Infrastructure Investment.

Infrastructure assets and private commercial real estate investments are two distinct types of investments that share some common features but also have significant differences. Both involve large, heterogeneous, illiquid investments in real assets that often follow a distinct development life cycle. However, the source of revenue and the risk-return profiles differ significantly. For instance, while a commercial real estate investment might involve purchasing an office building and generating revenue through rent, an infrastructure investment might involve financing a toll road and generating revenue through toll fees.

While value-add and opportunistic commercial or residential real estate investments generate market rents as a primary source of revenue, infrastructure investments have little or no economic value beyond the public goods or essential services they provide. For example, a residential real estate investment might generate revenue through rent payments, while an infrastructure investment in a water treatment plant might generate revenue through fees for water treatment services.

Contractual Relationships

The unique contractual relationships among public and private entities related to the use of infrastructure assets create distinct risk–return profiles for private investors. These investments are often grouped by the underlying industry associated with the service provided, such as power generation or transportation, as well as the associated stage of development. For instance, an investment in a solar power plant would fall under the power generation industry and could be at any stage of development from greenfield (new project) to brownfield (existing project).

Types of Infrastructure Investments

New infrastructure projects and assets are referred to as greenfield investment, while brownfield investment may involve the privatization or repurposing of existing public assets or an expansion of existing facilities providing the same service. Infrastructure projects and investment funds are often grouped by core, value-add, and opportunistic criteria. For example, a greenfield investment might involve building a new airport, while a brownfield investment might involve expanding an existing airport.

Compensation

The source, type, and timing of compensation offered for the provision of these essential services or public goods is of primary importance. In some cases, a local or regional government authority enters a concession agreement with a private firm that establishes terms and conditions to plan, build, operate, finance, and maintain an infrastructure asset, such as a toll road, bridge, or other facility. For instance, a private firm might enter into a concession agreement with a local government to build and operate a toll road, with the firm receiving a portion of the toll fees as compensation.

Infrastructure Investment Returns

Infrastructure investment returns are primarily derived from an asset’s income-generating potential, because most projects are single-use investments with little or no alternative economic value. They are often built on public land or land acquired under government authority for fair market compensation and are frequently transferred to the public entity at the end of an operating period with a terminal value of zero. For example, a toll road might generate income through toll fees during its operating period, but at the end of the period, the road is transferred to the government with no residual value to the investor.

Business Model

A key feature that distinguishes infrastructure from other investments is the underlying business model. In contrast to corporate issuers or real estate, long-term contractual arrangements clearly define services provided, as well as the economic terms. Infrastructure investors may act as private project developers and/or asset operators. For instance, an infrastructure investor might enter into a long-term contract with a government to build and operate a power plant, with the contract defining the services to be provided and the fees to be paid.

Revenue Generation Approaches

Infrastructure assets, such as hospitals, bridges, or power generation plants, are often developed and operated by private entities. These asset operators generate revenue through various approaches, which may include constructing facilities to specific technical specifications and receiving progress payments during the construction phase and upon completion of the project. Asset operators primarily use three approaches to generate revenue:

Fixed or Availability-Based Payment: In this approach, end users, which could be public or private sector entities, agree to a fixed income stream payment over the period during which the asset is available for use. For example, a private company might build a hospital and receive a fixed payment from the government for as long as the hospital is operational. The operator must meet all construction, operating, and financing cash flows from this income stream. This arrangement is common among social infrastructure investments, such as education, healthcare, and other government services, as well as the transport and energy sectors. At the end of the agreement, the asset is often returned to the public sector entity, and the terminal value is zero.

Commercial Payment: Under a commercial or merchant payment scheme, the operator has the right to collect service or user fees over the operating period. However, the operator remains exposed to the asset’s business risk based on demand and other economic factors. This scheme is frequently used for power generation and toll road assets. For instance, a company that operates a toll road would collect fees from drivers who use the road, but the company would also bear the risk of lower-than-expected traffic volumes.

Regulation-Based Payment: In industries where natural monopolies are common, such as power or water distribution, public authorities often seek to stabilize pricing or impose pricing restrictions. These measures may be designed to offer a specific return on investment, limit price adjustments to the rate of inflation or a predetermined rise in service charges, or encourage investment in a particular area or technology. While this approach limits potential returns, it can also encourage investment by reducing business risk to investors. Regulation-based payments are also used to promote investment in renewable energy.

