From asset allocation to infrastructure investment

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1 From asset allocation to infrastructure investment 1/32 From asset allocation to infrastructure investment A roadmap for the development of institutional investment in infrastructure Frédéric Blanc-Brude, PhD Research Director EDHEC-Risk A presentation prepared for the City Factory, 3rd breakfast discussion roundtable 16 October 2013, Paris

2 From asset allocation to infrastructure investment 2/32 Agenda Is infrastructure an asset allocation question? The performance of infrastructure equity investments: the evidence so far De ning relevant infrastructure instruments Implications for public procurement A roadmap to develop infrastructure investment solutions

3 From asset allocation to infrastructure investment 3/32 The world needs new infrastructure, but is it investors problem? Huge infrastructure investment needs have been identi ed Concerns about the sources of long-term nance $50Tr The OECD reports that The question of the role of institutional investors as providers of long-term nance to the real economy is now on the high policy agenda Should investors care? Is there something special about investing in infrastructure? are needed by 2030

4 From asset allocation to infrastructure investment 4/32 Is infrastructure investment a strategic asset-allocation decision? Asset allocation is institutional investors rst-order problem If infrastructure investment is relevant at the asset allocation level, it implies potentially large allocations: this is the link between the policy debate and investment decisions To answer this question we need an infrastructure investment benchmark ie robust expectations of what passive investment in infrastructure implies from the point of view of an otherwise well-diversi ed investor Is infrastructure investment new and unique compared to the existing investment opportunities?

5 From asset allocation to infrastructure investment 5/32 Is infrastructure investment an asset-allocation decision? The infrastructure investment narrative : Low price-elasticity of demand = low correlation with the business cycle Monopoly power = pricing power = in ation hedge Predictable and substantial free cash ow Attractive risk-adjusted cash yield, available over long periods Opportunity to invest in unlisted assets In other words, this ideal-type implies Improved diversi cation Better liability-hedging Less volatility than capital market valuations

6 From asset allocation to infrastructure investment 6/32 Empirical evidence of the performance of equity investments in infrastructure Expected behaviour listed infrastructure unlisted infra PE fund low risk no no low corr w/ biz cycle no no long term no exits after 5 to 7 years excess returns no yes but leverage limited drawdown no no (credit cycle) in ation protection no no (see Newell and Peng, 2007, 2008; Sawant, 2010; Rothballer and Kaserer, 2012; Bitsch et al, 2010; Weber and Alfen, 2010; Bird et al, 2012; Blanc-Brude, 2013) Listed infrastructure resembles a very inef cient low beta, large cap strategy is this a new ingredient in the asset or risk allocation mix? Infrastructure PE is generally found to be good diversi er of other PE investments But it is not fundamentally different either So what is new?

7 From asset allocation to infrastructure investment 7/32 The wrong approach: infrastructure assets are not real Focusing on tangible infrastructure is the wrong approach: we are interested in nancial instruments and the risk factor exposures they create for investors Our proposed solution to address the public policy agenda (channelling institutional money towards infrastructure) within the prudential regulatory framework is to ignore the notion of infrastructure and instead to focus on project nance This approach greatly clari es the debate: 1 Project nance is well-de ned as a set of nancial instruments (cf Basel-2) 2 Project nance is a unique form of corporate governance and can be expected to create new and unique risk factor exposures compared to other types of underlyings 3 Project nance encompasses the immense majority of investable and stand-alone infrastructure projects in the world today and in all likelihood will be used to deliver most future projects (eg the various public-private partnership programs in Europe mostly imply project nancing according to the Basel-2 de nition)

8 From asset allocation to infrastructure investment 8/32 Relevant infrastructure investments Project nance: the art and science of manufacturing commitment to solve the perennial long-term investment problem 1995 & 2013 A double ltering mechanism: separate incorporation + leverage A unique type of corporate structure: a single-project rm with no other asset than receivables and a nite life between $3Tr worth of project nancing A structured approach: splitting the free cash ow of the rm by level of predictability: high leverage signals low asset risk A new perspective: project nance is not the median infrastructure project (that is a good thing!) Project nance is a unique form of corporate governance If contracts, not tangible assets, de ne the characteristics of infrastructure investments, project nance makes such contractual characteristics explicit

9 From asset allocation to infrastructure investment 9/32 Risk transfer and management in infrastructure project nance Contract with a public or private party creating a binding commitment to pay contracts with other firms to commission a number of tasks at a fixed price { #facility manager #operator #builder [rights to a pre-agreed revenue stream*] *subject to performance AND/OR [rights to a merchant revenue stream] License granting the right to operate a regulated monopoly on a commercial basis established by a consortium of firms to enter into a longterm contract {ProjectCo} raises long-term finance for the construction, operation and maintenance of the relevant infrastructure [rights to the firm s free cash flow] $senior debt$ $junior debt$ $equity$

