Infrastructure Investing

Introduction

Infrastructure is the class of long-lived physical assets that provide basic services: transportation, utilities, energy, communications and public facilities. This guide describes what the class includes, the four ways its assets earn revenue, and how those revenue models place an asset on the spectrum from core to opportunistic. It then sets out the risks, a worked example of interest-rate and leverage sensitivity, and the ways the class is held, from unlisted and evergreen funds to listed vehicles and the direct ownership used by Canada's large pension plans.

What counts as infrastructure

Definitions vary between managers and index providers, but most group the class into five sub-sectors.

The sub-sectors share economic features that explain how the class behaves.

• High upfront cost and long lives. An asset is expensive to build and then operates for decades. Most of its cost is incurred before it earns anything.
• Operating cost that is commonly low relative to capital. Once an asset is built, much of its revenue goes to repaying and earning a return on the capital that built it.
• Limited competition. A second electricity grid or a parallel toll road is rarely built. Many assets are natural monopolies, or close to it, in the area they serve.
• Revenue set outside the market. Because competition is limited, revenue is usually set by a regulator or fixed by a contract.

The same asset type can sit in different revenue models. A wind farm selling under a long-term contract and one selling into the spot market are the same physical asset with different risks.

How infrastructure assets earn revenue

Regulated revenue

A regulated utility earns revenue that a regulator approves. In Canada, provincial regulators such as the Ontario Energy Board and the Alberta Utilities Commission set or approve rates for the utilities in their jurisdictions. The common approach starts from the rate base, the utility's invested capital in assets used to serve customers. The regulator allows the utility to recover its operating costs, depreciation and taxes, and to earn an allowed return on the rate base. Rates are reset in periodic proceedings, and some regulators use formulas that adjust rates between proceedings for inflation and an expected productivity gain.

The return therefore depends on what the regulator admits to the rate base and the return it allows, and growth comes mainly from adding capital to the rate base. Volume risk is usually small; regulatory risk is the main one.

Contracted revenue

A contracted asset sells its output or its capacity to a counterparty under a long-term agreement.

• Offtake agreements, including power purchase agreements, fix a price for a generator's output over a term of years.
• Take-or-pay and capacity agreements, common for pipelines and storage, require the customer to pay for reserved capacity whether or not it is used.
• Leases and service agreements let tower, fibre and data-centre owners earn rent from telecommunications carriers and other tenants.
• Availability payments under a public-private partnership (P3) pay the private owner for keeping a facility available to a required standard, regardless of how heavily it is used, with deductions when it falls short.

The investor's return depends on the contract's terms (price, length, escalation, termination rights) and on the counterparty's ability to pay. If an offtaker or tenant fails, the contract may have to be replaced at a lower price or not at all. When a contract ends, the asset is re-contracted at whatever terms are then available.

Usage-based concessions

A concession grants the right to operate an asset and collect fees from its users for a fixed period, after which the asset usually returns to the government that granted it. Toll roads, airports and ports are commonly run this way. Revenue depends on traffic volume and on the fee schedule the concession permits, which may include caps or a formula linked to inflation.

The investor carries volume risk: fewer vehicles, flights or containers means less revenue. Because the concession ends, the value of the asset to the owner runs down as the end date approaches, unless the term is extended.

Merchant revenue

A merchant asset sells its output at market prices with no long-term contract. A power plant selling into a wholesale electricity market is the standard example. Revenue moves with prices and volumes, and the asset's cash flows behave more like a commodity business than like a utility.

The four models compared

Many assets combine models, such as a generator with part of its output contracted and the rest sold at market prices. The mix determines where the asset sits on the risk spectrum.

Inflation and the economic cycle

The link between infrastructure revenue and inflation is set asset by asset, in the regulation or the contract.

