What are the current challenges in infrastructure investing?

Stable, long-term income payments, which are often linked to inflation, offer matching characteristics to the pensioner benefit payments that schemes make. 

Diversification and protection

There are also diversification advantages, as the allocation will act differently to equities, bonds or property — asset classes that may already be held in a pension fund’s portfolio.

Despite [infrastructure] being a fantastic asset class for pension schemes, it simply does not offer fantastic yields right now

The use of a toll road or a hospital is not going to change much depending on the economy, providing a degree of protection during downturns.

People still travel by car (though it may be increasingly common to drive an electric variety in the future) and there is always a need for hospitals, no matter what the FTSE 100 is doing.

Getting paid a better yield than a similar but shorter-term investment is attractive. The jargon for this is that it offers an illiquidity premium.

As pension schemes have longer-term horizons, with benefit payments stretching out to the lifetimes of their last pensioners, they are well-placed to hold a certain amount of longer-term investments, and get paid more for doing so. Some other investors cannot operate in the same way.

Depending on the type of infrastructure investment being made, it can also benefit the local area of the project and the wider economy.

To this end, there have been calls from the government to encourage more infrastructure investment.

Not a free lunch

Given that there are so many attractive qualities, it is no wonder that infrastructure has proved a popular investment for pension schemes. However, the asset class still faces a number of issues and challenges.

Firstly, it is complicated. Greenfield infrastructure, which involves building something from scratch, includes all kinds of risks that are difficult to assess, including design and construction risk. Even when investing in a brownfield project, which is already built, there are operating risks.

A lot of infrastructure projects also make use of leverage, and this can change the risk of the investment. As with leverage in all things, it can be good or bad as the results will be amplified.

However, specifically for infrastructure, the link to inflation can be swamped by impacts of leverage, therefore eroding one of the benefits.

Given that infrastructure is an illiquid asset class, it also means that while there is a secondary market, it is limited.

This brings with it an opportunity cost, where, as with any investment decision, there is an element of “look what you could have won” if you had made an investment elsewhere.

With such a long-term commitment, the opportunity cost relates not only to the other investment you forgo right now, but also to other opportunities in the future you may be forgoing. 

Politics and regulation can also play a part. Investment returns could be impacted by a change in government, regulation or legislation. This has been seen in the past with changes to subsidies for solar investments.

Current view: Is it worthwhile?

So do the characteristics of infrastructure and extra yield available make it worthwhile to accept the challenges? 

In part, it depends on how much of your portfolio is already illiquid.

Schemes that already have significant illiquid investments may not be able to take on more, even if yields are very attractive. 

Current market conditions have meant that recently these yields have come down a lot, both in absolute terms as interest rates are lower, and as the extra yield – otherwise known as the illiquidity premium – falls.

There are areas of the market where great projects can be invested in at worthwhile yields, but overall, despite it being a great asset class for pension schemes, it simply does not offer fantastic yields right now.

Matthew Simms is director at consultancy P-Solve