A poll conducted by AsianInvestor and QIC reveals the growing importance of infrastructure as a core asset class.

With global interest rates in a state of flux, Asian investors in infrastructure are on the lookout for established brownfield assets with stable cash flows. In general they remain bullish about the asset class, but they are also keeping a close eye on valuations and thinking hard about portfolio construction, according to a poll of investor attitudes conducted by AsianInvestor and QIC in April.

Respondents to the poll were asked to provide information on their allocation strategies and indicate whether they planned to increase or decrease their exposures over the next 12 months. They also shared their approach to selecting an infrastructure manager and listed the greatest challenges faced when investing in the asset class.

The survey gathered feedback from all types of firms, including family offices and endowments. Overall, 33% of respondents said they worked for insurance companies, 31% represented commercial banks and 21% were from public and corporate pension funds. Geographically, the majority of investors hailed from Hong Kong, Australia, Singapore, Japan and Korea.

When asked about current appetite for infrastructure investments, two-thirds of respondents said they had increased their allocation to infrastructure over the past 12 months.

Looking ahead, however, the survey forecasts a softening in enthusiasm with only 52% indicating they plan to increase allocations in the next 12 months, and nearly 40% saying allocations will stay the same.

Ross Israel, head of global infrastructure at QIC, said the results reflect a cautious mood in the sector, though he expects inflows to remain high in absolute terms.

“Private capital infrastructure is still attractive in general terms and 37% of investors who answered the poll said they hold 10% or more of their portfolio in the asset class,” said Israel. “This is symbolic of the growing importance of infrastructure as a core investment allocation.”

Israel acknowledges there are some challenges ahead. “Central banks around the world are running historically low interest rates and it’s becoming increasingly difficult to forecast when rates will revert to long-term trends. It is hard to know where the true risk free rates lie at present.”

The cautious mood is influencing investors’ geographic preferences, causing them to favour more established markets over emerging markets. As a percentage of portfolio assets, the poll shows allocations to the US and Western Europe increasing over the next 12 months, while allocations to South America and Asia will decrease.

“The focus is on established brownfield assets that have an existing earnings track record, and these are typically found in OECD countries,” said Israel. “Investors in the transport, utilities and the PPP (public-private partnership) space are also looking to invest in places that have predictable regulatory regimes and good governance practices.”

An eye on valuations

The preference for safe brownfield assets is having the knock-on effect of increasing prices as investors compete for a defined set of opportunities.

Recent auctions in the state of New South Wales in Australia have attracted aggressive bids from both local and foreign consortia. In 2014 the government reaped A$1.75 billion ($1.31 billion) from the long-term lease of a seaport in Newcastle, having earned another A$5.07 billion from the combined sale of Port Botany and Port Kembla in the previous year. Both auctions priced at a staggering 25 times prospective Ebitda and each attracted bids from four or more consortiums, underpinned by heavy-weight offshore institutional buyers.

These sales were followed by the A$10.3 billion privatisation of Transgrid in December last year – the first of three auctions for electricity distribution assets. The successful bidder for the 99-year Transgrid lease was a consortium comprised of Hastings Fund Management, Spark Infrastructure, the Abu Dhabi Investment Authority, CDPQ, and Wren House, part of the Kuwait Investment Authority. The buyers paid a premium valuation of 1.64 times the regulated asset base as of June 2015, beating market expectations by a long shot.

It’s no surprise, then, that respondents to the AsianInvestor/QIC poll are concerned about asset valuations. In fact 21% of investors listed valuation concerns as the greatest challenge facing the infrastructure investment sector – the highest single response in a list of eight challenges.

“Risk is being distorted by the low interest rate environment,” said Israel. “Corporate and strategic investors have access to a lot of cheap capital and are able to compete with financial investors to push up prices. “Without the benefit of hindsight, it’s hard to tell whether the prices being paid at the moment are high or not. If interest rates stay low for some time then the valuations being paid now could be seen as reasonable in the future. But if markets bounce and the returns on other assets increase then today’s prices will be seen as high.”

Israel doesn’t see a near-term end to the uncertainty. “A year ago the US Federal Reserve was flagging a clear tightening bias and interest rates were expected to rise. Now the picture is more confusing and nobody really knows what the Fed is going to do. For assets with a long-term shelf-life like infrastructure, this confusion makes it hard to forecast the value of fair returns.”

As investors cope with global ambiguity around rate settings, they are also adjusting their return expectations on infrastructure investments. The high returns enjoyed by first-movers in the sector – when there was a distinct lack of competition for assets – are no longer available. When asked what returns investors expect on core brownfield investments (defined as transport, energy, utility and airport assets in OECD countries), 46% of poll respondents said they were hoping for returns of 8%-10%. Another 22% expected returns below 8%, while only 15% said they were looking for returns above 12%.

“Returns have become tighter as more managers have moved into the sector,” said Israel. “If we drilled down into the figures, my guess is that a large proportion of the return appetite would now be seeking income rather than capital gains. This is another factor stemming from where we are in the market cycle.”