From asset allocation to infrastructure investment 10/32 Project nance: Investing in base case cash ows Base case equity and subordinated debt service Base case senior debt service (2 facilities)

10 From asset allocation to infrastructure investment 10/32 Project nance: Investing in base case cash ows Base case equity and subordinated debt service Base case senior debt service (2 facilities) Senior debt service cover ratio (DSCR) Example base case cash ows for a social infrastructure project nancing in the UK with a 30-year maturity The cash ow pro le is dynamic (predictable changes in time)

11 From asset allocation to infrastructure investment 11/32 Systematic risk factors and base case volatility base case volatility year 20 merchant revenues partly merchant year 5 pre-agreed revenues revenue risk model year 15 project lifecycle In the cross-section: contractual features explain cash ow volatility, especially revenue risk models (from guaranteed to commercial revenues) (Blanc-Brude and Strange, 2007; Blanc-Brude and Ismail, 2013) Across the lifecycle: the impact of de-leveraging (Merton, 1974) Other controls: host-country factors

From asset allocation to infrastructure investment 12/32 Listed infrastructure revisited A (equal weighted) basked of ve listed funds specialised in

12 From asset allocation to infrastructure investment 12/32 Listed infrastructure revisited A (equal weighted) basked of ve listed funds specialised in buying the equity tranche of social infrastructure project nance vehicles ie SPEs with long-term, in ation-linked contracted revenues with the UK public sector

13 From asset allocation to infrastructure investment 13/32 Listed infrastructure revisited PFI Portfolio Macquarie Infrastructure Index Europe FTSE All Shares Return 445% -603% 638% Risk 360% 1691% 1284% Sharpe Ratio 1232 (036) 050 Market beta na 995% VaR 946% 4960% 2669% UK RPI Corr 8724%*** -7547%*** 5599% Total return 945% -025% 994% Risk 364% 1695% 1286% Sharpe Ratio 2588 (002) % VaR 407% 4390% 2318% UK RPI Corr 9382%*** -4661%*** 5599% Comparative performance of the PFI portfolio with a market-cap weighted infrastructure index and the market index, annualised monthly data, 1 January October 2013, representing a market capitalisation of GBP45bn on the LSE and about 300 individual investments Annualised monthly data *** statistically signi cant at the 1% con dence level

14 From asset allocation to infrastructure investment 14/32 Implications for public procurement Dedicated infrastructure investment by institutionals at the asset allocation level implies exposures to well-diversi ed portfolios ie direct or indirect investments in numerous projects However, market capacity remains the most important bottleneck there are only so many investable projects at one point in time To support the development of institutional investment in infrastructure projects, the public sector can develop three important dimensions of the public procurement process: 1 Increase market size (but beware of affordability) 2 Standardise contracts 3 Use risk sharing mechanisms that match the cash ow requirements of investors

15 From asset allocation to infrastructure investment 15/32 Implications for public procurement The Private Finance Initiative PFI = project nance Credible commitment with attractive returns over 25 years Large number of contracts signed within a relatively short period of time Contract standardisation Availability payment ie minimum revenue guarantee In ation-indexation guarantee What is the difference with the approach taken in France with the Contrats de Partenariat?

16 From asset allocation to infrastructure investment 16/32 Implications for public procurement N33 Early involvement of pension funds at the procurement stage The project company issues in ation-linked debt with a 20-year maturity During the rst ten years the debt service is discounted compared to a xed-annuity nominal equivalent It then rises above the nominal Result: lower cost of debt and continuously increasing (with in ation) debt service

17 From asset allocation to infrastructure investment 17/32 Implications for public procurement Political risk Regulatory uncertainty remains a signi cant driver of cash ow volatility across projects Public sector commitment to stick to the initial contract is essential But it is not necessarily easy 1 contracts have to be renegotiated 2 procurement may have been too inef cient 3 political pressure may be too great It is essential that the public sector de nes current and future needs

18 From asset allocation to infrastructure investment 18/32 What investors want All the characteristics of project nance debt and equity plus In ation protection Fixed interest rates Long-term (no more miniperms) No more easy re nancing

19 From asset allocation to infrastructure investment 19/32 A roadmap to develop infrastructure investment for long-term investors We have established a relevant underlying: project nance We have established a methodology to measure risk in infrastructure project nance equity This methodology relies on the parsimonious collection of standardised data about individual projects base case cash ows and the debt service cover ratio A number of steps remain to make long-term infrastructure investment truly relevant to institutional investors We call these steps the roadmap to develop infrastructure investment for long-term investors

20 From asset allocation to infrastructure investment 20/32 The roadmap: next steps Next steps include 1 Collect cash ow data 2 Establishing a robust valuation framework in incomplete market conditions 3 Documenting the investment pro le of the equity underlying will allow the design of well-diversi ed investment benchmarks according to clearly de ned strategies and horizons 4 These benchmarks will reveal : whether the risk factor exposures created by infrastructure equity investments are different from existing choices available to investors the correlation of returns with other investments in different states of the world the accessibility of investment solutions offering exposure to the risk factors identi ed to the average investor

