InfrastructureApr 24 2019

Investing in alternative assets

twitter-iconfacebook-iconlinkedin-iconmail-iconprint-icon
Search supported by
Investing in alternative assets

Before the financial crisis, the traditional 60 per cent equity/40 per cent fixed income asset allocation mix still formed the basis of many portfolios, with the more adventurous investor perhaps looking to emerging market debt or high yield to add a little spice to things.

However, this approach has since evolved and investors are now able to access alternatives, such as renewable infrastructure, residential social housing, litigation finance or healthcare royalties.

While the move towards a broader investment universe originally began with large institutional investors, retail investors have increasingly embraced greater choice and the potential benefits it can bring to a portfolio.

Unsurprisingly, the willingness to consider alternative assets has been given added impetus by the current era of ultra-low interest rates; the search for yield has been an integral driver of asset prices over recent years and has opened minds to more diverse sources of return.

Infrastructure popular

One notable beneficiary of this trend has been infrastructure. Historically, responsibility for the construction and maintenance of a country’s infrastructure, whether that is energy supply, roads or railways, has rested with the public sector.

Only relatively recently has infrastructure evolved into an investable asset class for private investors.

However, since then, its popularity has grown almost exponentially. Last year, global fundraising for privately owned or ‘unlisted’ projects reached a new record level of circa $85bn (£75.2bn).

The boom in investor interest should not come as a shock given unlisted infrastructure can boast several attractive characteristics.

Most notably, investors can benefit from the low correlation to traditional asset classes, as well as potentially attractive risk-adjusted returns. On top of this, cash flows tend not only to be stable and predictable, but most have an embedded element of inflation protection.

Supply and demand

Of course, the asset class is not immune to the law of supply and demand. Given the large inflows of capital from pension funds, sovereign wealth funds and private investors, competition for assets has increased markedly and potential returns have been squeezed in some instances.

The impact of this has been most keenly felt in some of the larger-scale projects, or so-called ‘trophy’ assets. London City Airport, which traded a couple of years ago at a reported 40 times its pre-tax earnings, is a good example.

It is because of this that greater value often exists in mid-size and smaller deals, typically those with enterprise values (a measure of a company’s total value) of less than £200m.

A larger pool of potential deals and the absence of the intense competition that marks the ‘trophy’ end of the market mean investors can exercise greater price discipline while still being able to put their cash to work.

These opportunities extend across continental Europe, from ground-based solar panel farms in Poland to rolling-stock partnerships in the UK, Nordics, Germany and Italy.

While acknowledging that infrastructure is a diverse universe containing myriad assets with diverse risk/return profiles, the asset class appears particularly attractive at this late stage of the business cycle when a fair amount of uncertainty exists around recession risk.

The stable and predictable cash flows that come from many projects are relatively immune to fluctuations in the business cycle. While in the event of a US recession corporate earnings might be expected to fall by 30-40 per cent, the cash flows on, say, a state-subsidised wind farm would barely move. 

What drives the revenues of these assets is different to what drives the revenues of traditional equities and bonds, enabling them to provide recurring income streams irrespective of broader market turbulence.

Areas such as renewable energy offer good prospects due to growing demand for clean energy and the prevalence of government subsidies.

Investing in operational solar and wind farms comes with little or no construction risk or economic sensitivity.

Similarly, social housing projects with long-dated, government-sourced revenues can also provide reliable inflation-linked returns.

Social housing also has a low correlation to more economically-sensitive residential and commercial property sectors.

If we look generally across US and European infrastructure, there is a need to upgrade and private capital will be a part of that solution. It can be a difficult nettle for politicians to grasp, but it is something that needs to happen. 

Investment risks

It is not all upside however; no asset class ever is. Investors need to be aware of the risks involved when investing in infrastructure, some of them relatively specific to the asset class.

Liquidity risk is perhaps the most prominent of these, while there is also a risk that projects do not go ahead or run ahead of original cost projections.

Given the nature of many infrastructure projects and their integral role in society and the economy they can also be subject to greater regulatory scrutiny than most other sectors.

Ultimately, when we think about the long-term returns from different asset classes over three, five or 10 years, the valuations on traditional asset classes look stretched. If you focus on the very near-term macro outlook, it is reasonable but it is also very changeable.

Only a few months ago investors were concerned about a US-China trade war and the Federal Reserve tightening too fast, and all it takes is a tweet from Donald Trump to remind investors of these concerns.

Therefore, if we avoid the noise surrounding short-term macro themes and look over the medium term, traditional asset classes face challenges. However, as investors seek increased diversification without compromising on returns, alternative assets can play an important role in helping meet the requirements of a wide range of investors. 

Key Points

  • Since the financial crisis, investors have had access to a variety of alternatives assets
  • Alternatives, especially infrastructure, have low correlation to other asset classes
  • Liquidity is the biggest risk associated with infrastructure

Mike Brooks is head of diversified assets at Aberdeen Standard Investments