Does exposure to unlisted infrastructure benefit the average portfolio?

diversified portfolio
By Michael Steingold

The potential for uncorrelated, income-driven returns and structural inflation protection are two reasons why an allocation to unlisted infrastructure should be considered [1]. However, there are several practical challenges facing investors to build and maintain a well-balanced, diversified infrastructure allocation that is appropriately positioned to harvest the benefits of the asset class.

These challenges stem from the unique nature of unlisted infrastructure, which blends the operational burden of private-markets investing with the complexity of researching highly technical assets across numerous regulatory jurisdictions around the world.

Obstacles to investing in unlisted infrastructure
We see four categories of challenges that investors face throughout the lifecycle of creating and managing a private infrastructure allocation:
1. Constructing a diversified portfolio
2. Maintaining exposure
3. Handling the ongoing operational burden
4. Investing with discipline and flexibility

Each of these obstacles introduces execution risk and requires specialised capabilities to get right. Some investors have sufficient resources and skills in-house, but for those who don’t, leaning on the private-markets capabilities of an experienced third party may make sense. A skilled third party can streamline these challenges to establishing and maintaining a fully invested, diversified portfolio that is managed in real-time.

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Obstacle #1: Portfolio construction
A critical component of a successful infrastructure allocation is sufficient diversification, not only across categories - geography, sector, strategy and capital structure - but also within categories, such as sub-sectors, capital position and risk profiles. An effective diversification program should seek to harness the rich variety in the asset class while spreading risk efficiently. The potential benefits of diversification can be particularly high in infrastructure given the spectrum of factors present in the asset class, and thoughtful portfolio construction can combine these factors to create a balanced, resilient portfolio.

We believe that taking a multi-manager approach, with multiple fund investments, may offer investors an important diversification benefit over using a single fund as the investor’s only exposure to the asset class. A properly diversified multi-manager infrastructure portfolio can be built to have exposure to more than 100 underlying investments, compared to approximately 10 to 15 in the average single fund [2]. While investors taking a single-fund approach to the asset class might have exposure to, for example, multiple sectors (such as Energy, Utilities, Transportation or Social), there may only be one or two investments within each of those sectors. In contrast, a multi-manager approach can have numerous assets within a sector to reap the diversification power of exposures to the many different sub-sectors and asset types that can exist within a single sector.

This approach has the potential to enhance return and reduce risk due to low intra-sector correlations. Assets within the same sector can have very different return drivers and risks, and that intra-sector diversification potential is valuable. For example, consider two assets: a midstream pipeline with a take-or-pay contract, and a merchant power plant. Both pipelines and power plants are sub-sectors of the energy sector, but their returns have low correlation, owing to different levels of sensitivity to economic growth and inflation. We believe best practice in portfolio construction is to consider carefully the diversifying power of these imperfect sub-sector correlations.

Obstacle #2: Maintaining exposure
Once the private infrastructure portfolio is constructed, investors face the challenge of maintaining that exposure - both in terms of total money at work as well as the chosen strategic allocations within the asset class.
Closed-end funds are the most common way of accessing unlisted infrastructure, but such funds have a finite legal life. They call capital during the investment period and return capital as assets are sold. This means that maintaining the intended total amount of exposure requires investors to make new commitments regularly and to anticipate correctly the timing of drawdowns and distributions.
As the underlying funds acquire and sell assets, the portfolio’s allocations to key diversification dimensions change. Maintaining strategic allocations requires both diligent ongoing monitoring of the underlying funds, as well as constant market surveillance to know when a new product will come to market that can backfill exposures. We believe specialised portfolio management and research capabilities are crucial to maintaining exposures appropriately.

Obstacle #3: Operational burden
Just as in other private asset classes such as real estate and private equity, there are specific ongoing operational activities that come with holding infrastructure investments. For instance, a typical closed-end fund could require processing the following:

• 15-20 capital calls over a five-year investment period
• 20-30 distributions over a 12-year fund life
• Fund governance items to evaluate and cover every single year, such as votes, annual meetings and limited-partner advisory council meetings
• Ongoing operational due diligence

Note that all of that work would be for an investment in just one fund. In a diversified portfolio, this could be multiplied several times over.
These activities present an operational burden, which is a capability that, in our experience, is often not prioritised by generalist investors. This can be problematic, as the operational element of portfolio management is often a hidden source of risk. The cost of an operational mistake - such as missing a capital call or overlooking an operational due diligence red flag - can easily undo all of an investor’s good work in portfolio construction and management.  

In our experience, a large, specialised team with deep private-markets experience is necessary to ensure that all of these operational tasks are carried out properly, thereby avoiding mistakes that can have material consequences. Whether an investor has an unlisted infrastructure allocation already or is contemplating one, it is prudent to consider whether that investor’s team is sufficiently resourced and experienced to assume this operational burden and the additional risk of making mistakes.

Obstacle #4: Investing with discipline and flexibility
The long-term nature of unlisted infrastructure assets can magnify investment mistakes, such as overestimating growth or underestimating obsolescence. We believe successful investing in this asset class requires a delicate balance between the discipline to avoid bad investment ideas and the flexibility to adapt to a changing world.

This is evident in our guiding investment principle: We invest in long-lived, capital-intensive assets that earn privileged revenues for providing services that are essential to economies and improve quality of life. We believe investors should have a framework to guide building an infrastructure portfolio, selecting managers and evaluating investments.

There are several characteristics that differentiate this philosophy from others. For instance, we invest in pure-play infrastructure assets, not in service providers to those assets. Many investors do invest in services, but we believe that approach has a different risk profile and may not enjoy the same downside risk characteristics as pure-play assets.

Also, this approach seeks to recognise that what constitutes essential services in an economy may change over time. It is crucial, from our vantage point, to have a flexible framework to evaluate new infrastructure sectors so that we can avoid obsolescence while embracing new opportunities that meet our rigorous definition.

What does this mean in practice? Investors who follow this approach may invest in assets that may not look like traditional infrastructure but that have robust barriers to entry - whether granted by government or through market structure. For example, we recognise that data storage has become an essential service to modern economies in recent years. The challenge with accessing this trend is that the typical data centre has unattractive investment features: low barriers to entry, short contracts, high obsolescence risk and high unrecoverable capital expenditures. As we continued to research the space, we found an access point that worked and solved the key issues: a data centre for exclusive use by a government agency in the Asia-Pacific region that was fully contracted - including revenues and capital expenditures - and had very high security requirements that, in our analysis, served as a robust barrier to competition.

The bottom line
We believe unlisted infrastructure is worth the work. But investors face obstacles unique to private-markets investing when they set out to build and maintain an unlisted infrastructure allocation. These challenges are present throughout the investment lifecycle, from portfolio construction, to exposure management to ongoing operational activities. Mistakes in any of these areas can easily impair portfolio outcomes. To access the diverse range of opportunities available in this asset class, we believe specialist expertise across all elements is critical to success.

[1] Source: Deutsche Asset Management, “Why Invest in Infrastructure?” May 2017

[2] Source: Russell Investments

Any opinion expressed is that of Russell Investments, is not a statement of fact, is subject to change and does not constitute investment advice.

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