There are many reasons North American investors are taking a pass on buying emerging market infrastructure: compliance, due diligence, unfamiliarity with those markets, to name three. But is their caution warranted, or are attractive opportunities being missed? Kamal Suppal, chief investment auditor at Emerging Markets Alternatives, an investment auditor, and former senior research consultant at NEPC, believes it’s a little of both.
“North American investors are, for the most part, aware of the fact that there are bigger opportunities outside of North America that are very attractive investment opportunities, but there is a familiarity bias, or a home bias, that keeps them closer to home,” Suppal said. Also, with European infrastructure having become expensive of late (see related story), many investors are now holding too much dry powder, rather than venturing abroad. “One third of assets under management slated for infrastructure is now dry powder; that is too much cash,” according to Suppal. The result is that there is an abundance of investors looking for European deals or North American deals, which has greatly depressed the rate of return investors can command in those markets, he said. “It is indicative of the fact that there are too few opportunities,” he said.
“Investors do know that there is a greater opportunity set outside of the U.S. and North America, and that if you are pursuing those opportunities, you can command a premium for your capital,” Suppal noted. The median annual return of 17% for infrastructure funds that began investing between 2000 and 2005 averaged about 10% post the financial crisis,” Suppal said. Managers peg Organization for Economic Co-operation and Development (OECD) private infrastructure equity returns at 11-12% annualized with a potential to capture an emerging market risk premium of 6-7%, according to The Investor Perceptions of Infrastructure, 2017, a survey conducted by the EDHEC Infrastructure Institute-Singapore.
Nevertheless, U.S. investors continue to allocate increasing amounts of money to developed market infrastructure funds that are being raised by big, household-name firms in the U.S. and Europe. Suppal calls the situation a “vicious circle” of “too much money chasing too few opportunities, inflated assets and compressed returns, and capital concentrated into a limited number of funds.” He suggested that investors seem to be blinkered where seeing beyond developed markets for opportunities in the class is concerned. “A familiarity with [developed markets] is probably breeding contempt for new vistas of growth in EM that can potentially impact both portfolios and the socioeconomic quality of the developing world,” he said.
It’s a vicious circle of too much money chasing too few opportunities, inflated assets and compressed returns, and capital concentrated into a limited number of funds.
The water’s not that inviting
There are at least a couple of very real factors holding investors back from investing in emerging markets infrastructure. One is willingness to recognize cultural nuances. The other is the amount of due diligence needed to research and evaluate these deals, all of which takes resources—resources that many investors don’t have.
“North American institutions need to develop a level of comfort and need to have the resources and bandwidth and governance structure to do due diligence on these opportunities, and that is what keeps them away from looking at some of these opportunities outside of North America,” Suppal said. “When you look outside the U.S., the bar is higher, in terms of pursuing those opportunities,” he said.
Patrick Adefuye, head of real assets products at Preqin, said he has seen a reticence by investors to expose funds’ portfolios to risk. “Activity in Asia is less than in the developed markets because there are different pressures there in terms of the risk of making investment in those regions.” So investors shy away. According to data from Preqin, the number of emerging markets infrastructure funds have been on the decline since 2016, while capital raised by those funds has risen, reaching a record high of $25.9 billion in 2017. In fact, three funds are primarily responsible for the record fundraising total. “We’re seeing a concentration of capital on a few large funds–a trend seen across many different alternative asset classes,” said Naomi Feliz, a spokesperson at the research firm.
Unfortunately, investors tend to be more comfortable investing with brand name managers with global mandates whose local insights and networks and access to deal flow might be limited in some ways, according to Suppal. “Underlying a $420 billion-plus AUM (assets under management) industry is investors’ continued reach for yield, which lured more than 500 unlisted infrastructure funds (mainly North America and Europe) to raise $300 billion-plus in assets over the last seven years, whereas Asia in a similar time frame saw its AUM grow to only about $60 billion, which now accounts for approximately 13% of global infrastructure AUM,” he said.
Some funds ready to plunge, others not so much
Chicago Teachers’ Pension Fund, with an AUM of $10.5 billion, is not quite ready to allocate any of its infrastructure portfolio to the emerging markets, despite the potential for high returns. “We are not there yet,” said John Freihammer, real assets portfolio manager for the fund. “There is activity there, but there is enough opportunity in Western Europe and the U.S., where the most investor dollars are flowing. That is where the most fundraising is, and our focus has done well for us,” he said. The fund is seeing returns with net IRRs ranging from 10-12% for its European deals. In the U.S., returns have varied. “For our open-end infrastructure funds we see returns ranging from 8-10 % net IRR. The closed-end infrastructure funds have weighed in with returns from 12-18% net IRR,” Freihammer said.
The Chicago teachers’ fund is continually looking for infrastructure funds in which to invest, but with a U.S. or North American or European focus. In March of 2018, it issued a request for proposals (RFP) seeking open-end infrastructure equity funds to bring its exposure to the asset class back up to its 2% strategic allocation. The fund’s exposure has fallen slightly of late, because of maturing investments, Freihammer said.