• A regulated utility's rates reflect higher costs when they are reset, which happens with a lag; formula-based regimes commonly adjust each year.
• A concession may index its fees to the consumer price index, sometimes in full, sometimes in part, and sometimes with a cap.
• A contract may carry a fixed escalator, an escalator linked to inflation, or no escalation at all. A fixed-price contract has no inflation link for its whole term.
• A merchant asset's revenue moves with the price of what it sells, which may or may not track general inflation.

Inflation also raises operating, maintenance and construction costs, and interest rates have tended to rise with it, which raises the cost of floating-rate and refinanced debt and the rate used to value future cash flows. Whether an asset gains or loses in an inflationary period depends on how its revenue, costs and debt are each linked to prices.

The economic cycle works the same way. Demand for electricity distribution or water varies less with the economy than demand for many goods, and regulated or take-or-pay revenue barely depends on it. Usage-based assets depend on it directly: air and road traffic fell sharply in the spring of 2020, and airports and toll roads carried that loss in revenue.

The risk spectrum

Managers commonly describe infrastructure strategies with the same four labels used in real estate. The labels are not standardized. Each manager defines its own, so the useful question is what mechanism puts an asset in a category.

Two distinctions sit underneath the labels.

• Brownfield and greenfield. A brownfield asset is operating, with a revenue history. A greenfield asset is yet to be built, so it carries construction risk and earns nothing until finished. Diligence practice treats greenfield development labelled core as a reason for questions, because the label and the risk do not match.
• Revenue model and leverage. An asset moves along the spectrum as its revenue becomes less certain (regulated to contracted to concession to merchant) and as its borrowing increases. Two funds holding the same asset type can sit in different categories because of contract terms and debt.

The category describes the kind of risk taken; the outcome depends on the assets and the manager.

Risks and how they show up

Regulatory and political risk

Governments grant concessions, set or approve rates and write the rules. A regulator can lower an allowed return, disallow capital from the rate base or change the regulatory model. A government can renegotiate a concession, change subsidies or tax treatment, or, in extreme cases, take an asset back. The terms of an owner's relationship with public authorities can change during the life of the asset.

Interest rates and refinancing

Infrastructure is valued by discounting long streams of future cash flows. When the discount rate rises, their present value falls, and the longer they run, the larger the fall; the worked example below shows the arithmetic. Debt commonly has to be refinanced well before an asset reaches the end of its life, and if rates are higher then, more of the asset's cash flow goes to interest and less to equity.

Leverage

Borrowing against contracted or regulated cash flows is common practice in the class and a main driver of equity returns, in both directions: because lenders are paid first, a change in the asset's value is a larger change in the value of the equity. Debt can sit at the asset, at a holding company and at the fund, and diligence practice looks at every level.

Construction risk

A greenfield project can run over budget, finish late or fail to perform as designed. Until it is complete, it earns no revenue while its costs and interest continue. Construction contracts can shift some of this risk to the builder, and the terms of those contracts matter.

Operational risk

A generating unit can go offline, a pipeline can leak, and a P3 facility can fall short of its availability standard and incur deductions.

Demand and obsolescence

An asset's useful life can outlast the demand for its service. Changes in technology, policy or behaviour can reduce how much an asset is used or what its users will pay. When that happens before the asset's cost has been recovered, the remaining value can be written down, which is what a stranded asset is. The risk is greatest where revenue depends on volume or on re-contracting.

Concentration

An infrastructure fund commonly holds a small number of large assets, so one underperforming asset can move the result of the whole fund.

Environmental and social risk

Projects can carry environmental liabilities, face community opposition and depend on permits that take years to obtain. In Canada, the Crown's duty to consult, and where appropriate accommodate, Indigenous peoples applies to decisions that may affect Aboriginal or treaty rights, and it forms part of the approval process for many projects. Indigenous nations also participate as owners in some projects.

Valuation and liquidity

Unlisted infrastructure is valued periodically, by appraisal or model, so reported values change later and less sharply than market prices, an effect known as appraisal smoothing. Part of the lower volatility and correlation that unlisted infrastructure reports reflects this measurement, and part reflects revenue set by regulation and contracts. How much of each is debated.

