Features and Characteristics of Infrastructure

Infrastructure investments serve a societal role by promoting widespread economic, technological, and social development objectives. These investments are concerned with the allocation of resources to tangible, capital-intensive, and enduring assets designed for public consumption. These assets include: Airports, Healthcare facilities, Sewage treatment plants, etc.

Infrastructure investments resemble conventional equity and debt, but they also differ from one another. In the context of equity, it involves staking a claim in residual cash flows. On the other hand, debt is used for the financing and sustenance of these investments.

Characteristics of Infrastructure Investments

• Illiquidity and Uniqueness: Similar to real estate, these involve acquiring unique assets that aren’t easily liquidated, each having distinct locations and functionalities.
• Revenue Expectation: Investments in new infrastructure are undertaken with prospects of yielding cash either from capital appreciation or income.
• Partnerships: Often involve a consortium that merges multiple strategic partners with specialized skills and financial investors.

In most cases, infrastructure cash flows primarily stem from contractual payments rather than leases or rentals from commercial or residential tenants. These cash flows include:

• Availability Payments: Payments made in exchange for granting use to the facility.
• Usage-based Payments: Tolls, fees, etc., for utilizing the amenities.
• Take-or-pay Arrangements: Minimum purchase price agreements between buyers and sellers.

Driving Factors for Infrastructure Investments

• Demand: Allocations are driven by an augmented demand for infrastructure.
• Alternative Funding: Governments are persistently exploring alternative sources of funding for these investments.
• Privatization: Governments continue to sell state-owned entities to private investors, furthering the scope of infrastructure investments.

Public-Private Partnerships (PPPs)

Infrastructure assets are predominantly financed, owned, and operated by governments, with a significant portion of these investments being sourced from public funds in developing countries. Nevertheless, there is a growing trend toward private financing of infrastructure through public-private partnerships (PPPs) initiated by local, regional, and national governments.

A public-private partnership (PPP) is commonly defined as a lengthy contractual arrangement between the public and private sectors. Its primary objective is to enable the private sector to deliver a project or service that has traditionally been provided by the public sector.

Infrastructure investors might aim to:

• Lease assets back to the government.
• Sell freshly constructed assets to the government.
• Operate the assets till they attain operational maturity or even beyond.

Infrastructure investments often partner with institutions, which are specialized entities providing risk capital for non-commercial economic development projects. These can be at various scales, from global to local. An example includes the European Bank for Reconstruction and Development (EBRD), which invests in improving municipal services, including infrastructure.

Categories of Infrastructure Investments

Infrastructure investments are a crucial part of the economic landscape, often categorized based on the underlying assets. The broadest categorization distinguishes between two main types: Economic and Social infrastructure assets.

1. Economic Infrastructure Investments

Economic infrastructure investments are the backbone of economic activity. They include transportation assets, information and communication technology (ICT) assets, and utility and energy assets. Let’s delve deeper into each of these categories:

• Transportation assets: These include roads, bridges, tunnels, airports, seaports, and heavy and light/urban railway systems. For instance, the Golden Gate Bridge in San Francisco or Heathrow Airport in London. The income from these assets is usually linked to demand based on traffic, airport and seaport charges, tolls, and rail fares, and hence carries market risk.
• ICT assets: These include infrastructure that stores, broadcasts, and transmits information or data, such as telecommunication towers and data centers. For example, AT&T’s telecommunication towers or Google’s data centers.
• Utility and energy assets: These generate power and produce potable water; transmit, store, and distribute gas, water, and electricity; and treat solid waste. Environmentally sustainable development is covered by utility investments, which are increasingly focused on renewable technologies like solar, wind, and waste-to-energy power generation.

Because consumers’ needs for natural resources and energy fluctuate, revenue from utility assets may also be subject to demand risk. Utilities may also implement “take-or-pay” policies, which obligate customers to make minimum purchases regardless of supply needs.

2. Social Infrastructure Investments

Social infrastructure investments target human-centric activities, encompassing assets such as educational institutions, healthcare facilities, social housing, and correctional facilities. The primary emphasis lies in the establishment, operation, and maintenance of these infrastructure assets. The services offered within these facilities are typically delivered either directly by public authorities or through contracts with private service providers.

Revenue generated from social infrastructure primarily relies on lease payments structured around availability, asset management, and maintenance in accordance with pre-established standards.

Stages of Infrastructure Development

Infrastructure investments can be classified based on the stage of development of the underlying assets. These stages include greenfield investments, secondary-stage investments, and brownfield investments.

1. Greenfield Investments

Greenfield investments pertain to the creation of entirely new assets and infrastructure and are typically viewed as strategic opportunities. For example, a company might embark on the construction of a brand-new highway or wind farm. The objective may involve either leasing or selling these assets to the government after completion or retaining ownership and overseeing their operation.

If the assets are retained, this ownership period can extend over the long term or a shorter duration until they reach operational maturity. Subsequently, these assets may be sold to new investors, thus realizing capital appreciation that accounts for the construction and commissioning risks.

Greenfield investors frequently collaborate with strategic investors or developers who possess expertise in creating foundational assets. The construction phase typically involves an initial, lengthier stage of approvals and building activities, resulting in negative cash flows. The subsequent operational phase is regulated by a concession agreement, wherein the private investor generates revenue in accordance with predetermined criteria.

In the ultimate transfer phase, the investment is either handed over to a government entity based on predefined conditions, sold to a third party, or decommissioned.