David Hunter, executive director, chief investment officer of the $13.8 billion North Dakota Retirement & Investment Office (NDRIO), is more open to investing in the EM infrastructure sector, but remains cautious. “We focus on OECD-based infrastructure investments over the emerging markets,” Hunter said. “We do not yet have a dedicated allocation to emerging markets infrastructure, although we do gain exposure to some non-OECD assets via our globally diversified funds, and would expect those areas to continue to develop and grow in the future,” he said.
For the time being, the largest portion of the fund’s infrastructure portfolio remains invested in the U.S. “That’s because, at the time the NDRIO was looking to deploy its infrastructure capital, “the U.S. was where we saw the best opportunity set,” Hunter said. The fund also has some investments in Europe and an even smaller percentage in Asia (10%).
So, will the NDRIO consider broadening its EM infrastructure portfolio in the future? “We will be more cautious in areas where there is great uncertainty, regarding governance, currency, rule of law or greater volatility in the capital markets,” Hunter stated. The funds infrastructure portfolio is broadly invested within North America (45%) and Europe (35%) with smaller exposures in Australia and various emerging markets, including Asia.
Asian infrastructure plays
John Anderson, head of corporate finance at Manulife, which has $850 billion in AUM, agrees that the requirement of good governance is key to investing in the emerging markets. For infrastructure in Asia, “It’s all about the rule of law,” he said. “You are making investments in 20-year assets, so you have to look at whether or not your contract is enforceable. “You have Japan, where there is great rule of law, but returns are low; it’s a low-rate environment there,” he said. “In other Asian markets, you frequently have more emerging market risk, good infrastructure needs and demand, but more emerging, less tested rule of law and reliable contract enforcement,” he said. “Our Asian strategy for infrastructure investing includes a mix of developed and emerging economies, across both listed and private companies, in both debt and equity. Where the precedents on contract enforceability are less tested, we do smaller investment sizes and favor investments in public companies and securities,” he said.
Investments in Asia can also present challenges for investors due to the region’s varied financial and regulatory regimes. “If you have 12 countries, you have 12 different environments. You don’t have the uniformity in place that you have in places like the European Union and the U.S.,” Anderson said. Australia and Canada offer inviting rule-of-law, pro-market policies and competitive opportunities. By contrast, “There are countries in Asia and the emerging markets where contract enforcement might not be as strong, and where things are not as developed. You want to be careful, and maybe do deals with organizations such as development banks, the IMF or the World Bank, as partners,” he said. Asia has produced an average of 20% of the global aggregate infrastructure deal flow in the last three years, according to Preqin’s Adefuye.
Smaller deal sizes
Another reason investors may be avoiding emerging market infrastructure investments is that many of these deals tend to be smaller in size, making the investments just not worth the effort it takes to conduct due diligence. Suppal concedes that, “You need to commit more resources for due diligence, so that becomes a challenge.” For those investors who do attempt to invest outside the U.S., “they need to develop the right mindset and commit the resources required to do the due diligence, because opportunities outside U.S. are not a slam dunk,” he cautioned. For those willing to take the plunge, “They could spread the money out. U.S. institutions have big checks to write, so they could spread their bets and diversify. Instead of writing a $100 million check to just one fund, they could allocate it over three to four funds in infrastructure in the developing world, where infrastructure has a broader definition and potentially bigger social impact ,” he said.
We will be more cautious in areas where there is great uncertainty, regarding governance, currency, rule of law or greater volatility in the capital markets.
Projects situated in emerging markets may bring other risks, still. In Suppal’s blog post: Infrastructure Investing Your Lasting Impact on EM and Portfolios, he writes that, “according to a recent Indian government report, as many as 359 infrastructure projects have shown cost overruns of $30 billion, from delays in land acquisition, forest clearance, supply of equipment, funding constraints, legal cases and slack law and order. Systemic corrupt behavior, including nepotism in business-contract allocation, unfair distribution of regional transfers from the central government, and distorting data can jeopardize investments.”
To offset some of these risks, “experienced investors try to…ensure a country’s GDP is resilient and demand inelastic, affording pricing certainty. They also emphasize long-term committed revenue contracts from investment grade counterparties and ensure all operating permits are in place,” Suppal wrote. He concluded: “For a positive lasting experience, investors should carefully diligence local infrastructure managers to understand their strategies, execution and historical returns (time weighted, risk weighted) including loss history.”
Despite the difficulties associated with EM investments, North American investors’ views of EM infrastructure projects is softening. According to EDHEC report, 85% of surveyed respondents (62% asset managers and asset owners, including insurers, pension plans, and sovereign wealth funds, with the remaining 38% representing commercial and international banks, consultancies, government agencies and rating agencies) said they expect the infrastructure pipeline in emerging markets to increase over what was seen in the last three- to five-year period, versus just 35% who said they expect to see more growth in developed markets (DM).