For instance, the United Kingdom uses contracts for difference (CfDs) to promote investment in low-carbon electricity generation, such as wind and solar power. Under the CfD, a developer exchanges the difference between the strike price , or the fixed contractual rate agreed at a CfD auction for each period, and a reference price , or the average UK electricity market price for the period. If the pre-agreed strike price exceeds the market reference price, the project company receives the difference from the Low Carbon Contracts Company (LCCC), while the project company must pay LCCC the difference when the market price exceeds the strike price.

Special Purpose Entity (SPE)

Single, standalone projects are usually governed by a special purpose entity (SPE), also referred to as a special purpose vehicle (SPV), established to undertake a project. This approach is similar to asset-backed securities, where a standalone SPV is created to purchase loans from an originator and issue securities backed by loan interest and principal payments. In the case of a project SPV, the entity’s sole purpose is to facilitate the construction, operation, and financing of an infrastructure asset over its contractual life by limiting the liability of private firms that build, operate, and maintain the asset in exchange for contractual or commercial operating cash flows and by limiting debt and equity investor claims to a project’s net cash flows.

Infrastructure investments characteristics

Infrastructure investments are a unique asset class that is characterized by their long-lived, illiquid nature, and unique contractual and business risk characteristics. These characteristics result in distinct cash flow, diversification, and exposure profile features that set them apart from other investment options.

Cash flow features: Infrastructure investments, being long-lived, single-use assets, typically offer investors a higher cash yield than other asset classes. For instance, a toll road or a power plant, once built, will continue to generate revenue for many years with minimal additional investment. This is due to the limited opportunities for cash flow reinvestment into an existing project. Consequently, equity investors can generally anticipate a higher proportion of revenues as dividends. Similarly, debtholders can often expect relatively high yields compared to similar investments with low credit risk. For example, a bond issued by a utility company may offer a higher yield than a government bond of similar maturity.

Diversification Features: Infrastructure assets, due to their role in providing essential or public services that often have few substitutes and inelastic demand, exhibit lower correlation with other asset classes. They are also less exposed to cyclicality or market downturns. For instance, even during a recession, people will still need to use electricity and water, making utility companies relatively recession-proof. A study by PGIM, a global investment management firm, revealed that the total return correlation between private infrastructure equity assets and public equities from 2012 to 2021 was 0.57. This correlation is higher than that of equities and fixed income but lower than correlations between types of private equity.

Exposure Profile Features: Infrastructure assets, due to the distribution of relatively predictable cash flows over extended contractual periods, offer the potential for cash flow or liability matching for long-term institutional investors, such as pension funds. This makes them a valuable source of income and portfolio duration. For example, a pension fund with long-term liabilities could invest in a toll road with a 30-year concession agreement, providing a steady stream of income over the life of the investment.

Infrastructure Company Classification Standard (TICCS)

TICCS is a classification system that was initiated by the EDHEC Infrastructure Institute in 2018. The purpose of this system is to categorize infrastructure investments based on key characteristics that affect their relative risk and return. These characteristics include the form of business risk, the underlying industry, corporate governance, and geo-economic exposures.

Business risk: The business risk characteristics of infrastructure investments are defined by the nature of cash flows. These can be fixed or availability based, merchant or commercial, or regulation based. For instance, a toll road project might have fixed cash flows based on the number of vehicles using the road, while a power plant might have merchant cash flows based on the price of electricity. These cash flows constitute the income over the asset’s period of operation used to cover upfront development and construction costs and ongoing maintenance upon completion and to compensate investors over an asset’s life. Regulatory risk, which includes political, legal, and governmental change, is an additional feature of business risk for infrastructure assets.

Industry risk: The anticipated level and volatility of cash flows affect not only the level of risk and return but also the degree to which leverage can be used to finance these long-lived assets. Industry risk factors include cyclicality, concentration, and competitive intensity, as well as growth and demand. For example, a telecommunications company might face high competitive intensity and rapid growth, while a water utility might face low competitive intensity and steady demand. Relative risk and return are often dictated by the business model.

Corporate governance: The type of corporate governance refers to the use of single-asset project companies typically governed under Special Purpose Entities (SPEs), as opposed to multi-project corporations engaged in infrastructure. The choice of corporate governance used directly influences project capital structure. Lenders can exercise greater control over the sources and uses of cash flow for a single project and are therefore usually more willing to offer higher leverage in comparison to debt financing considered for a multi-project corporate structure. Infrastructure assets often require groupings with greater specificity based on the types of services rendered, technologies employed, and customers, as well as the terms of service. In the case of publicly traded infrastructure companies involved in multiple projects, debt and equity investors in liquid securities are exposed to an evolving project portfolio over time as opposed to a single-use asset for a finite period.

