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The “Sub-mega” Infrastructure Investment Opportunity

As featured in Portfolio Institutional – Friday View article on 12 June 2015

The attractions of infrastructure investments to institutional investors are well understood and well documented. They offer long term income streams, generate cash coupons, are backed by the security of real assets and are not significantly correlated to the other major asset classes. So when global markets show volatility, infrastructure assets continue in the main to provide the expected cash returns.

As a result of these attractive features, standalone investments in infrastructure assets by institutional investors are becoming increasingly common and large investors are joining forces to exert greater access into the market. Examples include the creation of the Pension Infrastructure Platform (PIP) and the recently announced £500m joint venture between the Greater Manchester Pension Fund and the London Pension Fund Authority, with a focus on infrastructure investments.

However the increasing appetite for infrastructure investments from large institutions has an impact. Given the size of these institutions, smaller investments are neither seen to justify the due diligence nor materially impact the portfolio when they outperform. As a result, large institutions typically seek large, “mega” infrastructure projects – in excess of £100m each. But the supply of these projects is outweighed by demand, and prices are being pushed up by the increasing number of bidders. The result is a large number of unsuccessful bidders and a handful of successful investors who have locked-in lower returns as a result of the competitive bidding forcing up prices. Furthermore, these “mega” projects also involve long construction periods and sometimes intense political scrutiny. A typical “mega” project may take over four years to generate revenue, or longer if decisions are deemed to be politically sensitive. All of these factors create a drag on returns for investors.

However, there exists a compelling alternative to the competitive marketplace for “mega” projects. Smaller scale projects (generally £5m-£50m) still benefit from the key infrastructure characteristics of asset backing, long-term contractual income streams from high quality counterparties (often index-linked) and capital preservation – yet they are typically available at lower prices, with shorter investment timeframes and less political interference. The term “sub-mega” has been coined for these assets.

There are numerous sub-mega infrastructure projects in the UK, the majority of which fall below the minimum investable threshold for large institutional investors. This creates an opportunity for smaller institutions to avoid the risk of large projects and invest into funds offering access to a portfolio of sub-mega projects.

Investments are intended to be long-term, typically for 20-25 year periods making sub-mega ideal for matching long-term liabilities. However, periodic liquidity opportunities are available to investors who require access to capital through healthy secondary markets.

Many sub-mega investment opportunities are currently available in the energy supply and distribution sector where counterparties are often a combination of the government and large scale utility companies. Examples include renewable energy generation and electricity grid support projects.

Other sub-mega infrastructure opportunities are emerging – such as industrial-scale energy efficiency projects to meet UK Government requirements. Future opportunities may include projects to deliver the long-term renewal and improvement of ‘public/private’ infrastructure, such as local social infrastructure (e.g. medical centres, council facilities). These projects are often turn-key opportunities offering investors immediate access to yield, without the long build phase of mega-infrastructure.

Institutional investment is usually either through limited partnership structures investing in a pool of sub-mega projects, or through stand-alone segregated investment. Operational asset management is usually delivered by the investment manager to ensure that assets are performing at peak levels throughout their lifetime.

So whilst infrastructure investment is increasingly recognised as an important asset class for large institutional investors, the emergence of sub-mega investment opportunities ensures its benefits are available to institutional investors of all sizes.