Israel said investors apply a different risk/return/price lens to each infrastructure opportunity based on the objectives of their underlying stakeholders. “Pension and corporate funds want duration and are focused on long-term stable assets that match their liabilities. Sovereign wealth funds, on the other hand, tend to be more return driven and have the flexibility to be expansive with their risk budgets. Similarly, endowments tend to play at the more risky end of the spectrum.”

Asian appetite grows

QIC’s understanding of investment trends is being honed as it undertakes roadshows for a new pooled infrastructure vehicle.

It aims to raise A$1.75 billion for the pooled fund with a hard cap of A$2.35 billion and a final fundraising deadline of February 2017. First close was reached in August last year and the fund made its maiden investment in a gas storage business, Lochard Energy, in Victoria.

The plan is to invest in up to 10 assets mainly in the energy, utilities and transport sectors with a cap of 10% on greenfield projects. About 60% of funds will be spent in Australia and 40% in the UK, Europe and North America. The fund is targeting a yield of 5%.

Melanie Pyzik, an investment specialist in QIC’s global infrastructure team, has been actively marketing the fund to Asian investors.

“Asian investors know QIC from our real estate and private equity platforms, and we have worked with them on infrastructure through separate managed accounts,” Pyzik said. “The pooled structure is an access point to the team’s strong investment capability and track record for investors who do not have the required dollar allocation for a separate managed account. The interest we have received in the Asia market has been significant and we are delighted with the results.”

Australia has an obvious appeal due to shared time-zones and cultural linkages. “We are spending a lot of time building relationships in the region and the key to making this work is gaining a deep understanding of what Asian investors want to achieve from their allocations to infrastructure,” said Pyzik. “In general, they take an academic, macro approach. They want to be comfortable with the big picture before talking about specifics.”

The success of the marketing campaign so far has been a combination of comfort with the QIC brand, the team’s investment philosophy and the firm’s commitment to running a transparent process. Investors also like the breadth of knowledge in the team.

Such attributes are underscored in the results of the AsianInvestor/QIC poll. When asked what qualities investors look for in an infrastructure manager (excluding fees and track record), 55% of respondents said their top priority was finding a manager with an experienced and stable team. They also placed great importance on having a strong brand and local presence.

In talking to Asian investors, QIC is also noting the changing role of asset consultants in allocation decisions. In the early days of Australia’s relationship with infrastructure, assets consultants acted as an important conduit. All new products needed to be reviewed and rated by the gatekeepers in order to gain traction in the market.

In Asia, however, they tend to play a corroborating role, coming in at the due diligence stage.

Only 6% of respondents to the poll said they rely entirely on asset consultants to select an infrastructure manager. Instead, 50% use an in-house process, and another 41% use a combination of both.

“When infrastructure was in its infancy, asset consultants played a critical role in educating trustee boards about the universe of options,” said Israel. “These days there is more information available publicly and the bigger funds are hiring people in-house to evaluate the universe of peers. More and more we see asset consultants used in a corroborating, devil’s advocate way to back up what thein-house team has already decided,” he said.

In general, Asian investors take a structured approach to their investments, said Pyzik. “Infrastructure is an evolving asset class in the region so very often a decision to invest in a pooled vehicle like ours requires a full credit approval process or board approval process.”

Local regulations can also restrict how they invest and how much they can hold in foreign currencies. In Korea, for example, most institutional investors who want to go offshore must invest via a local vehicle. In China, the rules restricting investments in unlisted assets outside the country were only recently lifted.

As for cheque sizes, QIC said orders for the pooled fund have ranged between A$200 million from the more seasoned institutions to around A$30 million from smaller funds or market newcomers.

Looking ahead

The success of QIC’s latest fundraising effort suggests the appetite for infrastructure as an asset class is growing and becoming stronger. “From a yield perspective, infrastructure has obvious attractions,” said Israel. “The stability and cash flow dynamics make it a highly desirable asset class.” As sophistication increases, Israel predicts investors will dedicate more energy to building thoughtful portfolios. Respondents to the poll are aware of the challenges of portfolio construction, and list ‘finding the right mandate to match internal criteria’ as their second biggest concern after valuations. “Investors are increasingly having a mature debate about how to add diversification,” said Israel. “They are asking questions about which assets, sectors, geographies to pursue to achieve longer-term objectives and to find the right level of risk/return to suit them.”

Israel is confident Asian investors will play an increasingly important role in the sector. “Asian investors are on a journey which will see their allocations grow driving an increasing need to diversify and export capital from their home market,” he said.

Much of this capital has the potential to end up in brownfield and expansion investments in OECD countries.

“With every investment they make the level of experience increases, requiring product providers to refine their processes, improve transparency and boost performance,” said Israel. “This is positive for the long-term vitality of the sector.”

Post from QIC. Printed in AsianInvestor.