Long-term investing and infrastructure

Overview

Infrastructure assets fall into various categories and have different lifecycles. Investors should have an understanding of this, as it can impact the risk-return profile of an investment, including its ability to match inflation.

An economic and social good

Infrastructure plays a crucial role in any economy. The availability of transport, communication, electricity, safe water and sanitation, and other basic facilities, has a tremendous impact on improving the quality of life and wellbeing for any country. Infrastructure facilities and services are essential for efficient production of goods and services, transport and trade – all of which spur economic growth – which in turn helps in reducing poverty.

In recognising the essential role that long-term financing for infrastructure plays in supporting strong, sustainable, balanced and inclusive growth, it is understandable that long-term investment vehicles, such as retirement funds, are approached to provide this type of financing for infrastructure projects.

Historically, governments have borne the main responsibility for infrastructure development, as infrastructure is typically considered a ‘public good’. However, in most countries, governments are struggling to keep up with the level of development required. This is proving especially true in a post-COVID economic environment, where most countries are experiencing unusually low growth.

African countries, similar to their international emerging market counterparts, have a significant infrastructure deficit, especially when compared to developed market peers. To combat the continent’s infrastructure deficit, alternative sources of funding are needed. Infrastructure investments are traditionally seen as inflation linked, and institutional investors are increasingly seen as suitable funding partners for infrastructure investments, given their long-term liabilities, which make inflation-linked assets attractive.

Greenfield and brownfield infrastructure projects

There are two main stages of infrastructure investment – greenfield and brownfield. Each type of investment carries its own inherent risks and abilities to match or beat inflation.

Greenfield infrastructure is an investment into new infrastructure – new development and construction projects.

For an investor, some inherent risks of these projects include construction risk, performance risk and off-taker risk. The creation of the asset primarily involves funding the project, with risk of the project not reaching commercial status.

Greenfield infrastructure assets do not traditionally provide inflation-hedging features.

Brownfield infrastructure is an investment into existing and ready-to-operate – or already operating – infrastructure assets.

For an investor, these brownfield assets can generate revenues. Given that the infrastructure already exists and is in use, the risks of investing into this project are substantially less than in a greenfield project, where the future cash generation is uncertain.

Understanding the nature of an infrastructure project

Infrastructure assets often exhibit ‘monopolistic’ features, in that they have exclusive possession or control of the supply or trade of a particular commodity or service. For example, a toll road or airport that travelers must use to access a specific city, town or region. In such cases, predictability of future cash flows to repay investors is more certain.

The figure above illustrates the project lifecycle of an infrastructure project and the potential sources of finance for initiating a project, or refinancing an existing asset. Early in the project lifecycle, government and development finance institutions (DFIs) play an important and catalytic role in attracting subsequent financing for a project, partnering with project sponsors and developing appropriate funding models. In later stages, as projects mature, different sources of finance come into play. Retirement funds are likely to have exposure to these assets at construction phase for greenfield projects and at operational phase for brownfield projects.

Brownfield infrastructure investments are also often scalable; by enhancing the facilities, greater output can be produced (for example, expanding a port or toll road) and therefore greater cashflows can be generated. These features allow for the cashflows emanating from brownfield infrastructure investments to be modelled to escalate or be linked to inflation. Given the long-term operating capacity of most infrastructure assets, they align well with the goals of long-term investors – such as retirement funds – who are seeking liability-matching assets.

However, it must be noted that not all infrastructure assets offer the virtues of inflation hedging and it is important for investors to understand the different categories of infrastructure assets, as well as the different life-stages of their development, as these result in different cashflow profiles. Prudential limits, such as Regulation 28, enable retirement funds to have exposure to infrastructure investments by means of different asset classes.

References

OECD | RISCURA | PICC

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