2. Brownfield Investments

Brownfield investments encompass the enhancement of pre-existing facilities, potentially involving the privatization of public assets or a sale-leaseback arrangement for completed greenfield projects. For instance, a company could invest in the expansion of an existing airport or the modernization of a power plant. These investments are distinguished by a shorter investment horizon, yielding immediate cash flows, and often come with an established operating track record.

Typically, some financial and operational history of these assets is accessible. As a result, brownfield investments may attract the interest of both strategic investors with expertise in managing such assets and financial investors seeking stable, long-term returns, particularly in the context of privatization.

3. Secondary-stage Investments

Secondary-stage investments involve the allocation of capital to pre-existing infrastructure facilities or fully operational assets, which do not necessitate further investment or development throughout the investment horizon. These assets yield immediate cash flow and anticipated returns over the investment period.

For example, a company might choose to invest in an already operational toll road or water treatment plant that is currently generating revenue. In contrast, certain assets never progress to this stage because they continually demand ongoing capital and development.

A comprehensive comprehension of these infrastructure development phases is vital for investors, as it aids them in discerning the associated risks and rewards at each stage. Greenfield investments, for instance, may offer higher returns but come with elevated risks stemming from uncertainties in construction and commissioning. Conversely, secondary-stage investments may present lower returns but are associated with reduced risks due to their established operational history and immediate cash flows.

Forms of Infrastructure Investment

Similar to real estate investments, infrastructure investments are available in various forms, and the selection of these forms can have an impact on liquidity, cash flow, and income streams. Infrastructure investments can be either direct or indirect:

Direct Investment in the Underlying Infrastructure

Direct investment in infrastructure allows investors to have control and the opportunity to capture full value. For example, a large pension fund might directly invest in a wind farm, allowing them to control the operation of the asset and capture all of the income it generates. However, it requires a large investment and can result in concentration and liquidity risks while the assets are managed and operated.

Due to these risks and the typical long-term horizon, direct infrastructure investment often occurs with a group or consortium of strategic investors. These strategic partners, such as large pension funds or sovereign wealth funds, are frequent direct investors as they are better equipped to manage certain risks to limit individual concentration risk. Often, these funds invest under specific mandates in infrastructure projects and prioritize domestic infrastructure needs.

Indirect Infrastructure Investments

Indirect investments encompass a range of options, including infrastructure funds (akin to private equity funds and available in closed or open-end structures), infrastructure exchange-traded funds (ETFs), and owning equity stakes in publicly traded infrastructure providers or master limited partnerships (MLPs). As an illustration, an individual investor might purchase shares in an infrastructure ETF that maintains a diversified portfolio of infrastructure assets. Investors concerned with liquidity and diversification often favor publicly traded infrastructure securities.

These securities offer advantages such as liquidity, reasonable fees, transparent governance, observable market prices, and transparent pricing, in addition to diversification across underlying assets. It’s worth noting, however, that publicly traded infrastructure securities constitute a relatively small portion of the infrastructure investment landscape and are often concentrated in specific asset categories.

Master Limited Partnerships (MLPs)

Master Limited Partnerships (MLPs) are publicly traded on exchanges and function as pass-through entities, much like Real Estate Investment Trusts (REITs). They adhere to income pass-through taxation rules, which work to reduce the occurrence of double taxation for investors. MLPs are primarily prevalent in the sectors of energy transportation, processing, and storage.

For instance, an MLP could possess a network of oil pipelines, deriving consistent cash flows from the fees it collects for oil transportation services. They typically allocate a significant portion of their available cash flow to their investors.

Debt Financing for Infrastructure Projects

Infrastructure projects can secure funding through debt, which can be either private debt or publicly traded debt. The terms of such debt instruments are typically adaptable to accommodate scenarios with no cash flow and extended development or investment timelines. For instance, in the case of a toll road project, it may opt to issue bonds to finance the construction, and these bonds are structured to accommodate a phase of zero cash flow during the road’s construction.

Additionally, publicly issued debt instruments, like the perpetual bonds issued by the Airport Authority of Hong Kong and the US dollar bonds issued by the Indonesian Infrastructure Fund, represent alternative methods of financing infrastructure projects.

Question 

An investor is considering investing in a pass-through entity that is most commonly used in energy transportation, processing, or storage infrastructure investments. This entity distributes larger parts of its free cash flow to its investors.

Which of the following is the investor most likely considering?

1. Master Limited Partnerships.
2. Direct Infrastructure Investment.
3. Indirect Infrastructure Investment.

The correct answer is A.

The type of investment the investor is considering is a Master Limited Partnership (MLP). MLPs are a type of business venture that exists in the form of a publicly traded limited partnership. They combine the tax benefits of a partnership – profits are taxed only when investors receive distributions – with the liquidity of a public company. MLPs are most commonly associated with assets that require significant capital expenditures, such as energy infrastructure. This includes pipelines, storage tanks, and processing facilities. MLPs are required to distribute the vast majority of their free cash flow to investors, which can result in high-yield returns. This makes them an attractive investment for income-focused investors. MLPs are unique in that they combine the tax benefits of a partnership with the liquidity of publicly traded securities.

B is incorrect. Direct Infrastructure Investment refers to the direct purchase of infrastructure assets, such as roads, bridges, airports, utilities, and other public works. While these investments can provide steady, long-term cash flows, they do not typically distribute the majority of their free cash flow to investors as MLPs do.

B is incorrect. Indirect Infrastructure Investment refers to the purchase of shares in a company that owns, operates, or invests in infrastructure assets. While these investments can provide exposure to the infrastructure sector, they do not have the same distribution requirements as MLPs.