, without sacrificing control over quality or revenues.

The lineup of players in the infrastructure investment universe is expanding in various combinations of engineering-construction operators, global investment fund managers, institutional investors, sovereign wealth funds and traditional lenders.

Eventually, probably sooner than later, state and local governments will have no choice but to embrace public-private partnerships as the crisis worsens.

Regulatory risks

Spooking some investors, especially in areas outside the U.S. and Western Europe, is an arbitrary and not wholly dependable regulatory environment. One threat is that once an investor is making money according to agreed-upon returns, the dynamic political environment may suddenly create a situation in which the government backs out. Concerns are also growing over the lackluster prospects for the general economy and how regulators’ appetites may decrease for permitting fee increases.

Investors’ appetite

Investor interest in U.S. infrastructure appears to be reviving as they come to terms with major issues, including leverage, regulations and the general tepid economic environment. Investors obviously want a measure of confidence in where they put their money, and that confidence is increasing.

In early 2010, investment flows were very slow, but they have picked up steadily in 2012.

The U.S. should eventually present a major opportunity for infrastructure investors, if only various state and local governments could figure out more uniform procurement practices and gain confidence in working with private partners. It would also help if the federal government could develop a long-term infrastructure plan to further a national infrastructure policy and support he states. Despite their own economic difficulties, eurozone countries are already ahead of the U.S. in formulating cross border infrastructure programs and allocating necessary resources.

I believe the consensus is that more money will head into the infrastructure sector as investors seek real asset alternatives to stocks and bonds. Players are also warily watching interest rate and inflation trends. Recent slow growth has compromised the flow of new work, but what happens to investments and costs if growth triggers hikes in rates or inflation kicks into gear as many expect? That will present an entirely new frontier of cost and valuation issues for an evolving industry.

William Ferguson is co-chairman and co-chief executive officer of FPL Advisory Group.