Supply-demand issue to hit infrastructure

Demand for infrastructure assets with a dependable, existing income stream now exceeds supply. That means investors might not get the income and return they hope for from future investments.

It's a familiar story in alternative investments, experts said: too much money chasing too few opportunities. This scenario often leads to poor returns.

Since the global financial crisis, cash flow has not been the biggest contributor to private infrastructure returns as some investors expected. And higher risk private infrastructure investments have provided less return than lower risk investments in the asset class, data show.

Industry insiders are concerned, although whether a bubble is forming is up for debate.

The asset class has such a brief investment history — just more than 20 years — that if infrastructure disappoints institutional investors now, they could stay away from investing in private infrastructure, said Peter Hobbs, managing director at Investment Property Databank Ltd., London, a research firm that is a subsidiary of MSCI Inc.

Michael Underhill, chief investment officer at Pewaukee, Wis.-based real asset money manager Capital Innovations LLC, is one of those who sees an infrastructure bubble forming.

He noted current data point that way. “Bubblicious fund activity — 148 private infrastructure funds currently in market as of 4 November 2014,” Mr. Underhill wrote in an e-mailed response to questions.

There was $150 billion in uncalled capital or “dry powder” committed to the asset class as of that date, as fund managers waited “for a correction or valuation reset” because values are high in North American infrastructure projects, Mr. Underhill wrote. He cited a combination of data from Capital Innovations, London-based alternative investment research firm Preqin and publisher Institutional Real Estate Inc.

“With record fundraising of $50 billion last year and some very high valuations being paid for large core assets, you can't help but wonder whether there is too much capital chasing too few deals,” said Todd Bright, managing director and head of Americas private infrastructure, for Zug, Switzerland-based alternative investment money manager Partners Group AG. “We believe that these investments could fail to deliver the stability of returns investors are looking for if the market environment does not stay as benign as it is currently.”

The reason is that some of the large core infrastructure transactions are underwritten with very optimistic assumptions about regulatory support and economic variables like growth, inflation and financing conditions, he said. Regulators have the power to set rates, thereby setting investors' rates of return, Mr. Bright explained. Regulators can also claw back windfalls of what they consider excess return from falling risk-free rates, he said.

“To avoid disappointment, I think investors need to remember that buying assets at historically high valuations exposes them to valuation risk, no matter how stable the underlying business is,” Mr. Bright said.

“While we'd stop short of calling a bubble, it is fair to say that in the private market, we've seen record and growing amounts of dry powder chasing limited deals, leading to rising prices paid for assets and declining” internal rates of return, said Vince Childers, portfolio manager, real assets at Cohen & Steers Inc., New York.

What's more, there are moves in Australia, parts of Europe and the U.S. to privatize infrastructure, which could add infrastructure investment opportunities. On Jan. 16, the Obama administration released a plan that included a tax proposal giving private firms access to public financing to encourage private investment in U.S. infrastructure.

Glen Matsumoto, partner, and head of infrastructure money management firm EQT Partners Inc.'s New York office, also doesn't think the current environment will lead to a bubble. The mitigating factor is that lenders are not yet willing to provide the high rates of leverage they did before the global financial crisis.

“Even if an infrastructure fund is willing to pay exorbitant prices, they would not get the same level of debt,” he said.

Indeed, highly leveraged infrastructure fund investments in September 2007 led to disastrous results in the 2008 financial crisis, with returns plummeting and some managers' businesses failing completely, Mr. Underhill said.

“That could happen again when the Fed raises rates and if funds are highly levered,” Mr. Underhill warned.

Overall leverage for infrastructure investments was 52% as of June 30; leverage for assets with contracts to buy their output was higher, at 57%, compared to leverage for uncontracted assets at 48%, IPD data show. Before the financial crisis, leverage rose to 80%, industry sources said.

Some core infrastructure investment funds also might have more risk than investors expect. For example, a manager could be buying a power asset with a five-year contract for power when the typical contract for a core project is 15 years, Mr. Matsumoto explained.

Investors are not being compensated for taking on additional risk in infrastructure, said Anthony De Francesco, executive director and head of IPD infrastructure products who is based in Sydney. The reverse was the case before 2008. This is in line with real estate, an asset class with which infrastructure is often compared, that also has failed to offer higher return to investors for riskier investments, he added.

In the five years ended June 30, lower-risk infrastructure investments produced an annualized return of 14%; moderate risk investments, 13.9%; and high risk earned 5.2%, according to preliminary analysis of data collected for the IPD Global Infrastructure Direct Asset index. (The new index's third-quarter returns are expected to be released in February.)

“As investors move up the risk curve, their performance has been diluted,” Mr. De Francesco said.

Asset owners think of infrastructure as stable and income-producing when in reality, the biggest slice of return over the past six years has been from appreciation, said IPD's Mr. Hobbs.

As of June 30, infrastructure's annualized total return was 14.7%, made up of a 4% income return and 10.4% appreciation, according to IPD index data.

Much of this is due to the fact that infrastructure rose in value, which cut the percentage of return that was derived from income during the period. But the proportion of return from infrastructure's income component might never be as high as it is for real estate, because the amount of capital required to maintain infrastructure is extensive, Mr. De Francesco said. Real estate income tends to make up 75% of its return, compared with 25% for infrastructure.

Most of the pressure is on investments in established, income-producing “core” assets, industry executives say.

Core infrastructure assets are in high demand and buyers have to pay higher prices for them, said Karl Kuchel, New York-based chief operating officer at Macquarie Group's North American infrastructure fund.

Investors are clamoring for core infrastructure assets because in a low interest-rate environment, core assets are attractive. They have allowed investors to achieve higher yield and higher return than they could gotten in other parts of their portfolio, Mr. Kuchel said.

But there still are more projects than capital for new infrastructure, so-called “greenfield” projects, said Matt LeBlanc, chief investment officer, OECD infrastructure equity at J.P. Morgan Asset Management in New York.

Mr. LeBlanc also cautioned against a strategy mismatch. Investors in value-added funds are not necessarily getting what they bargained for, he said, because managers are buying core or stabilized, income-producing assets for those funds. n