While great progress has been made in recent decades to alleviate global poverty, investment in infrastructure, one of the key drivers of gross domestic product growth worldwide, is still underfunded.
- There are 1.2 billion people without electricity.
- 660 million people are without drinkable water.
- A third of the population is without proper sewage.
McKinsey & Co. estimates the global shortfall at $3.3 trillion a year from 2016 to 2030, while the Asian Development Bank believes Asia alone needs $1.7 trillion a year before adjustments for climate-based costs.
Unfortunately, infrastructure funding is one of the first things to get cut from sovereign budgets when there is a downtrend and many countries have not renewed commitments to infrastructure development since the financial crisis of 2008-10. Sixty percent of the investment needed is in emerging economies, with China representing about half of that.
Without investment, eventually growth will slow and falter. The McKinsey Global Institute estimates needs already exceed investment by around 0.4% of global GDP and decaying infrastructure is responsible for loss of productivity. On the other hand, it estimates that a dollar of infrastructure investment can raise GDP by 20 cents in the long run.
Where will funding come from?
An obvious answer to the shortfall lies with banks and institutional investors that have $120 trillion in assets, largely from advanced economies. The breakdown includes $40 trillion held by banks, $29 trillion held by asset management companies and $26 trillion held by insurance companies and private pensions. Another $24 trillion is held by public pensions and superannuation plans, sovereign wealth funds, infrastructure operators and developers, infrastructure and private equity funds, and endowments and foundations.
Current allocations to infrastructure assets for major pension funds vary from 3.5% to 5%. In many cases, they are investing below their target allocation due to a lack of good options.
Private infrastructure investment offers investment diversification — the only free lunch — because it is not highly correlated with other asset classes. Publicly listed infrastructure investment is.
Of course, infrastructure investment can take many forms — direct investment, listed and unlisted funds, funds of funds, listed equity and bonds, private equity, bonds and loans, which provide investors with numerous options and return characteristics.
- Infrastructure debt investment can be attractive for matching long-term income streams with long-tenor debt, usually several times longer than banks are willing to provide. It offers a long-term stable cash flow at attractive yields. Typical yields are 150 basis points to 200 basis points above credit and another 200 basis points is possible in dislocated markets for private project bonds.
- Equity investment offers higher returns and risk. According to Macquarie Group, one of the largest asset managers in the world of infrastructure assets, internal rates of return are running about 7% to 8% per annum for listed funds. Private equity infrastructure funds with a core infrastructure focus such as power generation are yielding from below 10% to 13% gross in emerging markets, with a new median net IRR of about 9%.
- Direct investment offers the highest potential returns and risk. Greenfield investments have underperformed, in both core and value-add investments, usually because of initial planning and construction issues. Some 65% to 75% of direct investment in infrastructure is already done by corporate investors, such as energy, telecom and public utilities companies.
However, while the idea of using the liquidity of asset holders to fund infrastructure development has legs, several challenges remain.
- Inconsistent cross-border regulatory regimes and investment principles, causing crowding out of the private sector;
- Lack of a pipeline of well-developed projects from which investors can choose;
- Investor protection regulations and pension rules that restrict investment;
- Lack of transparency and standardization to judge relative performance;
- Lack of a developed secondary market and clear monetization path to provide liquidity; and
- Poor infrastructure project management.
Obviously, where the private sector can be engaged to finance infrastructure without tapping limited public sector funds, that should happen, although many investors are too nervous to come in at the greenfield stage.
Multilateral organizations can assist even with private sector projects by identifying projects and consulting in the early stages of development on planning, preparation and training before sending them to market for financing. Another possible solution is further investment in project preparation facilities, public or public-private organizations that help to move a project from concept to investment-readiness. The World Bank's Global Infrastructure Facility is a good example.
McKinsey estimates 20% to 40% could be saved in development costs for infrastructure projects if they were better managed, especially in the early stages. Issues include insufficient planning and design, lack of construction skills and technology. Here, too, development banks can take a role in helping to transfer learning and encourage best practices without necessarily dictating terms.
The game changer, however, for infrastructure development is public-private financing and management partnerships that have the potential both to increase global growth and create millions of jobs in the most demographically challenged countries.
As an example, Eastspring recently agreed to co-invest with IFC in a portfolio of emerging-market infrastructure investments with a layer of loss protection for insurance investors. The structure of this partnership breaks new ground in providing a credit enhanced platform for clients to participate in a portfolio of emerging market infrastructure loans.
Other multilateral bodies, such as ADB and Asian Infrastructure Investment Bank, particularly those with a focus on Asia where the need is greatest, should increase their efforts to expand private-sector blended finance and provide advice and encouragement to national governments to develop local capital markets facilities to do the same.
Multilaterals and not-for-profit international financial organizations such as International Association of Insurance Supervisors, International Organization of Securities Commissions, International Banking, Economics and Finance Association, Financial Stability Institute, Bank for International Settlements and the Basel Committee on Banking Supervision can work with representatives of the private sector to help formulate and agree best practices to set appropriate legal, regulatory and reserves policy for infrastructure capital in pension funds, insurance and banking companies to make it easier to invest. Hopefully, they may go further and harmonize legal documentation, free information flow and improve where necessary the bankruptcy, insolvency and resolution regimes, thus paving the way to a more liquid trading market for both private and public market participation in infrastructure deals.
Headway in the direction of cataloging infrastructure investment and creating performance benchmarks is being made by EDHEC Infrastructure. EDHEC has created several infrastructure indexes, modeling "free cash flow to equity," capital structure, payout volatility, and duration by country and industry over time intervals for numerous projects, both greenfield and brownfield. Over time, these indexes should help investors select projects with more investment upside and managers with proven track records.
In developed markets, life insurers have long invested in infrastructure assets. In Asia, direct investing in infrastructure is still in its infancy. It is important that the international investment community works together to accelerate the development of the investibility of this economically and socially important asset class.
Investors will benefit not only from the sustainable, long-term financial returns produced by properly managed infrastructure investments, but also in knowing that their savings are working hard to improve the quality of life in their own countries for the long run.
Virginie Maisonneuve is chief investment officer of Eastspring Investments, Singapore. This article represents the views of the author. It was submitted and edited under Pensions & Investments guidelines, but is not a product of P&I's editorial team.