The need for benchmarks of privately held investments in infrastructure may seem incongruous at first. After all, infrastructure projects are lumpy and highly idiosyncratic endeavors. If every infrastructure project is different, what can investors learn from a benchmark?
In modern finance, asset allocation is not about picking individual investments, but instead focuses on investing in groups of reasonably homogenous assets giving access to remunerated risk factors. The performance of each of these groups can be evidenced by a benchmark.
In effect, the narrative described above is also a model that describes the expected characteristics of the average investment in infrastructure. In turn, individual investments in specific jurisdictions, relying on one form or another of contractual or regulatory arrangement, may only have some or none of these characteristics.
However, assessing the opportunity to increase allocations to privately held infrastructure requires that investors understand the risks and performance to expect over time and in different economic environments, and that regulators understand the risks investors are taking.
None of these measures are currently available to long-term investors in infrastructure. Indeed, creating relevant performance measures is not without difficulties. Issues include the absence of readily available and comparable data, and the limitations of using listed proxies to benchmark lumpy and privately held financial assets like infrastructure equity or debt.
To achieve this objective, we have designed an action plan describing a series of applied research and data collection steps to arrive at the desired measures of infrastructure investment performance.
Benchmarking long-term investments in infrastructure requires a two-level approach, starting with underlying instruments and then documenting the behavior of different portfolios built with such instruments.
At the underlying level, five steps are necessary to clarify and document the performance of infrastructure financing instruments, both equity and debt:
1. Define the relevant financial assets
Improving the benchmarking and regulation of any type of investment first requires well-defined underlying instruments. As infrastructure investment is currently ill-defined, the first step of our roadmap is the creation of unambiguous definitions of financial instruments for long-term investment in infrastructure.
Indeed, infrastructure assets are not real assets but financial contracts. From an asset allocation perspective, industrial classifications such as “roads” or “power” are close to useless. A first solution to the absence of a widely agreed on definition of “infrastructure,” is to focus on project finance debt and equity as defined in the Basel II Accord. Other approaches to infrastructure investment at the underlying level must also be developed, as long as they refer to well-identified financial instruments (for example, the equity capital of certain types of regulated network operators).
2. Design adequate valuation and risk measurement methodologies
Once a clear and broadly accepted definition of underlying instruments is in place, adequate valuation and risk measurement methodologies that take into account the infrequent trading of most underlying infrastructure equity and debt can be developed.
By “adequate” we mean that such methodologies should rely on the rigorous use of asset-pricing theory and statistical techniques to derive the necessary input data, while aiming for parsimony and realism in data collection. The proposed methodologies should lead to the definition of the minimum data requirement (MDR), which is necessary to derive robust return and risk estimates.
3. Determine the data collection requirements
While ensuring theoretical robustness is paramount to the reliability of performance measurement, a trade-off exists with the requirement to collect real world data from market participants. In particular, proposed methodologies should aim to minimize the number of inputs in order to limit the number of parameter estimation errors.
Adequate models should also focus on using data points that are known to exist and are already collected/monitored, or could be collected reasonably easily. In all cases, data requirements should be derived from the theoretical framework, not the other way around.
In reality, the amount of available data initially will be limited both in scope, since not all types of infrastructure projects exist in large numbers, and by time frame, because infrastructure investments may have multi-decade lives and available records are unlikely to span such periods. Such data paucity can also be addressed if models are designed to allow for learning.
4. Standardize performance reporting
Standardizing infrastructure investment data collection allows for the emergence of an industry-wide reporting standard, which can be recognized by investors and regulators alike as best practice.
This reporting standard can increase transparency between investors and managers, who can be mandated to invest in a well-defined type of instrument and commit to report the relevant data. Adequate reporting will also maximize industry participation and reduce the cost of compliance.
5. Create a database of infrastructure equity and debt cash flows
Once the required data and a standardized reporting/data collection template is identified, a database of infrastructure project cash flows can be built to apply the methodologies mentioned above.
Initially, historical data can allow for documenting the past performance of well-defined infrastructure debt and equity instruments. Later, the ongoing collection of project cash flows can permit the production of regular updates of the known performance of such instruments over time.
Once the adequate valuation and risk measurement methodologies have been determined for a given type of financial instrument, and data collection and reporting have been standardized, the benchmarking of long-term infrastructure investments can effectively take place by focusing on the relevant performance measures at the portfolio level.
While a portfolio consisting of a representative basket of assets is the most intuitive benchmark, this approach is virtually impossible for investment in unlisted infrastructure debt and equity. Given currently available infrastructure investment vehicles, an investor cannot instantaneously buy a basket of assets that is representative of investable infrastructure projects in existence at that point in time.
It may be possible to invest in such a representative basket over time, but this may take several years, by which time what constitutes a representative basket of infrastructure investments is likely to have changed with the evolution of public procurement policies.
Therefore, the most useful long-term investment benchmarks are likely to be a combination of well-documented “building blocks” capturing systematic risk factors found in portfolios of infrastructure instruments. Such benchmarks can correspond to well-identified investment strategies and combine the performance of the different groups of financial instruments available in infrastructure finance to optimally achieve this explicit target strategy.
Frédéric Blanc-Brude is research director at EDHEC-Risk Institute and heads its thematic research program on infrastructure investment. Majid Hasan is a research assistant at the institute. This was an edited excerpt from a chapter in PEI’s newly released title “Infrastructure Valuation”, available at: peimedia.com/books
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