Geographic diversification: Investors often seek geographic diversification among similar infrastructure assets whose commercial revenue stream is closely tied to economic activity. A project’s viability may depend on the level of cross-border activity or global trade. For example, a port’s revenue might depend on the level of international trade. These large, immobile assets depend directly and indirectly on national government policies to determine how public entities partner with private sector entities to develop and operate infrastructure. Public–private partnerships (PPPs) are usually defined as a long-term contractual relationship between the public and private sectors involving a concession agreement or other form of compensation in exchange for delivering an essential service or public good. PPPs often face unique and unforeseen risks when put into practice. For instance, a PPP for a hospital might face risks related to changes in healthcare policy or technology.

Role of Private Infrastructure Investments

Infrastructure investments play a crucial role in the economic development of a country. They are the backbone of a country’s economy, providing essential services such as transportation, energy, and utilities. The role of private infrastructure investments varies between developed and developing markets. This note will delve into the characteristics of these markets and the common features they share in their infrastructure projects.

Developed Markets

Developed markets are characterized by diversified domestic economies, strong financial sectors, and extensive existing domestic transportation and energy networks. They have fiscal budgets that provide essential services and public goods through taxation and borrowing. An example of a developed market is the United States, where the private sector plays a significant role in infrastructure development.

Private infrastructure is prevalent in industries where public sector assets are privatized or a well-established regulatory framework governs activity. For instance, in the UK, the power and water utilities industries have seen significant private sector involvement following privatization.

Government intervention is used to promote either brownfield investment to revitalize disadvantaged areas or greenfield development to stimulate growth in areas like renewable energy. For example, the German government has been promoting greenfield investments in renewable energy, leading to the country becoming a global leader in wind and solar power.

Developing Markets

Developing markets, on the other hand, face less economic diversification, few budgetary resources to provide public goods, evolving transportation and energy networks, and a less robust financial sector with a greater likelihood of domestic currency devaluation, which creates currency risk. An example of a developing market is India, where infrastructure development is a key focus area for economic growth.

Private infrastructure investment is more often greenfield than brownfield and tied to projects that seek to provide a catalyst for overall economic growth and development. For instance, in Africa, private investors are heavily involved in greenfield projects in the renewable energy sector.

Global and regional development banks and supranational financial institutions, such as the World Bank and its affiliate, the International Finance Corporation (IFC), frequently play a pivotal role in providing technical assistance for infrastructure investments. For example, the Asian Development Bank has been instrumental in funding infrastructure projects in Southeast Asia.

Infrastructure asset performance in developing economies often hinges on the market for a key global commodity or domestic industry that may be a driver of continued economic development, as well as a critical source of foreign currency reserves. For instance, in Saudi Arabia, the performance of infrastructure assets is closely tied to the global oil market.

Common Features

Despite their differences, both developed and developing markets share common features in their infrastructure projects. These include a lack of adaptability to alternative economic uses and a development period with negative cash flows followed by a period of contractual cash inflows available to pay development costs and generate investor returns.

Investment methods and structures used to achieve the objectives of the public and private parties involved, as well as third-party investors, have similar features. For example, both developed and developing markets use Public-Private Partnerships (PPPs) as a common method for infrastructure development.

Infrastructure investments span the development and operation cycles. This means that investors are involved in both the construction and operation phases of an infrastructure project.

Practice Questions

Question 1: Consider an investment firm that is looking to diversify its portfolio by investing in infrastructure assets. The firm is particularly interested in understanding the unique characteristics of infrastructure investments compared to other types of investments such as commercial real estate. Which of the following statements accurately describes a key difference between infrastructure investments and commercial real estate investments?

1. Infrastructure investments and commercial real estate investments generate revenue in the same way, primarily through market rents.
2. Infrastructure investments have a distinct risk-return profile due to unique contractual relationships among public and private entities, unlike commercial real estate investments.
3. Infrastructure investments and commercial real estate investments have similar business models, with long-term contractual arrangements defining the services provided and the economic terms.

Answer: Choice B is correct.

Infrastructure investments have a distinct risk-return profile due to unique contractual relationships among public and private entities, unlike commercial real estate investments. Infrastructure investments often involve long-term contracts with public entities, such as governments or municipalities, which can provide a stable and predictable cash flow. These contracts often include provisions that adjust for inflation and other economic factors, further reducing the risk for the investor. Additionally, infrastructure assets often provide essential services, such as water, electricity, or transportation, which can make their demand more stable and less sensitive to economic cycles than commercial real estate. On the other hand, commercial real estate investments are typically more exposed to market conditions, such as changes in property values and rental rates, and do not have the same level of contractual protection as infrastructure investments.

