The World of Private Infrastructure Investments
(October 20, 2006)
Dear Subscribers and Readers,
As of Thursday evening, October 19, 2006, the Dow Industrials sits at 12,011.73 – closing 19.05 points higher for the day to end at over 12,000 for the first time in history. There is no question that the market is now overextended in the short-run and somewhat overextended in the intermediate run as well. Given that the market is definitely due for some kind of correction here, this author definitely does not recommend getting into any long positions until we have seen a correction of 200 to 300 Dow points. Should the market become weak tomorrow – especially in light of the Google earnings report – then it is probably a good sign that we have entered into a significant consolidation phase. Moreover, readers should remember that GM – a significant contributor to the Dow Industrials' outperformance over the last 12 months – is reporting earnings on the morning of October 25th (next Wednesday morning). And no matter how hard you slice and dice it, I don't think either the earnings report or the reaction to it will be good (although I have been wrong many times on this before). We will soon find out.
Let's imagine you are 30 years old today and want to invest in a few things you can hold until you retire. Or better yet, a few things you can still hold after your retirement and receive income during that time. Even though stocks are overvalued on a historical basis, it is worth noting that on a relative basis, they are still one of the most undervalued asset classes today – especially if one is talking about large cap growth stocks. And unless one wants to park his money in cash (which makes no sense if you're 30 years old unless you can time the markets), then it can be argued that a substantial allocation to the S&P 500 is essential – especially if one believes that the U.S. dollar is in a secular downtrend (in which case the profits of U.S. companies in U.S. dollar terms will continue to rise).
So now that this hypothetical 30-year hold has an allocation to the S&P 500, what other “long duration” assets should he or she hold? The typical asset allocator would then discuss a strategy of putting a certain amount in stocks, bonds, international equities, and maybe even some real estate or even commodities and timberland. Sure, a certain amount into international equities sounds good, but given that the world is now much more globalized than it has ever been for the last 90 years (since the beginning of World War I) an allocation into international equities most probably won't do too well for diversification purposes going forward. As for bonds, this author probably won't touch them with a ten-foot pole right now – especially if one wants to buy and hold a certain bond for over 50 years. The chances of the U.S. economy or any economy in the world experiencing another inflationary cycle over the next 50 years are just too high for my blood at current yields. We do live in a fiat currency world, after all, and I still have little or no confidence in our politicians to defend the U.S. currency going forward (even though I believe Chairman Bernanke is doing a decent job for now). In such a scenario, even TIPS may not be a viable option.
At this point, it is probably safe to assume that this 30-year old should have some stocks in his portfolio – and perhaps an S&P 500 index fund (or the Vanguard Total Stock Market Index Fund) if he cannot pick stocks like Warren Buffett does. After all, who can be comfortable with buying and holding a certain stock for over 50 years? There aren't that many stocks in the world where I would feel comfortable doing that – Coca-Cola notwithstanding. Of course – an active trading strategy is perfectly fine as long as you implement in a tax-exempt account – but given that most retail investors (and even most mutual fund managers) do not really hold an advantage when it comes to buying individual stocks, the best chance of getting decent returns (and being able to sleep at night) is still some kind of S&P 500 or some variance of the Vanguard U.S. Total Stock Market Index fund (where the annual expense ratio is only 7 basis points!).
It is probably also safe to assume that this 30-year would want to purchase a house – preferably in geographical areas where we still have decent valuations and where there are plenty of jobs (such as Texas). And while we are at it, let us throw in some emerging market equities – even though as I have previously discussed – that going forward, emerging markets as an asset class may have a significantly higher correlation to U.S. stocks relative to what we have experienced in the past.
So what else can we hold in our portfolio for our 30-year old for diversification purposes – with the requirements that it has to be a relatively “safe” and “long duration” asset? Real estate? Well, you already have a house. Hedge funds or private equity funds? Definitely not. Timberland? Maybe but the popular historical benchmarks of the performance of timberland are very narrow in scope and are not representative of the entire universe of “investable” timberland assets – not to mention that a significant amount of the historical performance of timberland has been “goosed” due to the fact that logging had been curtailed over the protection of the spotted owl. This author would argue that one possible universe where this 30-year old could invest for the long-run is “private infrastructure” assets.
So what are private infrastructure assets? In short, private infrastructure investment entails investing in physical assets that are responsible for providing public services, such as transportation, energy and water utility services, education, healthcare, parks and recreational services, and so forth. The total market value of public infrastructure assets in the U.S. today is estimated to be nearly $3 trillion. Interestingly, the U.S. has actually lagged behind Australia and Europe in privatizing roads and other public infrastructure – and according to recent research by RREEF (the real estate and infrastructure division of the Deutsche Bank Group), “There now exist secular drivers for greater private financing of infrastructure in the US including budgetary state and local government fiscal constraints, the advent of successful public-private partnerships, and historical underinvestment in crucial infrastructure projects.” Recent examples include the 99-year lease of the Chicago Skyway and the 75-year lease of the Indiana Toll Road to private entities.
