How you can invest in an asset everyone is talking about infrastructure
Scan the headlines of any major news organization on any given day and there will be stories on infrastructure: How to fix our crumbling infrastructure. How to build the necessary infrastructure to create future-friendly cities. How the definition of infrastructure is changing in a digital economy. And, of course, how every institutional investor is allocating enormous sums of capital to “infrastructure investments” to generate cash flows and growth to keep up with inflation.
It is certainly true that all jurisdictions across the globe have an “infrastructure deficit,” whether they’re striving to maintain woefully inadequate facilities that have been undercapitalized for decades or to keep up with the fast pace of the modern world, but let’s focus on the investing side by answering three questions: What is infrastructure? What are the options for investors to allocate to infrastructure? And should ordinary investors follow the lead of institutional investors and invest the way they invest?
What is infrastructure?
The historical understanding of what constitutes infrastructure was generally reserved for the physical structures required for societies to operate, such as bridges, roads, tunnels, hydroelectric dams, railways and airports.
These certainly still qualify, but the definition has been significantly expanded in recent years to include parts of the digital revolution, those can’t-live-without systems such as fibre optics, cellphone towers, data centres and even cloud services and cybersecurity operations.
Effectively, a working definition of what constitutes infrastructure today boils down to anything that is required in modern society for the transfer or protection of people, goods or information.
How to invest in infrastructure?
The most obvious and most liquid approach to infrastructure investing is to buy shares of companies that build or operate infrastructure, either individually or as part of an aggregated exchange-traded fund or mutual fund.
For example, Canadians can directly invest in the shares of companies such as Brookfield Infrastructure Partners LP, Canadian National Railway Co., Enbridge Inc. and Stantec Inc., or in an array of passive and active ETFs that provide geographical diversification and exposure to hundreds of publicly traded companies across the infrastructure spectrum.
Some institutional investors buy the stocks of companies they believe in as part of their allocation to different sectors, but they tend to invest in private funds that provide more specific exposures to subsectors and geographies in the infrastructure space.
The majority of institutional capital deployed in this fashion is to what is known as “core” infrastructure funds, which hold fully stabilized, long-term assets that provide very consistent cash flows, often directly linked to inflation and interest rates. Core infrastructure includes toll highways, public hospitals, prisons, airports and large-scale traditional and renewable energy assets.
Effectively, the cash flows are generated through very long-term contracted revenue models between the owners of the assets and the users, whether they be governments (hospitals and prisons), operating companies (airports and pipelines) or even individuals (toll highways and communications towers).
Should I invest the way institutions do?
As with all good questions, the answer to this question is that it depends. On the publicly traded side of things, individuals can certainly benefit from the growth and liquidity enjoyed by institutional investors in the same space.
On the private funds side of things, there are a number of reasons that individuals (meaning high-net-worth individuals who are able to access private investments) might invest in infrastructure somewhat differently than their institutional counterparts. The three main differences between institutional and individual investors are their tax status, their required rate of return and their investment horizons.
Most institutional investors are tax-exempt, meaning that their before- and after-tax returns are the same. Individuals enjoy a lifetime partnership with the Canada Revenue Agency, so any taxable cash flows or growth earned through their investments are highly taxed, often leaving less than half of what they started with.
In addition (and perhaps in part as a consequence of their tax-exempt status), most institutional investors may require lower returns from the investments they make than individuals, meaning that a six per cent to eight per cent total return, even in a higher interest rate environment, can be acceptable, whereas those returns might not work for highly taxed individuals.
Institutions also tend to have 50-plus-year investment horizons. Although they must ensure that their stakeholders (such as pensioners) receive the money they are due in real time, they must equally ensure that they will be solvent generations into the future in order to satisfy their obligations to the people they serve and represent.
Individuals (especially high-net-worth individuals) also purport to have intergenerational investment time horizons, but are far more likely to fall into the “what have you done for me lately” category than their institutional counterparts.
As a result, individuals should probably not think of infrastructure investing as primarily a cash-flow vehicle (in which they might be disappointed with both the amounts received and the taxation applied to those cash flows), but rather as a growth vehicle that can provide significantly higher returns and are more tax efficient because those gains are typically taxed as deferred capital gains instead of ordinary income.
This approach requires these investors to look not at the core infrastructure funds described above, but at diversified, long-term, “value-add” funds that build and stabilize the assets that will generally end up in the core funds that generate the cash flows that institutions seek.
Although these funds can produce materially higher returns than the core funds, they do carry the operational and financial risks associated with the development of any infrastructure assets, and since the projects don’t produce cash flows until they are built and stabilized, many of these funds don’t offer real-time distributions to investors.
In sum, the long-term, risk-adjusted performance of value-add infrastructure funds (especially on an after-tax basis) can be very attractive, similar to those found in other long-term investments in real estate development and private equity.
David Kaufman, JD, CAIA, is founder and co-CEO of Westcourt Capital.