Choice A is incorrect. Infrastructure investments and commercial real estate investments do not generate revenue in the same way. While commercial real estate investments primarily generate revenue through market rents, infrastructure investments often generate revenue through long-term contracts with public entities, user fees, or a combination of both.

Choice C is incorrect. While both infrastructure investments and commercial real estate investments can involve long-term contractual arrangements, the nature of these arrangements and the services provided can be very different. For example, a commercial real estate contract might involve leasing office space, while an infrastructure contract might involve providing water or electricity services. Furthermore, the economic terms of these contracts can also be very different, with infrastructure contracts often including provisions for inflation adjustments and other economic factors that are not typically found in commercial real estate contracts.

Question 2: A private firm is considering entering into a concession agreement with a local government authority to plan, build, operate, finance, and maintain a toll road. The firm is trying to understand the potential returns from this infrastructure investment. Which of the following statements correctly describes the primary source of returns for such an infrastructure investment?

1. The returns are primarily derived from the asset’s potential to generate income, as most infrastructure projects are single-use investments with little or no alternative economic value.
2. The returns are primarily derived from the asset’s market value, as infrastructure investments have significant economic value beyond the public goods or essential services they provide.
3. The returns are primarily derived from the asset’s potential for capital appreciation, as infrastructure investments often involve the privatization or repurposing of existing public assets.

Answer: Choice A is correct.

The primary source of returns for an infrastructure investment such as a toll road is indeed derived from the asset’s potential to generate income. Infrastructure investments are typically long-term, capital-intensive projects that provide essential public goods or services, such as roads, bridges, airports, utilities, and telecommunications networks. These projects generate income primarily through user fees or tolls, which are often regulated by government authorities. The income-generating potential of these projects is usually stable and predictable, making them attractive to investors seeking steady, long-term returns. Most infrastructure projects are single-use investments with little or no alternative economic value. This means that their value is largely tied to their ability to generate income, rather than their potential for capital appreciation or their market value.

Choice B is incorrect. While infrastructure investments do have significant economic value beyond the public goods or services they provide, this value is not the primary source of returns for investors. The market value of an infrastructure asset can fluctuate based on a variety of factors, including changes in regulatory policies, economic conditions, and technological advancements. However, these fluctuations do not typically translate into direct returns for investors.

Choice C is incorrect. While some infrastructure investments do involve the privatization or repurposing of existing public assets, the potential for capital appreciation is not the primary source of returns. The value of an infrastructure asset is largely tied to its ability to generate income, not its potential for capital appreciation. Furthermore, the privatization or repurposing of public assets often involves significant regulatory and political risks, which can impact the returns from these investments.

Glossary

• Government’s Jurisdiction: The geographic area over which a government has authority, subject to certain conditions.
• Terminal Value: The value of a business or project at the end of a specific forecast period.
• Asset Operator: A private entity that develops and operates infrastructure assets.
• Fixed or Availability-Based Payment: A revenue generation approach where the operator receives a fixed income stream payment over the period during which the asset is available for use.
• Commercial Payment: A revenue generation approach where the operator collects service or user fees over the operating period.
• Regulation-Based Payment: A revenue generation approach where public authorities stabilize pricing or impose pricing restrictions.
• Contracts for Difference (CfDs): A financial contract that pays the differences in the settlement price between the open and closing trades.
• Special Purpose Entity (SPE): A legal entity created to fulfill narrow, specific, or temporary objectives.
• Infrastructure Investments: Investments in long-lived, single-use assets such as roads, bridges, tunnels, airports, etc.
• Cash Yield: The annual income from an investment expressed as a percentage of the investment’s value.
• Correlation: A statistical measure of how two securities move in relation to each other.
• Exposure Profile: The pattern of potential gains or losses from an investment or portfolio.
• Portfolio Duration: A measure of the sensitivity of a portfolio’s price to changes in interest rates.
• Infrastructure Company Classification Standard (TICCS): A classification system for infrastructure investments based on key characteristics affecting relative risk and return.
• Business Risk: The risk associated with the nature of cash flows of an infrastructure investment.
• Regulatory Risk: The risk associated with political, legal, and governmental change for infrastructure assets.
• Corporate Governance: The system of rules, practices, and processes by which a company is directed and controlled.
• Public–Private Partnerships (PPPs): Long-term contractual relationships between the public and private sectors involving a concession agreement or other form of compensation in exchange for delivering an essential service or public good.

Private Markets Pathway Volume 2: Learning Module 7: Infrastructure; LOS 7(a): Discuss important infrastructure investment features