According to a recent CFA Magazine article entitled “Alternate Route,” the history of all this started in the Australian State of Victoria in the early 1990s. Quoting the article:
This story begins in the early 1990s, when the Australian state of Victoria ran into the standard set of financial difficulties: too many obligations, too little tax revenue, and few traditional ways to bridge the gap without courting regime change. So, local officials, like their counterparts in dozens of other places, analyzed their balance sheet and found a treasure trove of undervalued assets. “They decided that the best way to overcome their difficulties was to privatize a number of assets, including power stations, grids, and toll roads,” says Mark Ramsey, head of unlisted equities at Macquarie Group, Australia's largest investment bank. Rather than simply taking these assets public or selling them directly to private sector operators, Victoria structured the deals as long-term leases, with operating companies paying large up-front fees in return for multi-decade contracts to manage the assets. Macquarie and a handful of other investment banks arranged financing, lined up operating companies, and sold equity stakes in the operating companies to pension funds and insurance companies, either directly or through funds created for that purpose. “It was a very successful exercise,” says Ramsey. “The government released a huge amount of equity. This took a state which had been in fiscal difficulty to fiscal soundness. Other governments now recognize it as a good model.”
Yet shamelessly quoting the article still further:
This deal structure appears to offer something for everyone. Institutions, for instance, love the resulting securities for their long durations. “They're ideal for pension funds or insurance companies with long-term liabilities,” says Peter Hobbs, global head of real estate and infrastructure research at Deutsche Bank's RREEF Division. But they're more than garden-variety bonds, which pay the same coupon year after year. A toll road or airport, if managed well, can grow over time in number of users and the level of fees over time. “Because the cash flows are both predictable and growing, you have, in effect, an indexed bond with a bit of upside, similar to listed electric utilities in terms of duration and stability,” observes Hobbs.
For those investors who want to invest in relatively “safe” or stable private infrastructure assets, the U.S. is the place to be going forward. According to the same CFA Magazine article, there are several reasons why:
- We all know that the developing world has a dire need for investing in physical infrastructure – especially in places like China, India, Vietnam, the Philippines, Thailand, and Indonesia (despite all the recent talk, only China has really been investing significant sums of money into building infrastructure), It is estimated that in order to maintain current growth rates, Asian countries will need to spend an estimated US$200 billion a year on infrastructure growth. However, it is worth noting that both the economic and regulatory systems in these countries have not matured to the point where it is relatively simple to predict toll road or airport revenues going forward. Sure, there are definitely high potential growth and returns as well, but this is left to the realm of hedge fund investors – not retail investors or pension funds who want to buy and hold for the long run.
- Only a very small amount of U.S. infrastructure has been privatized. It is estimated that only 13 of 517 U.S. airports and approximately 2,400 of 54,000 municipal water and wastewater systems are privately-run. In contrast, even socialist France has gotten into the privatization act – as the French government has recently just sold off one-third of Aeroports de Paris – the operator of 13 airports in near Paris.
- Many new regulatory rules have now made it much easier for states to allow the construction of private toll roads – as exemplified by President Bush's Executive Order #12803 and the 2005 Transportation Equity Act.
- The 99-year lease of the Chicago Skyway two years ago has captured everyone's attention – a 7.8 mile stretch of road that was built nearly 50 years ago linking the Indiana Toll Road to the Dan Ryan Expressway. At the time the road was built, the financing came in the form of muni bonds. Traffic growth did not occur and the muni bonds were subsequently defaulted on. However, the most recent deal involving the city of Chicago and the investment consortium of Australia's Macquarie and Spains's Cintra turned out to be huge successes (the city of Chicago received an up-front payment of $1.8 billion for approximately $45 million of annual revenues – a revenue amount that should be somewhat linked to inflation as well as traffic growth.
- Most cities and states in the U.S. are in dire need for cash – and there is no question that other state and local governments will follow the lead of city of Chicago. Again, quoting the CFA Magazine article: “A 75-year, US$3.85 billion lease of the Indiana Toll Road is in the works, the Texas Corridor is progressing, and even New York's Tappan Zee Bridge is on the block. Cities and states are looking at power grids, airports, water systems, you name it.”
An investment in a physical asset such as an established toll road has many enviable features, such as 1) an established and consistent stream of cash flows, 2) a good hedge for inflation, as toll prices can be raised and adjusted for inflation over time, 3) the potential for traffic growth given the steady population growth of the U.S. (unlike much of Europe or Japan), 4) the fact that there is a good chance that folks will still be using that toll road 100 years from now – barring the invention of the flying car which “futurists” have been calling for since the 1950s.
The only near-term treat to such an established toll road or bridge would be rising oil prices as people drive less and telecommute – but this author can also envision many scenarios where toll revenues can actually rise faster than the rate of inflation going forward – such as rising wealth, a more automated transportation “grid” where automobiles can generally be driven faster – thus increasing traffic flow to the toll road or bridge without causing significant delays, etc. Other threats include “endogenous” events such as earthquakes, terrorist attacks, and fires – but as long as this 30-year old holds a portfolio of these infrastructure assets (e.g. a couple of toll roads in different cities plus stakes of a few airports thrown into the mix), I think this will good enough for diversification purposes – not only within the private infrastructure asset class but within his or her entire portfolio as well. The next time someone pays a toll – one can smile knowing that part of the proceeds is going into his pocket, and not the government's coffers.
For further reading, I would also highly recommend reading the following commentary from RREEF discussing specifically the near-term opportunities for private infrastructure investments in the U.S.
Henry To, CFA