Currency

A fund that invests outside Canada or reports in another currency produces Canadian-dollar returns that move with exchange rates as well as with the assets, unless the exposure is hedged.

Worked example

The example is hypothetical, uses round numbers and describes no real asset or fund. It shows how a change in the discount rate affects a contracted asset's value, and how leverage magnifies that change for the equity.

Assumptions. An asset has a contract paying 10 a year, at a fixed price with no escalation, with payments at the end of each year. Its value is the present value of those payments. The discount rate rises by one percentage point, from 6% to 7%. Values are rounded to one decimal.

Step 1: a 10-year contract.

The value falls by 3.4, or about 5%.

Step 2: a 20-year contract.

The value falls by 8.8, or about 8%: in percentage terms, about 1.7 times the fall on the shorter contract, because more of the value lies in distant payments.

Step 3: the 20-year asset with debt. Assume the 20-year asset is financed with 70 of fixed-rate debt, and that the value of the debt does not change. The equity is what is left after the debt.

The asset falls by about 8%; the equity falls by 8.8 on 44.7, or about 20%. The debt takes none of the loss, so all of it falls on the smaller equity stake.

The example leaves out things that change the result in practice: an inflation-linked escalator would offset part of the fall, the value of fixed-rate debt itself moves with rates, and floating-rate or maturing debt would raise interest costs. The direction holds: longer cash flows and more leverage mean greater sensitivity to the discount rate.

How the class is held

Unlisted closed-end funds

A closed-end infrastructure fund is usually a limited partnership: limited partners commit capital, the general partner draws it through capital calls as assets are acquired, and capital returns as income is distributed and assets are sold. The fund has a fixed term. Some infrastructure funds follow the ten-year pattern common in private equity; longer-life funds are designed to hold assets well beyond that. Fees commonly follow the management-fee and carried-interest model, with terms that vary by strategy. An interest can be sold before the end of the term only through the secondary market, usually at a negotiated price and with the general partner's approval.

Open-end and evergreen funds

Because infrastructure assets can operate for decades, some managers hold core and core-plus assets in open-end funds with no fixed term. New capital is admitted periodically and investors can ask to redeem, with the fund's documents setting notice periods and limits on how much can be redeemed at a time.

Evergreen funds offered to individual investors apply the same idea. They accept subscriptions and offer redemptions at intervals, commonly monthly or quarterly, at a net asset value the manager calculates. Their documents commonly cap redemptions in a period, and the manager can prorate or suspend them when requests exceed the cap. The fund typically holds some cash, credit or listed securities to meet redemptions, which affects its return. Minimums are often lower than for a closed-end fund, and money is invested on subscription rather than through capital calls. The liquidity is periodic and limited; the underlying assets are as illiquid as in any other structure.

Listed vehicles

Infrastructure is also held through securities that trade on stock exchanges: shares of regulated utilities, pipeline, tower and other infrastructure companies; listed partnerships and trusts that own infrastructure assets; and mutual funds and exchange-traded funds that hold a basket of such securities. They can be bought and sold on any trading day, with low minimums and public disclosure.

Their prices move with the stock market. A listed infrastructure company and an unlisted fund holding similar assets can report very different volatility over the same period, because one is priced by daily trading and the other by periodic appraisal. Listed vehicles may also carry corporate-level debt and businesses beyond the assets themselves.

Direct ownership and co-investment

The largest institutions own infrastructure assets directly, alone or with partners, with their own teams handling acquisition, financing and oversight. Between direct ownership and fund commitments sits co-investment: a limited partner invests alongside a fund in a specific asset, usually at reduced fees or none, under rights commonly negotiated by larger limited partners.

How Canada's large pension plans hold the class

Several of Canada's large public pension plans report infrastructure as a separate asset class in their annual reports. They hold it through direct ownership by in-house teams, partnerships with other institutions, and commitments to external funds.

