Infrastructure: Alignment Still a Roadblock

Ashby Monk

Long time readers of this blog know that I’m fascinated by ‘long-term investment’ strategies. I guess I have a sincere belief that an institutional investor with an inter-generational time horizon can (if set up correctly) outperform short-term investors. (Technically, I think they can achieve a higher Sharpe Ratio, which is a slightly different concept but close enough for this medium.) There are a variety of reasons for this: I think long-term investors can minimize transaction costs, collect illiquidity premia, influence portfolio companies, capitalize on long-term tipping points, and price long-term risks into their portfolios, among other things. And, in my view, the investments that seem to make the most sense in this regard are in infrastructure.

As an asset class, infrastructure has high barriers to entry, economies of scale (e.g., high fixed, low variable costs), inelastic demand for services (creating pricing power), low operating cost, high target operating margins, and long duration (e.g., concessions of 25 years, leases of 99 years). These characteristics provide investors with uncorrelated returns and long-term, stable cash flows. Infrastructure also offers a good inflation hedge with low default rates. All these factors have made the asset class quite popular among institutional investors. Indeed, according to a Preqin survey released today, it appears investors are increasingly keen on this asset class:

“… institutional investor appetite for infrastructure is again on the rise, with 70% of surveyed investors expecting to make further investments in the asset class in the coming 12 months.”

That’s positive, but problems persist, as some potential investors in infrastructure remain on the sidelines. This has nothing to do with the underlying asset. Rather, it’s because of the the misaligned incentives associated with the typical infrastructure vehicles. Indeed, constraints from time-inconsistency to principal-agent problems are really preventing some investors from shifting their allocations towards this asset class (and leveraging their long-term advantages). And this fact also comes through in the recent Preqin results:

“…the current infrastructure fundraising market remains highly competitive and the same contentious issues continue to impact investor appetite and the ability of fund managers to raise capital…The management fee charged and how carried interest is structured remain two of the most prevalent areas in need of improvement, with 62% and 53% of investors citing each issue as a problem respectively. One investor commented: ‘Manager fees are far too high in most cases, and there are a number of conflicts of interest that can arise. Performance fees are often structured poorly, based on capital appreciation rather than performance above a hurdle.'”

Why are the private equity style fees and alignment of interests such a problem? I’ll let Mark Wiseman of the CPPIB (a voracious infrastructure investor) explain the problem:

“Given the gross returns tend to be around 10% to 12% to 14%, to invest in a fund does not make sense because of the fee on this type of deal. The operational complexity tends to be substantially lower…Put it this way, if you buy the New Jersey Turnpike, it was a turnpike 60 years ago, it’s a turnpike today and it’ll probably be a turnpike 60 years from now. The only change might be a new ticketing system. For a financial investor, it’s much easier to invest in an asset like that.

So, the private equity fee structure may be overcompensating managers as well as distorting their inventives. What’s an institutional investor to do? Well, they can start by reading this paper. They can then start thinking creatively about ways to align interests in this complex and difficult asset class.

1 Response to “Infrastructure: Alignment Still a Roadblock”

  1. 1 Cor August 26, 2011 at 5:40 am

    Maybe interesting to look at infrastructure investments in emerging markets. Apart from the benefits you mention, this would also be beneficial in light of the ‘big fish small pond’ problem ( i.e. looming emerging market public equity bubble.

    And while we’re at it, why not focus on emerging market low-carbon infra to mitigate climate tipping points? e.g. Asian Development Bank’s Climate Public Private Partnership fund ( (That Indian energy SWF should not be necessary!)

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This website is a project of Professor Gordon L. Clark and Dr. Ashby Monk of the School of Geography and the Environment at the University of Oxford. Their research on sovereign wealth funds is funded by the Leverhulme Trust and The Rotman International Centre for Pension Management.

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