August 29, 2019
Incorporating alternative assets, such as infrastructure or commercial real estate, is helping more and more investors to diversify their portfolios beyond traditional stocks and bonds. In this post, we lay the foundations for understanding infrastructure investments.
Deconstructing the asset class
Infrastructure assets typically provide a fundamental service that has an entrenched or protected market position. They can be categorized as either traditional infrastructure assets or energy infrastructure assets.
While encompassing a range of structures and services, what these assets have in common is that each boils down to a contract between the private and public sectors. For a traditional infrastructure asset, the contract is often called a concession agreement that binds the private sector party to design, finance, build and maintain the asset, and binds the public sector party to deliver a fixed stream of cash payments over the term of the contract so long as the private sector party meets its obligations. Exceptions are volume- or toll-based assets, such as a toll road. In this example the private sector party's income may be at least partly dependent on the number of vehicles that use the road. However, most traditional infrastructure assets in Canada have little or no volume risk.
Energy asset contracts often take the form of off-take agreements, which bind the private sector party to finance, build and operate the asset, while the public sector party is bound to pay a fixed price (often adjusted for inflation) for all the power produced over the term of the agreement.
For traditional infrastructure assets the public sector party is most often the government, and for energy assets it's usually the government or a government-owned utility company. Contracts for both types of assets can run 15-40 years.
Building diversification with infrastructure investments
By making an allocation to infrastructure within a balanced portfolio, an investor may increase returns while reducing risk. To understand how, think about this situation.
Back in the spring of 2012, Europe was in the grip of the sovereign debt crisis and global equity markets were highly volatile, increasing the risk in equity investors' portfolios. Over this same period, one of our larger infrastructure investments, the Harrison Hydro Project located in British Columbia, generated near-record performance. The rivers used by the hydro project were flowing as fast and strong as they ever had done—meaning the project was producing significant energy for sale under its long-term contract to the local utility; the project's revenue was unaffected by global macroeconomic events.
The point here is that the returns on infrastructure investments aren't closely correlated to the returns on other asset classes and can generate long-term, stable cash flow streams that don't ebb and flow with the ups and downs of the stock market or economic activity.
We have never seen more opportunities for private sector infrastructure investors.
The increase in investment opportunities has been driven by a number of factors. First, the last three decades have seen a chronic underinvestment by developed-world governments in basic infrastructure. Many experts estimate the funding gap in Canada alone, which will need to be plugged, is over $100 billion. Second, many governments have stretched balance sheets, prompting them to look at privatizing nationalized infrastructure assets, like airports and seaports, to raise capital. Third is the ongoing transformation of power-generation assets, switching from thermal-based power generation to renewable energy sources—a transformation we believe is still in its early stages and that should result in many opportunities globally over the next couple of decades.