The central paradox facing the infrastructure industry today is that while some 60% of institutional investors have underspent their allocations to infrastructure, there is a global  shortfall of investment in infrastructure of over USD 1 trillion per year. The gap can be bridged by improving communication between stakeholders structuring investment opportunities with the needs of institutional investors  in mind. This article examines what those needs are.

A match made in heaven?

Institutional capital is increasingly taking the place of bank lending, as banks deleverage and the  low-return investment environment forces institutional investors to diversify their portfolios. The  UK Chancellor, George Osborne, has set the Government the ambitious target of securing GBP 200  billion of institutional capital for investment in UK infrastructure projects.

At first glance, infrastructure appears to be an ideal asset class for institutional investors.  Pension funds  and insurance companies, with long-term liabilities and exposure to inflation risk,  are attracted to the stable, inflation-linked cash-flows of infrastructure. Sovereign funds who need to deploy large amounts of capital over a long-term horizon are also often attracted  to the potential returns from the asset class.

Yet there has been some frustration with the slow rate of progress in accessing capital from these  institutional investors for investment in infrastructure. Better communication between investors  and those seeking their capital, as well as creative structuring of investment opportunities, is needed in order to  bring the two sides of the equation together.

Portfolio construction

Anyone seeking to attract institutional capital needs firstly to understand how infrastructure fits  into the overall portfolio of an institutional investor. As a recent report from the World Economic  Forum highlights:

Investors evaluate an infrastructure opportunity in relation to other asset classes such as  government bonds, equity markets and private equity. That is to say, investors evaluate not just  how but whether to invest in infrastructure at all.1

People seeking investment need to understand that not only are they competing for capital with  other infrastructure projects in their country, but they are competing against other asset classes  and across global markets.

Institutional investors are generally conservative and invest predominantly in gilts, corporate  bonds and listed equities. It is normal for such an investor to have no more than 25% of their  portfolio invested in what they term ‘alternative’ asset classes, which encompasses a broad range  of assets from hedge funds to private equity and infrastructure.

Allocations to ‘alternatives’ have increased over the past ten years due to low gilt yields and a  low-return investment environment. However, infrastructure is still fairly novel to the institutional  investment community and is often considered more cutting-edge than asset classes which may on  their face appear riskier, such as hedge funds.

Who’s afraid of construction risk?

There is an urban myth that institutional investors will not invest in greenfield projects as they  are deterred by construction risk, but this is not always the case. Many pension funds and other  institutional investors are aware that in order to secure higher returns from their infrastructure  assets, they need to take some of the construction risk.

More importantly, the ‘holy grail’ for pension funds is inflation linkage (since their liabilities  are inflation linked) and with most secondary market assets, this has been stripped out. Pension  funds are increasingly aware that in order to secure inflation linkage, they need to structure the  assets themselves, which means involvement in the construction phase.

On the other hand, institutional investors can be reluctant to invest in projects with significant  demand risk, hence the preference for taxpayer-funded social infrastructure projects. To secure  more funding for UK infrastructure projects, the UK Government should consider ways of managing  demand risk. There have been many creative solutions proposed, such as franchising regions of road  networks rather than seeking investment in a toll road.

One size does not fit all

It should also be borne in mind that pension funds, sovereign funds and insurance companies have  slightly different needs and risk tolerances. Pension funds have to comply with statutory guidelines on risk and diversification, and insurance companies have  regulatory capital requirements. Sovereign funds, which do not have fixed liabilities and have the longest term horizons, are more likely to seek the high returns from economic  infrastructure projects such as HS2 or investment in nuclear power. Some pension funds prefer the low-risk, predictable  cash-flows from social infrastructure and renewables.

Targeting the right institution and creating an investment portfolio which fits the requirements of  the targeted investor will be key in securing financing for infrastructure projects.

It’s good to talk

Greater dialogue between the Government and institutional investors can ensure that investment  opportunities are packaged in a way that is attractive and comprehensible. Clyde & Co have been  working closely over the past several years with a range of institutional investors and academic  institutions across the world, including the seed investors in the Pensions Infrastructure  Platform, and are well-placed to advise on the opportunities in this market.

We are optimistic that the gap can be bridged, and that the billions of pounds of capital looking  for a home can be used to provide the investment in global infrastructure that is critically needed.