Infrastructure targets absolute returns

On the face of it, the new infrastructure funds from groups like First State, Macquarie and HSBC have been launched at a fortuitous time. The sectors most investors look to for income generation – property and bonds – have both been sold down and face an uncertain few months. The new funds claim long-term, inflation-linked income streams established and maintained by contract, plus capital preservation. This seems the ideal place to invest in trouble markets. Or is it?

Infrastructure undoubtedly has some good things going for it: The macro backdrop is supportive. Infrastructure includes both government and non-government related projects. On the government side, the concept of private funding of infrastructure projects is no longer a political issue. Both left and right recognise the advantages of private involvement in, for example, building hospitals and schools, or maintaining railways. Non-government related projects have been given a boost by the move to alternative energy sources. Supply in both areas is improving all the time.

The need for infrastructure globally also suggests this area offers opportunities. John Husselbee, chief executive of North Investment Partners, says: “We like this as a long-term theme. It works well and should continue to work well. You only have to look at what is happening in India and China to realise why. There is no reason that should slow.” Emerging markets need infrastructure development, which will generate both supply and demand over the longer-term.

And it offers some protection against declining markets. Tony Roper, director, infrastructure investment at HSBC, says that the contractual nature of many infrastructure projects can protect against a downturn. The revenues streams from projects like airports or railways or toll roads tend to continue regardless of what is happening in the wider economy.

Stephen Vineburg, head of global infrastructure at First State, says that the main thing he looks for in any infrastructure project is predictable revenue within a stable regulatory environment: “Anglian Water Group fulfils a lot of these criteria. A lot of people need water.” Typically returns from infrastructure will come from income rather than capital and will be higher than bonds, but with higher risk.

But it is not one-way traffic. The failure of Underground maintenance group Metronet and the recent controversy surrounding British Airports Authority has shown that these projects can fail. Infrastructure funds are divided into those that invest in the shares of infrastructure companies, like the Macquarie Global Infrastructure fund, and those that invest directly in infrastructure projects, like the HSBC Infrastructure Company. Direct investment requires successful maintenance of the asset (set down in contract). If an infrastructure investor fails to maintain that asset adequately, those lucrative revenue streams can be removed by the ‘sponsor’ (usually governments). Also these assets are illiquid, so they should be viewed as a long-term holding and will tend to be structured as closed-ended funds.

Funds of infrastructure shares may be new, but are still essentially sector funds. Infrastructure companies have certain characteristics, like reliable income streams, that will protect investors in a downturn, but they still own shares and are therefore still vulnerable to market volatility. In practice many income funds may offer similar protection.

Many infrastructure funds do not yet invest in emerging markets because the contracts are insufficiently robust, so this area remains relatively untapped. Vineburg admits they have not yet found the financing mechanism to meet Asia’s enormous demand for power. Ultimately, infrastructure funds are certainly in a growing and profitable part of the global economy, but they are not yet a panacea to the woes of equity markets.

1 October 2007