Infrastructure: An emerging real asset class

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1 Market & Investment Insights Infrastructure: An emerging real asset class LISA FERRARO, MANAGING DIRECTOR AND PORTFOLIO MANAGER, ENERGY AND INFRASTRUCTURE Article Highlights: Infrastructure including roads, bridges, pipelines, airports and electricity projects is an emerging real asset class that is attracting rising interest from investors. Governments are partnering with private investors to replace aging infrastructure in developed markets and to build new infrastructure in emerging markets. Infrastructure assets offer investors stable, long-term returns, portfolio diversification, and can also provide a hedge against inflation. Around the world, there is a large and growing need for infrastructure investment. Rebuilding existing infrastructure and constructing new facilities to meet the demands of a growing global populace is an enormous task. The Organization of Economic Cooperation and Development (OECD) estimates that $53 trillion of new investment will be needed to meet global demand for infrastructure through Faced with severe budget constraints, governmental agencies are looking to private investors to supply the capital needed for infrastructure projects in the coming years, creating unique investment opportunities. What is infrastructure? Infrastructure is a type of real asset that generates revenue through service contracts, user fees, tariffs, or taxpayer subsidies. It encompasses a wide variety of asset types water treatment facilities, electric transmission lines and power plants, roads, airports, schools, hospitals, bridges and tunnels. Infrastructure assets can be grouped by sub-sector: Energy pipelines, storage and transfer facilities, power generating stations, power transmission and distribution networks Communications data and telephony transmission and distribution cables, satellites, wireless communications towers Transportation highways, bridges, tunnels, railways, airports, seaports

2 Water pipelines, distribution networks, desalinization plants, treatment plants Social hospitals, schools, governmental offices, military facilities, stadiums and recreational facilities In the past, these assets were usually created and operated by governmental agencies, municipalities or utilities. Budget constraints and large debt burdens coupled with the risk of cost overruns, poor quality construction and delays in completion, have encouraged public officials to seek private investment and expertise to build and operate infrastructure assets. For investors, infrastructure assets have several characteristics in common. Most new infrastructure projects require a large, up-front capital investment followed by relatively low ongoing operational expense. Also, they operate under either natural or government-granted monopolies, shielding them from the intense competition that many businesses face. The contracts that govern these projects often include provisions allowing the operator to recoup their direct costs, helping to maintain consistent profitability during periods of rapid inflation. Public/Private partnerships Public sector investment in infrastructure is in long-term decline. According to the OECD, public infrastructure investment in developed countries has declined from about 4% of gross domestic product in 1980 to about 3% in In the U.S., government spending on infrastructure has fallen to a 20-year low of 1.7% of gross domestic product.

3 To bridge this funding gap, governmental authorities are turning to arrangements known as public/private partnerships. These partnerships can take numerous different forms, but they all involve a governmental agency contracting with private investors to take responsibility for an infrastructure project in return for a series of defined payments over a specified length of time. These payments may come from user fees, such as in a toll road, tariffs charged by pipelines, or from tax revenue. Some agreements allow private investors to own the asset in perpetuity, while others call for a lease that expires after a certain period. One popular type of arrangement is known as BOOT Build, Own, Operate, Transfer. In this type of contract, private investors undertake construction using their own funds and own the finished project. They recoup their investment during a specified period of operation, after which ownership reverts to the government. In addition to supplying badly needed capital, public/private partnerships can offer several advantages over typical government procurement, including faster, more cost-efficient delivery; increased accountability; heightened competition; and improved risk management. To encourage private investment, many nations have passed legislation that establishes a legal framework with which to create public/private partnerships and specifies how they operate, the rights of various parties, dispute resolution, liability limitations, and how existing laws covering public procurement apply in these situations. Nations with well-developed legal foundations for public/private partnerships are generally considered to be less risky for private infrastructure investors than those with comparatively weak or no legal foundation.

4 Why is infrastructure attractive? For investors, infrastructure assets have several unique qualities that make them attractive both for diversification as well as expected total return: Low correlation to other asset classes: Infrastructure assets offer investors portfolio diversification, as their returns tend to have low correlations with the returns provided by stocks and bonds. Long-term, stable cash flows: Infrastructure projects are typically natural or government-granted monopolies, and thus not subject to intense competition. Long-term operating contracts, sometimes 50 years or longer, are common. Also, because they provide essential services, demand tends to be steady through the ups and downs of economic cycles. Inflation-linked: Infrastructure project contracts often include provisions that tie service price increases to the rate of inflation or allow the operator to pass along higher costs, helping to maintain profit margins if inflation accelerates. Infrastructure investments also carry risks. Each sub-sector has its own economic sensitivities, revenue characteristics, and operational risk factors. For investors, these risks can be mitigated by owning funds that hold a diversified portfolio of infrastructure projects. Also, because they operate under government concessions, infrastructure projects carry political and regulatory risks. Investing in countries with transparent, stable regulatory regimes and well-developed legal frameworks for private infrastructure investment can serve to lessen these risks. New projects, particularly those still in the planning or construction stage, carry more risk than existing assets with established operating histories and revenue streams. New projects tend to offer higher returns to compensate investors for the added risk. Accessing infrastructure Investing in infrastructure and other real assets offers many compelling opportunities for investors, but require specialized knowledge and can be difficult to access. These assets demand a high level of expertise on the part of managers if investors are to realize expected returns. To address the risks and challenges of investing in real assets, we recommend that investors partner with experienced managers who have a wide investment mandate, deep access to capital, and industry expertise. Attractive infrastructure projects take a long time to develop, so it is important that managers of infrastructure portfolios have broad market access in order to find opportunities wherever they may arise, including both developed and emerging markets. Also, most infrastructure investments require large financial commitments, especially in early stage projects where returns are likely to be greatest. Managers with access to large pools of capital can make the sizable financial commitments that infrastructure projects require.

5 They can also invest in many different projects, helping to diversify operational and political risks. Lastly, managers with lengthy experience investing in infrastructure are better able to conduct the rigorous due diligence needed for infrastructure projects, and to manage infrastructure portfolios spread across many different geographies. For those seeking long-lasting, stable cash flows, infrastructure assets offer a unique opportunity. The material is for informational purposes only and should not be regarded as a recommendation or an offer to buy or sell any product or service to which this information may relate. Certain products and services may not be available to all entities or persons. Investment, insurance and annuity products are not FDIC insured, are not bank guaranteed, are not bank deposits, are not insured by any federal government agency, are not a condition to any banking service or activity, and may lose value. TIAA-CREF Asset Management provides investment advice and portfolio management services to the TIAA-CREF group of companies through the following entities: Teachers Advisors, Inc., TIAA-CREF Investment Management, LLC, and Teachers Insurance and Annuity Association (TIAA ). Teachers Advisors, Inc., is a registered investment advisor and wholly owned subsidiary of Teachers Insurance and Annuity Association (TIAA). Past performance is no guarantee of future results Teachers Insurance and Annuity Association of America-College Retirement Equities Fund (TIAA-CREF), 730 Third Avenue, New York, NY C18017