In June 2006, the Spanish developer Grupo Ferrovial
startled the market when it bought Britain's BAA-the world's largest
airport operator-for $29.3 billion. By September, BAA was contributing
more than 30% to the company's 1.64 billion, nine-month EBITDA
(earnings before interest, tax, depreciation and amortization). By
year's end, Ferrovial's 2006 earnings per share was up by more than
57%. As of early May 2007, its shares had soared by more than 50% over
the previous year, driven by the company's shift away from domestically
focused construction and real estate activities to less cyclically
minded global infrastructure and services.
Much of the developed world outside of the U.S., from Canada to the United Kingdom to Australia, has regarded infrastructure as an attractive investable asset for quite some time. Until recently, U.S. investors had been reticent to embrace it because there hasn't been a whole lot of domestic opportunity, and because it's assumed that the rest of the world pretty much learns from us-not the other way around.
Tradition Of Infrastructure Finance
There is nothing new about financing airports, highways, bridges and tunnels. Wall Street has been underwriting municipal bonds that support these enterprises for decades. And institutional and individual investor portfolios are chock-full of them.
But some of the big brokerages (along with city, county and state pension plans) are taking a page from their foreign counterparts, like Australia's Macquarie Bank-which pioneered infrastructure securitization-and Swiss bank UBS. These firms have realized it's more profitable to own such assets outright. And as cities and states struggle to pay for maintenance and capital improvements, a growing number of governments appear all too happy to pass the financial and management buck over to companies with deeper pockets and expertise.
Sounds like a panacea.
Well, maybe. The sale or very long-term lease of key public trusts into private hands, whose primary focus is on the bottom line, can raise conflicts of interest.
Nevertheless, privatization of infrastructure is a necessary reality. And given its character, perhaps it's no surprise to find that this new, evolving asset class is behaving so far like a cross between government bonds and stock. Growing, inelastic demand for these services generates predictable cash flow. Regulatory oversight ensures that rates adjust for inflation. The realization that such securities are pretty good ways to meet the investment criteria of many public and private funds-especially pension funds-has sparked a demand for these securities that is producing capital appreciation.
Just as appealing is the nuts-and-bolts character of infrastructure, which can be easily understood and measured.
Benjamin Tal, an economist for CIBC World Markets in Toronto, consolidated the performances of four leading infrastructure indices: Lazard, UBS, Macquarie and Standard & Poor's. He found that over the past two years this amalgam of listed toll roads, water utilities, ports and communication networks has soared 60% in U.S. dollar terms through early 2007, exceeding the MSCI World Equity Index by roughly 20%. At the same time, the consolidated benchmark's standard deviation was 10% lower than that of the global market.
Given such performance, advisors may wonder if they may be too late to join in. Michael Wilkins, managing director of S&P's European Infrastructure Finance Group in London, reports that $100 billion to $150 billion has been raised globally to target infrastructure investments, while debt raised on some infrastructure deals is peaking close to 30 times EBITDA. To Wilkins, the potential of overvaluation and excessive leverage are ingredients of an asset bubble.
But other industry observers are more sanguine, believing that the combination of adequate global liquidity and the increasing pace of privatizations, especially in the nascent U.S. and emerging markets, should enable supply to keep pace with demand.
Srikant Dash, S&P's index strategist in New York, reports that his company's Global Infrastructure Index has sustained its overall valuation despite having realized annualized returns of 24.8% (in U.S. dollars) over the past five years through May 4, 2007. "We have found P/E ratios have held steady between 18 and 19, price/book has held around 2.6 and yields have remained around 3.1%," observes Dash.
How is that possible? Dash believes the key is annualized rebalancing. "By keeping industry weighting steady-30 utilities, 30 transportation shares and 15 energy shares-the index has generally prevented soaring prices in any one industry from dominating the index." Specifically, he points to the gravitational pull that takeovers and new issuances can have on maintaining the index's overall valuation.
Based on the compelling characteristics of infrastructure and the current outlook, Dash recommends that well-balanced portfolios should include 5% to 10% exposure to such activity.
