There are big hurdles in place right now
The industry needs to promote better standards, methods and benchmarking. That’s the only way to remove the hurdles that are preventing institutional capital from flowing into infrastructure.
Institutional investors have become increasingly interested in infrastructure investment in recent years, in search for new sources of returns, diversification, duration and inflation hedging. However, they cannot be expected to make a substantial and durable contribution to the long-term financing of infrastructure if important changes do not take place.
Other key players want to make this happen too. The World Bank’s initiative to maximise finance for development (MFD) aims to “find solutions to crowd in all possible sources of finance, innovation, and expertise” in order to achieve its Sustainable Development Goals. In the case of infrastructure investment, the bank’s plans require a significant proportion of long-term private finance to come from from institutional investors such as pension plans, life insurers or sovereign wealth funds.
So what are these three essential changes?
1. Better valuation
Valuation methodologies need to improve to represent financial performance more accurately.
Current valuation methodologies used in private infrastructure are wrong. That was the view of 50% of the respondents of the largest survey of asset owners (1) ever undertaken (by EDHEC on behalf of the G20). And it’s easy to see why they take this view. Discounting 25 years of ‘base case’ cash flows using a single discount rate build from ad hoc risk premia assumptions, with little regard for the term structure of risk that characterises infrastructure firms contradicts basic corporate finance textbooks. It is easy to do a lot better.
Advanced private asset pricing techniques using stochastic DCF take into account market transactions and systematic sources of risk. This approach can make significant improvements to those based on ‘forward-looking views’. As often as not, there are merely unrealistic guess work about the future of energy prices or the world economy over the next 25 years.
2. Better risk evaluation
Credit risk methodologies need to evolve to better capture default risk.
Infrastructure debt seldom defaults. But that doesn’t mean it’s a risk investors can ignore. Even witha large number of credit instruments, a representative set of default events may not be available. This is the case especially if the analysis makes no attempts to control for financial structure or business model. If almost no defaults have been reported in project finance 10 years after origination, is 10-year old project debt risk-free? Is it AAA-rated? Of course not. The so-called “reduced form” models used by credit rating agencies work well when large samples of defaults can be observed. When this is not possible, structural models that look at the risk of crossing certain observable default thresholds (like the debt service cover ratio) perform a lot better.
Recent EDHECinfra results show that such an approach accurately predicted default rates as high as 5% in European merchant infrastructure in 2013, or a cumulative 10-year default rate close to 50% in Spanish infrastructure projects. A far cry from the usual ‘stylised facts’ from credit risk studies but also much more realistic in hindsight. Importantly however, this approach would also have predicted this level of credit risk at the time (2).
3. Better benchmarks
Evaluating infrastructure managers and strategies against “absolute return” benchmarks should be abandoned. Investors need proper benchmarks capturing the risks inherent in such investments instead.
Infrastructure is often described as an absolute return strategy. It is expected to deliver a certain level of performance defined ex ante, typically a few hundred basis points above the risk free rate or inflation. Such targets can be useful for investors, especially if they have liabilities defined in similar terms#. However, the performance of infrastructure products, strategies and teams should not be compared with “absolute” returns.
Benchmarking a strategy against “risk-free-plus-five” implies that it is risk free and has an alpha of 5%! Instead, infrastructure investors face credit risk, interest rate risk, macro risks and certain systematic risks only found in infrastructure. (Examples include the systematic differences between merchant, contracted and regulated investments). They are also likely to face exposure to risk factors found in stocks such as the size (small outperforms large) and momentum (winners tend to keep winning) effects.
Better tools will bring the potential for more investment
Only by insisting on adequate risk-adjusted benchmarks can the industry counteract investors’ disillusionment with performance measurement in private infrastructure. This, in turns, requires better methods, data and reporting to better understand and measure risk and performance.
The World Bank’s MFD calls for the best use of all sources of finance but also for innovation. This has to happen across the board, in the area of performance measurement and reporting, in credit risk modelling and scoring and above all in benchmarking the risks that private investors take on. These improvements will play a significant role in maximising the private finance flowing into infrastructure.
New projects are an important channel to support and implement such innovations. These include projects such as the ones championed by the Global Infrastructure Facility and the co-lending structures adopted by IFC. When innovative projects are supported by multilateral organisations, this creates a positive demonstration effect. Positive momentum can then spill over in the more private and opaque parts of the infrastructure financing sector.
These changes will take time and will not be easy to achieve. They require an unprecedented paradigm shift in the world of private infrastructure finance and investment. These changes are however necessary and asset owners will increasingly demand them if they are to invest in infrastructure on a large scale. Maximising this potential today however will require leadership and vision.
(1) More than half of respondents representing USD10 trillion of assets under management declared that they did not trust or were not sure if they could trust the valuations reported by infrastructure asset managers.
(2) Based on 20 years of debt service cover ratio data.