21 From asset allocation to infrastructure investment 21/32 The road map

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24 From asset allocation to infrastructure investment 24/32

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26 From asset allocation to infrastructure investment 26/32 The road map: progress to date

27 From asset allocation to infrastructure investment 27/32 Contribute! Developing institutional investment in infrastructure will not happen without a signi cant involvement from investors, managers, regulators and academics: 1 We need to think clearly about the relevant mechanisms and instruments 2 We need to agree on methods, data reporting and benchmarking 3 We need a lot more data! You can help (create a 5-trillion dollar industry) Read our papers Join the debate and support the development of adequate methods and a cash ow reporting standard for project nance Contribute your historic and future data to allow the eventual production of investment benchmarks

From asset allocation to infrastructure investment 28/32 Relevant publications: NATIXIS & EDHEC-Risk Research Chair on Infrastructure Debt Investment Who is afraid of construction risk?

28 From asset allocation to infrastructure investment 28/32 Relevant publications: NATIXIS & EDHEC-Risk Research Chair on Infrastructure Debt Investment Who is afraid of construction risk? Infrastructure debt portfolio construction EDHEC-Risk Publications Frédéric Blanc-Brude & Omenia RH Ismail July 2013 Available at wwwedhec-riskcom/multistyle_multiclass/natixis_research_chair and cibnatixiscom/infrastructure

29 From asset allocation to infrastructure investment 29/32 Relevant publications: Meridiam Infrastrutcure, Campbell Lutyens & EDHEC-Risk Research Chair on Infrastructure Equity Investment An EDHEC-Risk Publication Towards Efficient Benchmarks for Infrastructure Equity Investments A review of the literature on infrastructure equity investment and directions for future research January 2013 Towards Ef cient Benchmarks for Infrastructure Equity Investments EDHEC-Risk Publications Frédéric Blanc-Brude January 2013 with the support of Available at wwwedhec-riskcom/multistyle_multiclass/meridiam_infrastructure_ and_campbell_lutyens_research_chair

From asset allocation to infrastructure investment 30/32 Relevant publications: working papers Measuring risk in unlisted infrastructure equity investments EDHEC Business School Working Paper

30 From asset allocation to infrastructure investment 30/32 Relevant publications: working papers Measuring risk in unlisted infrastructure equity investments EDHEC Business School Working Paper Frédéric Blanc-Brude & Omenia RH Ismail September 2013 Measuring the credit risk of unlisted infrastructure debt EDHEC Business School Working Paper Frédéric Blanc-Brude & Omenia RH Ismail August 2013

31 From asset allocation to infrastructure investment 31/32 Relevant publications: working papers Construction risk in project nance EDHEC Business School Working Paper Frédéric Blanc-Brude & Dejan Makovsek January 2013

32 From asset allocation to infrastructure investment 32/32 References Bird, R, H Liem, and S Thorp (2012, May) Infrastructure: Real Assets and Real Returns European Financial Management Bitsch, F, A Buchner, and C Kaserer (2010) Risk, Return and Cash Flow Characteristics of Infrastructure Fund Investments EIB Papers 15(1), Blanc-Brude, F (2013) Towards ef cient benchmarks for infrastructure equity investments Meridam & Campbell Lutyens Research Chair on infrastructure equity investment EDHEC-Risk : EDHEC-Risk Blanc-Brude, F and O R H Ismail (2013) Who is afraid of Construction Risk? Portfolio Construction with Infrastructure Debt NATIXIS Research Chair on infrastructure debt investment EDHEC-Risk Blanc-Brude, F and R Strange (2007) How Banks Price Loans to Public-Private Partnerships: Evidence from the European Markets Journal of Applied Corporate Finance 19(4), Merton, R (1974) On the Pricing of Corporate Debt: The Risk Structure of Interest Rates The Journal of Finance 29, Newell, G and H W Peng (2007) The signi cance and performance of retail property in Australia Journal of Property Investment & Finance 25(2), Newell, G and H W Peng (2008) The role of US infrastructure in investment portfolios Journal of Real Estate Portfolio Management 14(1), Rothballer, C and C Kaserer (2012) The Risk Pro le of Infrastructure Investments:Challenging Conventional Wisdom 18(2), Sawant, R J (2010) Infrastructure investing: managing risks {& rewards for pensions, insurance companies {& endowments, Volume 549 Wiley Weber, B and H W Alfen (2010, March) Infrastructure as an Asset Class Investment Strategies, Project Finance and PPP John Wiley & Sons

From asset allocation to infrastructure investment

From asset allocation to infrastructure investment 1/40 From asset allocation to infrastructure investment A roadmap for the development of institutional investment in infrastructure Frédéric Blanc-Brude,