Their structure explains the approach. A pension plan's obligations run decades ahead and its cash needs can be planned in advance, so it can hold assets that cannot be sold quickly. Scale and internal staff let a plan assess and manage individual assets itself, and owning directly removes a layer of fund fees. Each of these is a property of the institution rather than of the asset class.

Channels for individual investors

Unlisted infrastructure reaches individual investors through the same channels as other private investments: a direct commitment to a fund manager, a fund of funds, an exempt market dealer, or an online platform. The channels differ in who selects the investment, who carries out diligence, what they add to the fund's own fees and where their conflicts sit. In each, the investor's own review of the fund and its manager still applies.

How allocation frameworks treat the class

Institutional frameworks have commonly sized infrastructure within a real-assets allocation, alongside real estate. The thinking behind it was that long-lived assets with regulated or contracted revenue, some of it linked to inflation, produce cash flows that resemble the long-dated obligations a pension plan has to meet.

Some frameworks split the class by risk. Core infrastructure has been grouped with the income-oriented part of a portfolio, on the reasoning that its cash flows behave somewhat like long-dated bonds with partial inflation adjustment. Value-add and opportunistic infrastructure have been grouped with growth assets, on the reasoning that their returns depend on construction, expansion and markets. The comparison with bonds has limits: an infrastructure equity stake has no maturity value, ranks behind the asset's debt, and carries regulatory, operating and demand risks that a bond does not.

How much an institution holds follows from its horizon, the timing of its obligations, its scale and staff, and its ability to hold assets through a full fund term. An institutional allocation describes what an institution with those features holds.

What holding the class involves

Unlisted forms of the class keep capital committed for a long period, through a closed-end fund's term or an evergreen fund's redemption limits, and closed-end funds call capital over time. Core strategies lean towards income, and later points on the spectrum towards growth in value. Operating capability and contract judgment drive outcomes as much as the asset type does, which is why diligence practice concentrates on a manager's experience with the specific assets, contracts and regulators.

Questions to ask

• How does each asset earn its revenue: regulated, contracted, usage-based or merchant, and in what proportions?
• Who are the main counterparties, how long are the contracts, and what happens to each asset when its contracts or concessions end?
• How, specifically, is revenue linked to inflation, and how are operating and financing costs linked to it?
• What share of the portfolio is greenfield or under construction, and how are construction risks allocated between the owner and the builder?
• How much debt is there at the asset, holding-company and fund levels, how much of it is floating-rate, and when does it mature?
• How does the manager define core, core-plus, value-add and opportunistic, and why does each asset sit in the category it does?
• Who values the assets, how often, by what method, and what discount rates are used?
• For an evergreen fund: how often can redemptions be requested, what limits apply, and what happens when requests exceed them?
• What experience does the team have operating and financing assets of this type, under these regulators?
• What are the total fees, including any charged at the asset level?

Key terms

• Rate base: the invested capital on which a regulator allows a utility to earn a return.
• Concession: a time-limited right granted by a government to operate an asset and collect fees from its users.
• Offtake agreement: a long-term contract to buy an asset's output at a set price, such as a power purchase agreement.
• Availability payment: a payment for keeping a public-private partnership facility available to a required standard, however much it is used.
• Merchant revenue: revenue from selling an asset's output at market prices, with no long-term contract.
• Greenfield: an asset yet to be built, as distinct from an operating brownfield asset.
• Stranded asset: an asset whose value falls before its cost is recovered because demand for its service has declined.
• Closed-end fund: a fund with a fixed term and fixed committed capital, which cannot be redeemed before the term ends.
• Open-end fund: a fund with no fixed term that admits new capital and allows periodic redemptions, within limits.
• Co-investment: a limited partner's investment directly in a specific asset, alongside a fund.

Related reading

• Private Real Estate Investment Strategies
• Private Credit
• Private Equity Real Estate