Investors seek cash yields despite lower return expectations
Cash yields are driving investors into infrastructure and other real asset categories, despite lower expected returns powered by all that capital moving into the sector.
Overall, the amount of capital raised by infrastructure funds has been rising steadily since 2011, with $67.7 billion raised in 2017, a 10-year high and up from $65 billion the year before, according to London-based alternative investment research firm Preqin Ltd. In the first five months of 2018, some $24 billion was raised, Preqin data show. What's more, infrastructure managers have a record amount of committed but uninvested capital — $152.3 billion as of Sept. 30, 2017.
Global infrastructure had an internal rate of return of 10.11% for the one year and 11.84% annualized for the 10 years ended March 31, according to the EDHECInfra Global Unlisted Infrastructure Equity index.
At the same time, managers are steadily raising specialized energy funds to take advantage of rising oil prices that are making energy investments more attractive. Also, clean energy is gaining popularity as alternative energy sources such as solar and wind are showing promise due to lower costs and expected technological advancements. That gives infrastructure investors extra exposure to energy because infrastructure funds also invest in energy infrastructure.
According to Preqin, energy funds raised $66.8 billion last year, the second-largest fundraising year over the past decade. The highest fundraising year for energy funds over the past 10 years was in 2015, when managers closed on $71.2 billion.
Not waiting on White House
Investors and managers are not basing infrastructure investment decisions on President Donald Trump's infrastructure proposal, especially since little has happened to advance it and most infrastructure investment is by states and municipalities, industry insiders say.
"Infrastructure assets are owned at the local level and tend not to be federally owned," noted Julio Garcia, head of infrastructure, North America, at IFM Investors Pty. Ltd. in New York. "It's helpful to get federal assistance, but it is not critical."
One example of IFM Investors' U.S. deals is its 2015 investment in the Indiana toll road. In 2016, IFM sold a 10% stake in the 157-mile toll road to the $352.8 billion California Public Employees' Retirement System, Sacramento.
Most of the investors that invest in infrastructure are continuing to invest globally, Mr. Garcia said.
"There's a missed opportunity for the government in the U.S.," he said. "If opportunity is not in the U.S., investors will look elsewhere."
IFM also invests in infrastructure assets in Australia, Latin America and Europe, where governments are more open to partnerships with the private sector, he said. IFM has a total of $80 billion in assets under management.
"Projects need to be built and there are no municipal bonds to finance them," Mr. Garcia said.
IFM executives are interested in investing in midstream energy infrastructure right now, he added. Major oil and gas companies are weeding through their pipelines and storage facilities, doing sale-leaseback deals on assets executives think the company doesn't need to own.
"This means they may sell ownership in the assets themselves and still have access," Mr. Garcia said.
Now that oil is well below $100 a barrel, despite a rebound in prices earlier this year, major oil companies are selling assets to bulk up the cash on their balance sheets, he said.
Meanwhile, master limited partnerships are not as active investing in pipelines because they are having a harder time raising capital, "creating more opportunity for us," Mr. Garcia said.
Making matters worse for MLPs is that on March 15, the Federal Energy Regulatory Commission announced a rule that, when implemented, would result in lower revenue for MLPs, explained Shalin Patel, Houston-based head of research and head of midstream and infrastructure at money manager BlackGold Capital Management LP. In the past, MLPs have been able to recover a tax allowance when setting their tariff rates. The new rule would no longer allow this because it had resulted in a double tax recovery for MLPs.
"This means that large pipelines with cost-of-service rates would have to lower their tariffs or remove tax recovery, resulting in lower revenues going forward," Mr. Patel said.
Infrastructure and energy tend to overlap, industry executives say.
"There's a fair amount of energy in infrastructure," noted Alan A. Pardee, New York-based co-founder and managing partner of placement agent Mercury Capital Advisors Group LP.
"Energy and power together are most of (infrastructure investment) in the U.S., for the simple reason that toll roads, airports and ports are generally not for sale here in the U.S.," Mr. Pardee said.
That is not the case overseas, and infrastructure funds will have exposure to those types of investments located outside of the U.S., he said.
No matter the sector or the location, investors are most interested in established infrastructure projects that produce a middle-level, double-digit return, Mr. Pardee noted.
With all the capital flowing into infrastructure, not all managers with infrastructure funds are able to attract investors.
Investors across real asset and alternative investment asset classes are worried because they know this economic cycle will end, he said.
"They want to put money to work, but they are being careful," Mr. Pardee said. "They are aware this cycle will come to an end at some point, and nobody has a crystal ball to tell them when it will shift."
Many investors want to stick with managers they know, he said. "The big (infrastructure) fund managers are only getting bigger and as a corollary, smaller managers are getting smaller but in the middle, performing players are doing well."
According to Preqin, 42% of the infrastructure capital raised in 2017 was secured by the five largest funds closed last year. Global Infrastructure Partners raised the largest infrastructure fund ever, the $15.8 billion Global Infrastructure Partners III, in January 2017.
Jim McDonald, Chicago-based chief investment strategist at Northern Trust Corp., which includes $954.4 billion money manager Northern Trust Asset Management, sees real assets' role as insurance to protect against the unexpected — such as a rise in inflation. Infrastructure and real estate do a better job of that than energy, he said. The reason is infrastructure's pricing power tends to be linked to inflation, Mr. McDonald explained.
