Understanding private infrastructure

By 2050 the world’s population will increase by nearly two billion, according to United Nations estimates. And more people means we need a lot more infrastructure.

Why you should be interested in private infrastructure

Private infrastructure first emerged as an investable asset class in the 1990s, mostly to fill a funding gap for maintaining and building essential services, such as transportation (roads, bridges, airports), and public utilities.

Early infrastructure deals were mostly public/private partnerships with government entities, and included projects such as the private management of public parking meters and toll roads. Today, private infrastructure is a rapidly growing $1.1T¹ asset class (see chart) that funds and manages essential services, as well as invests in growing sectors, such as digital infrastructure and alternative energy.

Some of the potential benefits - which vary depending on the strategy - of investing in private infrastructure funds include:

Weak correlation with public stocks and bonds: Infrastructure funds invest in essential services or projects that are in constant demand regardless of economic conditions, which can help them withstand market shocks and volatility. In some instances, there may be government-guaranteed contracts for services, which might provide additional protection in an economic downturn.

A potential hedge against inflation: Many infrastructure properties, such as toll roads or utility companies, are government-owned or regulated, and some are monopolies. Contracts for these essential services can include inflation-linked rate adjustments, or a regulated rate of return, where the government determines the rates that a public utility can charge.

Steady, predictable cash flows: Infrastructure cash flows may come from contracted essential services that are government-regulated or guaranteed. These long-lived assets, such as bridges, airports, and toll roads, are initially capital intensive, but once built they typically have relatively low operating costs and stable cash flows. 

CAIA Association CEO William Kelly explores opportunities in private real assets

What is private infrastructure?

Private infrastructure funds invest in the development, maintenance, and/or operation of essential systems, such as water, transportation, sanitation, pipelines, electrical grids, and other resources necessary to society. 

A fund may acquire and manage an asset or provide financing for its development and maintenance. Funds may also invest in future infrastructure needs, such as providing financing for data centers and other underpinnings of our digital lives.

Infrastructure projects are typically classified as either greenfield (undeveloped, or under construction) or brownfield (existing facilities that are operating, or potentially expanding). Returns typically stem from contractual payments for managing assets – which are often inflation-protected – and/or value appreciation, depending on the strategy.

The funds vary widely in terms of underlying assets, investment mix (debt and equity), and investment strategy. Given the sheer number and types of unique potential projects, it is basically impossible for two infrastructure funds to be identical.

The long-term nature of these investments means that fund managers must be able to successfully evaluate and select the right markets, sectors, industries, and properties for “right now,” as well as for the future. Infrastructure strategies need varied levels of hands-on active management. Necessary skills can range from the capacity to analyze and manage public utilities to the ability to successfully structure public/private partnerships, and evaluate future growth sectors, such as alternative energy or space. 

Strategies are typically divided into (from lowest to highest risk): core and core-plus, value-add, and opportunistic. Core is most focused on generating regular income/yield, while opportunistic strategies may drive returns by creating or benefiting from capital appreciation.

The strategies…

Core: This strategy focuses on stable, low-risk brownfield assets with more predictable cash flows tied to long-term contracts with municipalities and utility companies. These are essential, well-established entities, usually with a monopoly position, such as highways or utilities.

Core-plus: These are largely stable brownfield assets that are already operational and generating steady income but may have additional growth potential or value-add opportunities. Returns are led by income from long-term contracts, but there can be a capital appreciation component.

Value-add: These projects may initially lack cash flow or optimal conditions, and may have a greenfield component. These assets generally require significant improvements, and the goal is to actively manage and improve these assets through renovation, repositioning, or completing construction, which ultimately increases their overall value. Returns are primarily from capital appreciation.

Opportunistic: The underlying assets in this classification typically are greenfield, and may be in the developmental stage, or potentially in financial distress. Opportunistic strategies may target market inefficiencies, distressed assets, or unique situations where the potential for outsized returns is deemed to outweigh the associated risks. This is the riskiest of the infrastructure strategies, and returns are primarily generated through capital appreciation.

How do I invest in private infrastructure?

While it is possible to invest directly in single infrastructure projects, it is highly impractical and risky for individual investors. The simplest approach is through a fund.

Private funds are set up as limited partnerships and the money is contributed by individual or institutional investors, who are called limited partners (LPs). The general partner (GP) is responsible for making and managing investments with the money contributed by the LPs, who are generally passive.

Committed and called capital

Infrastructure investments are long term. During that time, your investment is largely illiquid. You cannot sell your investment in private infrastructure in the same way you can a publicly-traded stock or bond. 

However, private funds do not require the entire investment upfront. They take a “just in time” approach to collecting your money. Committed capital is the money you agree to invest in a fund throughout its life. Called capital is the money the fund manager collects from you as it makes investments. 

You get capital calls throughout the investment period, typically one to three years. This means you do not have to provide all the money upfront, but will need to have ready cash when there is a capital call. These calls can come with little notice and you need to respond quickly.

Fees in infrastructure funds

Private fund fee structures are different from the flat fees you pay for a mutual fund or an ETF. Designed to incentivize the fund manager to do their best, there are two types of fees, as well as some general expenses. We talk about this in more depth here, but in short…

Management fees

First, there is an annual management fee that covers most of the fund’s basic operating expenses. This typically includes salaries, office rent, legal and due diligence costs, and other administrative costs. This fee usually ranges from 1% to 2.5% of the capital you committed.

Performance fees

The fund manager also receives a share of the fund’s profits, commonly called carried interest or just “carry.” The standard carry is around 20%, but it may vary depending on the terms of the fund agreement. 

Carry is typically subject to a hurdle rate. This means that performance fees only start to accrue after investors get their capital back as well as the pre-approved hurdle rate. At this point, the GP receives 100% of returns until their carry matches what they would have received if the hurdle rate did not exist.

Aligning interests

As this performance fee structure makes evident, there is strong alignment of interests between investors and the fund managers.

Put simply, if a fund is successful, the manager profits. If not, they take the losses alongside their investors. Of course, we should note that management fees provide a small amount of income for the manager throughout the fund life.

Risks…

As with any investment - public or private - it is possible to lose your money. Similar to real estate, many infrastructure investments are hard assets that could be exposed to catastrophic risks, such as hurricanes, flooding, and other natural disasters.

By their nature, infrastructure investments are long term and illiquid. Before making an investment, investors need to determine how much money they are willing to lock up for the duration, which may be 10 years or more.

…and the rewards

Nevertheless, with careful fund selection, appropriate levels of diversification, and the support of the right partners, an allocation to private real infrastructure may have a role to play in a well-balanced portfolio.

Private infrastructure is a diversified and constantly evolving market, offering a variety of options for income generation and capital appreciation, as well as a potential hedge against inflation. It has the potential to usefully augment the income-focused component of a well-balanced portfolio. Infrastructure can provide diversification and, in conjunction with its limited correlation to public markets, enhance overall portfolio risk-adjusted returns.

Still curious about private markets? Click on the Fundamentals tab on our Insights.