Buying the index would seem a reasonable way for advisors to test the infrastructure waters. But investors will have to wait at least several months before an ETF that tracks the S&P index comes to market. Buying shares of individual companies like Ferrovial would gain partial infrastructure exposure, but few firms are pure diversified infrastructure plays, and such investments would require substantial due diligence and constant monitoring.
There are many public funds available in foreign markets that U.S. investors may purchase through a locally funded account. But for advisors who want to stay domestic, only Macquarie offers access to infrastructure funds-through an ETF, a closed-end fund and a trust-that trade here in the states.
In January, State Street Global Advisors packaged the SPDR FTSE/Macquarie Global Infrastructure 100 ETF. A composite of the broader 255-stock Macquarie Global Infrastructure Index, this large-cap focused ETF is heavily tilted toward utilities (85.72%) and U.S. shares (40% of assets). But it has individual country weightings of between 8% to 9% in Germany, Spain, the United Kingdom, France and Japan.
Back-tested five-year annualized returns run more than 20%. For the year through early May, the ETF is up 12.84%, topping the MSCI World Index by nearly four percentage points.
The Macquarie Global Infrastructure Total Return closed-end fund, which became available through an IPO in August 2005, is up a cumulative 60%, outpacing the MSCI World Index by more than 24% since inception. Like the ETF, its unhedged currency exposure has allowed it to benefit from the weakening dollar. With about 30% leverage, the fund is able to boost its yield to 4.59%.
Its portfolio is distinct from that of its ETF cousin. Its average market cap is much smaller at $5 billion to $35 billion. Its utility exposure is lower, 55% versus 86%, while its airport and toll road exposures are higher at 7.4% and 6.9%, respectively. The country weighting is also different, with less than 24% of its assets in the United States and more than 17% in Australia.
An IPO of the Macquarie Infrastructure Company Trust was offered on the NYSE in the beginning of December 2004. But unlike the first two funds, which make passive minority investments in a variety of companies, this stock actively owns and manages a handful of U.S. infrastructure ventures. Its operations include airport services and parking, energy, gas production and distribution and bulk liquid storage.
The stock, which pays out most of its earnings, currently yields 5%. Since its inception, shares are up a cumulative 60% through early May, more than doubling the MSCI U.S. Index.
Macquarie fund manager Jon Fitch, who runs a total of seven funds worth $2.2 billion in Australia, Canada, Taiwan and South Korea, believes that the prospects for forward performance remain positive as the pace of asset privatization remains strong. "The U.S. is just in the early stages of securitizing infrastructure, which could bring many billions of new projects into play," Fitch posits, "and the same is true across emerging markets, where rapid economic growth is requiring substantial infrastructure investment."
Several basic risks Fitch sees include inflation and regulatory decisions. Many deals structure-in rate increases to keep pace with inflation. But if maintenance and capital improvement costs were to soar, there may be limits to how aggressively rate increases could be passed on.
The supply side is under increasing pressure from a rising number of private equity firms, including the likes of Goldman Sachs, The Carlyle Group and Kohlberg Kravis Roberts & Co., bidding for infrastructure assets. Peter Hobbs, global head of real estate and infrastructure research at Deutsche Bank, sees that "the risk premium has declined lately as investors have become more comortable." At the same time, Macquarie analyst David Rickards observes that the number of "new deals coming to market has not kept up with the growth in demand, resulting in a re-rating of assets."
Today's low interest rates help buyers deal with rising asset prices. Last year, Macquarie teamed up with Spanish private transport developer Cintra to buy the 157-mile Indiana Toll Road for $3.8 billion with only 19% equity. However, a secular rise in long-term rates could challenge the current investment calculus that relies on substantial leverage to sustain attractive return on equity.
Despite such potential challenges, with proper due diligence and oversight, Fitch believes these are manageable risks. "Infrastructure is offering investors a unique investment opportunity," Fitch explains, "that can combine the low-risk, cash-yielding characteristics of government bonds with equity-like growth without being correlated to either asset class."
While that should remain true for the near term, if the supply of infrastructure opportunities fails to keep pace with demand, then there may be a musical chairs aspect to infrastructure. Early investors seated should do fine. But those rushing in, paying too much and failing to structure the right kind of deals may not end up faring as well. Discerning this difference will be the key for financial advisors and other investors trying to cash in on this evolving and compelling asset class.