However, when interest rates rise meaningfully, infrastructure and real estate are not as attractive relative to other types of real assets, such as natural resources, he said. "Infrastructure and real estate have more sensitivity to interest rates than natural resources does."
Returns over the next five years are expected to fall due to the amount of capital being invested in the asset class.
Infrastructure is no different from many asset classes, Mr. McDonald said.
"There's a lot of capital chasing into real estate, the bond market, stock market," he said. "The implication, historically, is higher valuations today mean return expectations over the next five years should be more modest."
"I just think it is critical to think of it as an insurance policy against the risk of a higher inflationary environment," Mr. McDonald added. "You buy insurance when you don't need it because it's less expensive. If you wait to buy insurance when inflation rises, the premiums will be a lot more expensive."
Investors agree and are putting more money into infrastructure. In May, the $55.6 billion Los Angeles County Employees Retirement Association, Pasadena, added an infrastructure allocation, amounting to 3 percentage points of the pension fund's 17% allocation to real assets and inflation hedges.
Private infrastructure provides an inflation hedge, additional diversification and modest potential for return enhancement, according to a report by Meketa Investment Group, LACERA's general investment consultant.
Elizabeth Crisafi, chief investment officer of the $8 billion San Diego City Employees' Retirement System, said, "From our perspective, the biggest reason to have infrastructure in the first place is diversification and for its cash-flow characteristics. It's fairly recession resistant."
However, SDCERS is steering away from core infrastructure because the capital seeking to invest in the sector has driven up pricing. Pension fund officials are focused on the opportunistic end of the infrastructure investment spectrum, "where there is still value," Ms. Crisafi added. Among the opportunistic and value-added areas of focus is infrastructure related to information technology and communications, she said. While the portfolio could include some greenfield, the portfolio mostly has brownfield infrastructure, she added.
Last month, SDCERS adopted a new infrastructure benchmark to more fully compare to the value-added risk posture of its infrastructure program, Ms. Crisafi said. The new benchmark is the consumer price index plus a premium of 500 basis points. The former benchmark was CPI plus 300 basis points.
A few investors and managers are investing in cleaner sources of energy, betting on the increasing profitability of solar and wind and new technology that could upset the oil- and gas-based energy market.
"Clean energy is an acquired taste for investors," Mercury Capital's Mr. Pardee said. "Investors have had mixed experiences investing in renewables … (but) there is demand. There are people becoming good at it. ... Renewable investments seem to do better in a broader fund in which the manager can time what they see as opportunity."
Last year, for example, the C$189.5 billion ($146 billion) Ontario Teachers' Pension Plan, Toronto, and clean-energy distributor Anbaric created Anbaric Development Partners for clean-energy infrastructure projects in North America. OTPP will hold a 40% stake in the new firm.
In February, CalPERS invested an additional $246 million in Gulf Pacific Power, an infrastructure separate account that is an existing partnership between CalPERS and Harbert Management Corp., investing in clean energy. The total asset size of the account could not be learned.
CalPERS also has a custom fund of funds with $257 million in plan assets managed by Capital Dynamics investing in clean energy and technology.
"Renewable projects, especially with long-term contracts, are good for pension funds, insurance companies, sovereign wealth funds — people with long-term investment horizons," said John Breckenridge, New York-based managing director and head of clean energy infrastructure at Capital Dynamics.
The firm closed a $1.2 billion fund, Capital Dynamics Clean Energy & Infrastructure V, in January 2017 and by February 2018, executives had invested the entire fund, Mr. Breckenridge said. The fund is a 15-year fund whose lifespan can be extended.
"For very, very large investors — investors with hundreds of millions of dollars — we try to accommodate them" if they want to continue owning their slice of the investment, he explained. When the fund comes to the end of its life, large investors can continue owning their portion of the investment.
"Once projects are up and running, there is a stream of cash flows people like and it has an (environmental, social and governance) aspect to it," Mr. Breckenridge said.
David Scaysbrook, Isle of Capri, Australia-based co-founder and managing partner of Quinbrook Infrastructure Partners Pty. Ltd., a manager focused on low-carbon and renewable energy infrastructure investments, sees a lot of opportunity in the U.S.
"It's not ideological anymore but based on dollars and cents," Mr. Scaysbrook said. "The amount of activity and money around clean infrastructure is reaching heretofore unprecedented levels."
Coal-fired and other traditional sources of energy cannot compete on costs with cheaper renewables, he said.
What's more, investors will need to consider that technological advancements in the renewable sector could result in clean energy sources cutting into the businesses of traditional energy producers and eventually upend the energy sector, Mr. Scaysbrook said.
For example, toll-road investors should consider whether to install charging stations for electric vehicles, he said.
"Wind and solar, in particular, represent 80% of all investment dollars in clean energy. ... There is no question they are forcing out higher-cost coal products," Mr. Scaysbrook said.
Renewables are, however, not competing with gas, which is now a transition fuel that takes over "when the wind doesn't blow and the rain doesn't shine," he said. "Gas can support clean energy until clean energy can go around the clock. … How long? Not 10 years — maybe 20 years from now," Mr. Scaysbrook said.